Thinking through your options
You may be compensated with more than just salary, fringe benefits and bonuses. Many people are rewarded with incentives like stock options, deferred compensation plans and restricted stock. These benefits come with complicated tax consequences, giving you perils to avoid and opportunities to consider.
Benefitting from incentive stock options
Stock options remain one of the most popular types of incentive compensation, and incentive stock options (ISOs) deserve special attention in your tax planning. If your options qualify as ISOs, you may be able to take advantage of favorable tax treatment.
ISOs give you the option of buying company stock in the future. The price must be set when the options are granted and must be at least the fair market value of the stock at that time. Therefore, the stock must rise before the ISOs have any value. If it does, you have the option to buy the shares for less than they’re worth on the market.
ISOs have several potential tax benefits
- There is no tax when the options are granted.
- Long-term capital gains treatment is available if the stock is held for one year after exercise and two years after the grant date.
- There is no tax when the options are exercised as long as the stock is held long enough to qualify for long-term capital gains treatment.
However, there is potential alternative minimum tax (AMT) liability when the options are exercised. The difference between the fair market value of the stock at the time of exercise and the exercise price is included as income for AMT purposes. The liability on this bargain element is a problem because exercising the option alone doesn’t generate any cash to pay the tax. If the stock price falls before the shares are sold, you can be left with a large AMT bill in the year of exercise even though the stock actually produced no income. Congress has provided some relief from past ISO-related AMT liabilities, and a new more generous AMT credit is also available. (Read more about the AMT credit.) Talk to a Grant Thornton advisor if you have questions about AMT-ISO liability.
If the stock from an ISO exercise is sold before the holding period for long-term capital gains treatment expires, the gain is taxed at ordinary income tax rates in a disqualifying disposition. The employer is entitled to a compensation deduction only if the employee makes a disqualifying disposition.
If you’ve received ISOs, you should decide carefully when to exercise them and whether to sell immediately or hold the shares received from an exercise. Waiting to exercise until immediately before the ISOs expire (when the stock value may be highest) and then holding on to the stock long enough for long-term capital gains treatment is often beneficial.
But acting earlier can also be advantageous in some situations
- Exercise earlier to start the holding period for long-term capital gains treatment sooner.
- Exercise when the bargain element is small or the market price is low to reduce or eliminate AMT liability.
- Exercise annually and buy only the number of shares that will achieve a break-even point between the AMT and regular tax.
But beware; exercising early accelerates the need for funds to buy the stock. It also exposes you to a loss if the value of the shares drops below your exercise cost and may create a tax cost if the exercise generates an AMT liability. If the stock price may fall, you can also consider selling early in a disqualifying disposition to pay the higher ordinary-income rate and avoid the AMT. Tax planning for ISOs is truly a numbers game. With the help of Grant Thornton, you can evaluate the risks and crunch the numbers using various assumptions.
Considerations for restricted stock
Restricted stock provides different tax considerations. Restricted stock is stock that’s granted subject to vesting. The vesting is often time-based, but can also be performance-based, so that the vesting is linked to company performance.
Income recognition is normally deferred until the restricted stock vests. You then pay taxes on the fair market value of the stock at the ordinary-income rate. However, there is an election under Section 83(b) to recognize ordinary income when you receive the stock. This election must be made within 30 days after receiving the stock and can be very beneficial in certain situations. (See Tax planning opportunity 8.)
Understanding nonqualified deferred compensation
Nonqualified deferred compensation (NQDC) plans pay executives in the future for services being performed now. They are not like many other traditional plans for deferring compensation. NQDC plans can favor certain highly compensated employees and can offer executives an excellent way to defer income and tax.
However, there are drawbacks. Employers cannot deduct any NQDC until the executive recognizes it as income, and NQDC plan funding is not protected from an employer’s creditors. Employers also must now be in full compliance with relatively new IRS rules under Section 409A that govern NQDC plans. The rules are strict, and the penalties for noncompliance are severe. If a plan fails to comply with the rules, plan participants are taxed on plan benefits immediately with interest charges and an additional 20-percent tax.
The new rules under Section 409A made several important changes. Executives generally must make an initial deferral election before the year they perform the services for the compensation that will be deferred. So, an executive who wants to defer some 2010 compensation to 2011 or beyond generally must make the election by the end of 2009. Additionally:
- Benefits must either be paid on a specified date according to a fixed payment schedule or after the occurrence of a specified event — defined as a death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.
- The timing of benefit payments can be delayed but not accelerated.
- Elections to change the timing or form of a payment must be made at least 12 months in advance of the original payment commencement date.
- New payment dates must be at least five years after the date the payment would have been made originally.
It is also important to note that employment taxes are generally due when the benefits become vested. This is true even though the compensation isn’t actually paid or recognized for income tax purposes until later years. Some employers withhold an executive’s portion of the tax from the executive’s salary or ask the executive to write a check for the liability. Others pay the executive’s portion, but this must be reported as additional taxable income.
