Planning is essential to optimize tax treatment for the many forms of executive compensation.
The varied forms of compensation in executive compensation plans lead to a myriad of income tax consequences, dependent on type and timing. There are also gift, estate and generation skipping transfer taxes to consider in your wealth plan. The following guide provides an overview of the tax treatments for common forms of executive compensation, including salary and bonus, stock options, stock awards and wealth transfers. As each situation is unique, you will want to work with your advisors to build a nuanced plan to address your specific needs.
At a glance
The table below outlines the U.S. federal income tax rules that apply to common forms of executive compensation.
Cash compensation: salary and bonus
Salary and bonus are taxed as ordinary income at the time of receipt. Federal income tax, state income tax and federal payroll tax apply.
Incentive Stock Options
Incentive stock options (ISOs) are not taxed at grant or exercise. Instead, tax is predicated on whether the disposition is qualified or disqualified. A qualified disposition is stock disposed (sold or transferred) more than two years from the grant date and more than one year after exercise. A disqualified disposition is one that does not meet the holding period requirements of a qualified disposition. Unlike NQSOs, ISOs are subject to a $100,000 annual exercisable grant limitation.
Non-qualified stock options
The most widely granted options are non-qualified stock options (NQSOs), which are taxed as ordinary income when exercised and receive capital gain/(loss) treatment upon sale.
Restricted stock awards
A restricted stock award (RSA) is payment in the form of restricted shares. An RSA transfers the stock to the recipient upon grant, subject to vesting restrictions. Unlike options, RSAs come with voting and dividend rights immediately since the recipient actually owns the stock upon grant. The fair market value of the stock is taxed as ordinary income when the restriction lapses (i.e., vests). Upon sale, subsequent gains/(losses) receive capital gains/(loss) treatment. Section 83(b) of the Internal Revenue Code permits recipients of an RSA to elect to pay ordinary income tax on the value of the stock at grant, with subsequent stock appreciation or loss being treated as long-term capital gain/(loss) upon sale.
Gift, Estate and Generation-skipping Transfer Taxes
The federal government imposes gift, estate and generation-skipping transfer taxes on the transfer of property during life and at death. The majority of states also impose an estate tax on transfers at death. Although you may reside in a state with no estate tax (i.e., Arizona, California, Colorado, Florida or Texas), if you own a vacation home in a state that imposes estate tax, part of your estate may be subject to state estate tax. With intentional planning and coordination with the income tax, you may optimize the use of available transfer tax exclusions and minimize the overall tax burden to you, your estate and beneficiaries.
Access the Northern Trust 2022 Federal Taxes Reference Guide for all current tax rates.