A Guide to Maximizing Corporate Executive Compensation
Optimizing equity-based compensation starts with understanding the scope of its intricacies.
As a corporate executive, your compensation differs from others in your company and is comprised of fixed base compensation, performance bonuses and long-term incentives with varied attributes, often accompanied by a jumble of acronyms. For example, one of the greatest benefits available to you is equity-based compensation, which is extremely advantageous to the growth of a wealth plan. But this advantage is not without complexity. Indeed, executive compensation plans are inherently complicated — much more so than merely owning stock and waiting for its value to appreciate. There are many details that require attention and understanding, including specific company retention guidelines, performance metrics, vesting and expiration periods. And once these are addressed, it is imperative to balance your short- and long-term liquidity needs in consideration of securities laws and income taxation while also accounting for the impact market volatility has on stock valuation.
You may have access to some, all or a hybrid of the compensation arrangements discussed here. Although your employment agreement and company’s policy will dictate the specifics to which you must adhere, take the time to understand the basic tenets surrounding the technical aspects and attributes of each offering. Doing so will help ensure that you maximize pertinent wealth planning strategies to meet your unique financial goals. To determine the best strategies and courses of action, you will likely need to engage in ongoing discussion with your trusted advisors.
By far, your salary and short-term incentives are likely to pale in comparison to the wealth you stand to acquire from long-term incentive programs and equity-based compensation. However, salary and short-term incentives are the most predictable aspects of your compensation plan, and neither rests on stock valuation or vesting. Although base compensation and bonuses do not necessarily require specialized planning, take advantage of the certainty they provide. Consider how best to utilize them for financial objectives:
- build cash reserves to establish liquidity in your portfolio;
- minimize mortgage debt on your primary home or vacation property;
- fund a 529 Plan for future education costs;
- elect to defer a portion of compensation in your company’s deferred compensation plan;
- pay the premium on an individual life insurance or disability income policy separate from your company; or
- establish a charitable gifting plan for the causes and organizations important to you.
It is important to remember that if you are an executive of a public company, details of your compensation package will be made public due to the U.S. Securities and Exchange Commission (SEC) mandate for full disclosure of executive compensation. As you tackle complex planning issues, be mindful of perceived ethical concerns as the pay gap between non-management employees and executives widens, and be willing to take an informed, principled approach to any pay equity inquiries you may face internally or externally. Likewise, be prepared to address privacy issues you or your family may be exposed to due to the public disclosure of your compensation.
Stock options are a popular form of incentive compensation. Companies generally impose a vesting schedule on both ISOs and non-qualified options, seemingly making you earn an option twice — initially upon grant and later when it eventually vests. Further, the tax treatment hinges on the holding period and, generally, where the income was earned from grant to vesting date. For these reasons, it is important to understand the technical aspects and attributes of each option granted during your tenure to determine how future exercise of the option and disposition of the underlying stock will impact your wealth.
TAX TREATMENT UPON EXERCISE: FEDERAL AND STATE TAX CONSIDERATIONS
Building on the framework above, for ISOs and non-qualified options there is no tax upon issuance or vesting. Instead, tax is deferred until the option is exercised. For ISOs, the difference between the strike price and the value on the exercise date will be included in the alternative minimum taxable income. For non-qualified stock options, the difference between the strike price and the value on the exercise date will be subject to ordinary federal income tax, state income tax and federal payroll tax.
State income tax is simple to calculate if the stock option is granted, vests and exercised all in the same state. Issues arise when an executive is granted a stock option while living and working in one state but later vests in another state. Although the income is realized in the future for federal tax purposes, most states require income to be sourced where it is earned. Prior to vesting and exercising an option, undertake careful planning to anticipate a potential state tax hit given your future mobility and residency.
TAX TREATMENT UPON DISPOSITION
When the underlying stock from an option is eventually sold, the tax treatment is similar to that of stocks acquired in a traditional manner. To determine short- or long-term capital gain treatment, the holding period will begin on the exercise date and the cost basis will be the value on that date. Any appreciation (or decrease in value) will be treated as short-term capital gain (or loss) if the stock is held for less than one year, or long-term capital gain (or loss) if held for one year or more.
There is an important distinction for stock received from the exercise of an ISO. In addition to the one-year holding period rule, in order to receive long-term capital gain treatment there is a two-year holding period requirement from the date of the grant. If the stock is sold within two years of the grant, the difference between the strike price and the value on the exercise date will be taxed as ordinary income. It is also important to note that for ISOs cost basis could be different for AMT and regular tax purposes.
FOR MORE INFORMATION
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If you would like to learn more about these and other services offered by Northern Trust, contact a Northern Trust professional at a location near you or visit us at northerntrust.com.
Suzanne L. Shier
Wealth Planning Practice Executive & Chief Tax Strategist/ Tax Counsel
August 28, 2019
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