Significant recent societal and economic changes require thoughtful navigation for institutions and individuals, including executives. The following strategies can help you plan in an evolving landscape.
Vaccine distribution, improving global COVID-19 data and, by some measures, an increasingly optimistic economic outlook suggest that we are emerging from one of the greatest periods of uncertainty in recent memory. Yet as with other momentous events in history, meaningful changes have taken place — requiring organizations and individuals alike, including executives, to navigate new dynamics. Most fundamentally, the medical and economic fallout of the pandemic remains unknown. Concurrently, certain increasingly prevalent corporate practices — namely, linking executive compensation to environmental, social and governance (ESG) criteria — are also making it more difficult to forecast future compensation. And recently, the potential for higher taxes in light of political outcomes has complicated decisions around equity-linked incentives, deferred compensation and other planning decisions.
We continue to advise clients to “plan, don’t predict” and, to that end, we have found the following strategies valuable in recent discussions with numerous executive clients. Work with your advisors to determine the best course of action given your unique circumstances and goals.
Mitigate concentration with a disciplined, tax-aware approach.
Develop or revisit your strategy to reduce concentration in your company while being mindful of stock holding requirements and insider trading restrictions. This could include:
- Realize capital gains when necessary to fund goals or manage risk. President Biden’s initial tax policy plan calls for treating all capital gains (short- and long-term) and dividends as ordinary income for investors earning more than $1 million and doubling the rate at which they are taxed, from 20% to 39.6%. While the likelihood of this scenario remains uncertain, consider whether it makes sense to realize capital gains in 2021 at the current, lower long-term capital gains tax rate.
To understand how tax changes could impact your future wealth, work with your advisors to model how various scenarios could impact your goals. Our analysis indicates that, under the Biden plan, realizing gains in 2021 at the current, lower longer-term rate could make sense for positions intended to fund near- and intermediate-term goals.
- Execute a Rule 10b5-1 Plan, approved by your company and executed in accordance with SEC law, to divest your concentration position in a systematic manner and avoid unfavorable optics around selling your shares.
- Satisfy charitable giving goals by contributing low-basis stock to a public charity, donor advised fund, private foundation or charitable remainder trust. You can contribute long-term appreciated stock directly to a charity without paying any capital gains on the fair-market value. The tax rules have many nuances, but with proper planning you may benefit from a significant charitable income-tax deduction.
- Invest in separately managed equity portfolios focused on tax-loss harvesting that track designated indices excluding your company’s stock and other stocks highly correlated with it.
Evaluate your wealth transfer plans in light of the current wealth planning trifecta.
If you have determined you will be able to transfer significant assets to future generations, consider employing techniques that are especially effective in the current environment of low interest rates, high exemption amounts and uncertain future tax policy. These include:
- Grantor retained annuity trusts (GRATs): A GRAT is a type of trust designed to transfer property to beneficiaries with little or no gift taxes. If structured properly, the amount transferred to the GRAT is not counted against your allowable lifetime gift exemption. Additionally, any return above the applicable interest rate in effect when the GRAT is funded passes to its remainder beneficiaries with no further gift tax consequences. Today’s interest rate is near the historic low, making this an ideal time to create a GRAT.
For executives, GRATs can be particularly valuable, as they can be funded with non-qualified stock options, stocks or units in an LLC that holds company interest. A “successful” GRAT may be frozen prior to the end of the annuity term by substituting cash or fixed income assets for shares that have appreciated in the GRAT. Note that GRATs can be part of an effective strategy for planning in advance of an IPO or private sale.
While GRATs were not addressed as part of the 2020 presidential campaign, they are likely to be a topic of debate if Congress begins considering tax law changes to raise revenue. In 2016, the Obama administration’s budget proposal included many provisions to curtail the use and the effectiveness of GRATs. If considering a GRAT, it may be prudent to consider implementing this strategy before these proposals resurface.
GRAT Appreciation in Lower Interest Rate Environments
Distribution amount to beneficiaries in 5 years assuming GRAT funded with $5 million and experiences a 7% growth rate.
- Lifetime gifts: The Tax Cuts and Jobs Act of 2017 doubled the lifetime gift and estate tax exclusion amount from $5 million to $10 million, adjusted for inflation ($11.7 million for individuals and $23.4 million for married U.S. couples in 2021). This provision is scheduled to sunset on December 31, 2025, at which time it will decrease back to $5 million (indexed for inflation). However, President Biden has indicated that he would like to return estate taxes to “historical norms” — which could indicate higher tax rates and a lowering of the higher exemption sooner than its planned expiration, perhaps to as low as $3.5 million.
Regardless of whether you decide to pursue the benefit of this “bonus” amount while it is available, gifting during your life allows you to transfer appreciation out of your estate gift-tax free. However, because this decision rests on your ability to fund your lifetime goals, you should work closely with your advisor to understand your capacity to afford such gifts.
Decide whether to defer compensation in light of risks and uncertain future tax policy.
Deferring compensation and the corresponding tax liability into the future may be advantageous if you do not need the income to fund near-term goals. However, deferring less this year into your non-qualified compensation plan could be prudent. Recall that income deferred under these plans is sheltered from individual income tax (but not payroll tax) when earned and later taxed when received. The possibility of higher future income tax rates makes this a less attractive option if needed to fund near-term goals.
Also, remain aware that your company’s non-qualified deferred compensation plan is essentially an unsecured obligation of your company. Before deciding whether to participate in it, assess the financial strength of your company, evaluate the diversity of your portfolio and calculate your anticipated liquidity needs.
Further, if you plan to relocate, consider state tax implications. Federal tax rules dictate whether a state may tax a distribution. If you elect a distribution period of less than 10 years, income will be taxed in the state earned. On the other hand, if you elect a distribution period of 10 years or more, then each distribution will be subject to state tax in the state of domicile upon receipt.
Assess the benefits of an IRS §83(b) election for eligible restricted stock.
It is becoming increasingly common for public companies to grant restricted stock or RSUs rather than stock options. Upon vesting, the value of stock is subject to ordinary federal income tax, state income tax and federal payroll tax. For stock expected to significantly appreciate, consider the potential benefits of a Section 83(b) election of the Internal Revenue Code, which permits payment of the tax liability at time of grant versus when the shares vest at a future date. The potential tax savings from this election are always worth considering, but may be even greater this year given the increased possibility of higher future income tax rates.
Remain aware that there is a risk that the stock price could decline in the future, or worse, conditions are unsatisfied and vesting never occurs. For this reason, understand the potential risk of a Section 83(b) election before you pay tax on value that may never materialize. Further, if capital gains tax rates rise, the potential economic benefits of an 83(b) election may diminish.
To illustrate the mechanics of a Section 83(b) election, consider the following. Assume an executive is awarded restricted stock in 2021, which will vest in 2026.
- At the time of the award the stock has a value of $100,000.
- Upon vesting the stock has a value of $125,000.
- The executive sells the stock in 2027 when it is valued at $175,000.
If the executive makes a Section 83(b) election, the executive will pay ordinary income tax on $100,000 for the year of grant. Upon vesting, no tax is owed on the appreciation value of $25,000. However, when the stock is sold, the executive will owe long-term capital gains tax on the entire stock appreciation in the amount of $75,000 ($175,000 fair market value at sale, less $100,000 cost basis).
No 83(b) Election
If the executive decides not to make a Section 83(b) election, the executive will pay ordinary income tax on $125,000 — the value of the stock when it vests. When the stock is later sold, the executive will owe long-term capital gains on $50,000 ($175,000 fair market value at sale, less $125,000 cost basis).
Run a wider range of financial planning scenarios to understand your shortfall risk.
To achieve greater confidence that you will be able to fund your goals, work with your financial advisor to model the impact of a broader range of future income streams on your planned outlays. This will provide clarity on your shortfall risk: the probability that you will fall short of funding your lifetime consumption. You can then reprioritize your goals if needed and optimize decisions about asset allocation and wealth planning techniques. At Northern Trust, we use a goals-based framework that allows you to easily model a range of scenarios, evaluate tradeoffs and uncover new opportunities to improve your plan.
The above are only examples of strategies that can be implemented to optimize your plan during this time of heightened uncertainty. To determine the best strategies for your specific circumstances and take advantage of the current wealth planning trifecta, please reach out to one of our advisors and explore additional planning advice for executives.