Executive Tax Consulting Services
Executive tax planning involves understanding the economic, risk, and opportunity characteristics of alternative courses of action. Income tax rates, amounts, and timing can vary drastically depending on choices made. The role of the executive tax consultant is to illustrate the potential tax results and place them into perspective as important components of the final decisions.
Generally, any economic benefit that an executive receives from his or her employer is taxed as salary subject to ordinary income taxes and payroll taxes. The value is included in taxable wage income reported on the executive’s annual Wage and Tax Statement, IRS Form W-2, and the executive pays income tax and payroll tax withholding. Tax strategies include deferring income to later years, converting income from ordinary to capital gains, and avoiding payroll taxes.
Incentive Stock Options (ISO) and Employee Stock Purchase Plans (ESPP)
Incentive stock options and ESPP allow executives to purchase stock in their company for a price (“Strike Price”) that is lower than the trading price (Fair Market Value, or "FMV"). The discount is called the “Bargain Element”. There is no tax* on the Bargain Element until the stock is later sold by the executive.
If the executive sells the stock after more than 12 months, the gain is a long-term capital gain and not subject to payroll taxes. However, for ESPP stock where the FMV at grant date was more than the strike price, that difference will be ordinary “salary” income. A special rule exempts this additional salary income from Social Security, Medicare, and federal income tax withholding.
If the stock is sold by the executive 12 months or less after exercise, the bargain element is treated as salary income subject to ordinary, not capital gains, income tax rates. Any additional gain is short-term capital gain, which is also taxed at ordinary income tax rates. A special rule exempts this salary income from Social Security, Medicare, and federal income tax withholding.
The key time frame is how long the stock is held after options are exercised to purchase the stock. It doesn’t matter how long the options are held before they are exercised.**
*Alternative Minimum Tax (AMT): Unfortunately, in the year of exercise the Bargain Element is taxable income for AMT (unless the stock is sold that same year). However, this AMT income is reversed in the year the stock is eventually sold, typically resulting in a refund or credit of AMT previously paid. AMT is primarily an issue when the options are exercised in one year and the stock is sold in a subsequent year.
* * Early exercise will generally disqualify the options and/or plan, but plans prohibit early exercise so it is not a concern from the executive’s perspective.
Non-Qualified Stock Options
Like ISO’s, Non-Qualified Stock Options (NSO’s, a.k.a. NQSO’s) allow executives to purchase stock in their company for a price ("Strike Price") that is lower than the trading price (Fair Market Value, or “FMV”). Unlike ISO’s, the discount (“Bargain Element”) is taxed as ordinary salary income immediately upon exercise. At that point income tax withholding and payroll taxes are due, and typically some of the stock is immediately sold (“same-day sale”) to cover these costs. The difference between trading price (Fair Market Value, or “FMV”) at exercise and at the time the stock is sold is a capital gain or loss. Even in same day sales the price can differ slightly from the time of exercise to the time of sale and result in a small capital gain or loss.
Since the bargain element is not tax-deferred, there is no Alternative Minimum Tax (AMT) adjustment for that amount. Therefore, Non-Qualified Stock Options do not cause the type of AMT problem that one encounters with ISO's.
If the stock is received subject to restrictions, a Section 83(b) election can be made to save taxes on future appreciation (see below).
Restricted Stock
Restricted stock functions similarly to Non-Qualified Stock Options. When stock is transferred to an executive subject to restrictions, there is no taxable income to the executive until the restrictions lapse. At that point, the difference between the amount the executive paid and the Fair Market Value (FMV) is taxed as ordinary salary subject to income tax withholding and payroll taxes.
If it is expected that the value of the stock will increase significantly after the shares are acquired, the executive can make an election under Internal Revenue Code § 83(b) to pay tax based on the FMV at a date earlier than the date that the restrictions lapse. Although this results in paying tax earlier than would otherwise occur, further appreciation would then be capital gains income not subject to payroll taxes.
Non-Qualified Deferred Compensation / Rabbi Trust
An executive compensation plan that allows executives to choose to have a portion of their salary put into a special trust is often referred to as a Rabbi Trust. The executive does not pay tax on the income until it is paid out of the trust to the executive in a future year. The risk is that if the company goes bankrupt, the assets of the Rabbit Trust can be used to pay the company’s creditors and the executive will never receive the income.
Tax Projections
Sophisticated tax planning software can be used to perform what-if scenarios to see the impact of various alternatives on current and future years’ tax liabilities. Combined with qualitative factors, this allows the executive to make well-informed decisions to save taxes and maximize long-term wealth.
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