Compensation plans have evolved and expanded in recent years as employers seek to attract top talent. In fact, CEO compensation has soared 1,322% since 1978, according to Economic Policy Institute (EPI). EPI also reports that in 2020, CEOs earned 351 times more than a typical American worker. As an executive or key employee, your compensation package may include a mix of salary, annual and long-term incentives, equity, and other benefits. Indeed, your compensation plan can be very valuable. However, tax consequences for executive compensation plans can also be complex and significant. Therefore, careful tax planning is essential for executives and other high-earning professionals.
Qualified Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs) allow you to buy company stock in the future before a set expiration date at a price that’s equal to or greater than the stock price on the date of the grant. In other words, ISOs are only value if your company stock appreciates in value. If you’re eligible to exercise your options, you can then purchase company stock at a discount for an immediate profit.
ISOs receive tax-favored treatment but also come with a strict set of guidelines. Key tax considerations include:
- You owe no tax when your employer grants you the ISOs.
- There’s no ordinary income tax liability when you exercise the ISOs. However, profits are included in alternative minimum taxable (AMT) income.
- If you hold on to the stock for at least one year after exercising the ISOs and two years after the grant date, you pay your long-term capital gains rate on any gains. You also may owe the Net Investment Income Tax (NIIT). The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates and trusts that have income above the statutory threshold amounts.
- If you sell the stock before the long-term capital gains tax applies, any gains are taxed at your ordinary income tax rate. However, short-term gains aren’t subject to FICA and Medicare tax.
If ISOs are included in your executive compensation package, be sure to consult a tax professional or financial planner as rules and tax minimization strategies can be complex. Plus, market movement and company-related risks can affect the value of your options. Lastly, the timing of when you exercise your ISOs can affect your ordinary income tax rate and capital gains rate. It can also potentially subject you to the NIIT.
Non-Qualified Stock Options
Like ISOs, you typically don’t owe any taxes when your employer issues the Non-Qualified Stock Options (NQSOs). However, NQSOs are taxed as ordinary income when you exercise them, regardless of how long you hold the stock afterwards. Additionally, NQSOs don’t create an AMT preference item.
In some cases, you may need to make estimated tax payments or increase withholding to cover the taxes associated with exercising these options. And depending on when you exercise your NQSOs and the payoff, you may move into a higher tax bracket. This could potentially trigger the additional 0.9% Medicare tax and the NIIT.
Restricted Stock Units (RSUs)
If your executive compensation package includes restricted stock units (RSUs), it’s important you understand your vesting schedule and any holding requirements. For example, you may be on a five-year vesting schedule where 20% of your RSUs vest each year. The market value of your shares at the time of vesting is considered taxable income in that year. That amount is subject to your ordinary income tax rate.
Alternatively, you can make a Section 83(b) election to recognize ordinary income when you receive the stock. You must make this election within 30 days of receiving the RSUs. If you do, you can recategorize potential future gains from ordinary income to long-term capital gains. This also defers your tax liability until you sell the stock.
A Section 83(b) election typically makes most sense when the income at the grant date is negligible. It may also be beneficial if you expect the stock to appreciate significantly in the future. However, like ISOs and NQSOs, recognizing the income up front can push you into a higher tax bracket and trigger additional taxes, including the NIIT.
Non-Qualified Deferred Compensation (NQDC)
Many employers offer Non-Qualified Deferred Compensation (NQDC) plans as part of their executive compensation package. These plans allow you to delay paying taxes on a portion of your income. If you’re currently maxing out your other retirement savings plans, deferring a portion of your income might make sense. By doing so, you’re assuming your tax bracket will be lower in the future.
There are a number of factors you should consider before opting in to an NQDC plan. For one, you should be reasonably confident your employer is financially secure, so they can honor their future obligation. You’ll also need to decide how much of your compensation you can afford to defer and when to take distributions.
In addition, while opting in to an NQDC plan defers your income, your employer will likely owe payroll taxes when you perform services. That means your employer may withhold part of your salary or ask you to write a check to cover your portion of the liability. On the other hand, if your employer pays the tax for you, that creates additional taxable income for you.
A Trusted Advisor Can Help You Maximize Your Executive Compensation Package
Indeed, your executive compensation package can be extremely valuable. However, exercising your options at the wrong time or failing to understand the rules associated with your compensation plan can lead to excessive tax consequences. Be sure to work with a trusted advisor who understands the complexities of these plans, so you can maximize your net income.
Milestone Asset Management Group specializes in financial planning for high-earning professionals and executives. We have a full suite of CPAs and tax attorneys in house who stay current on tax laws and tax minimization strategies. If you’d like to speak with a member of our team about maximizing your income and preserving wealth long-term, please schedule an introductory call.