Executive Compensation & Tax Consequences
If you’re an executive, you may receive some or a majority of compensation in the form of equity, typically company stock or some derivative form of company stock such as restricted stock, restricted stock units (RSU’s) or stock options. The tax consequences of these types of compensation can be complex and are subject to ordinary income, capital gains, employment and other types of taxes. Please note that our discussion for the purposes of this blog provides an overview of certain forms of executive compensation, and is not intended to be comprehensive review of all types of executive compensation.
Restricted Stock refers to shares in a company that are issued to an employee as part of his/her pay, subject to a substantial risk of forfeiture until certain conditions have been met. Normally, when an employee becomes substantially vested in the restricted stock, the employee pays tax on the stock’s fair market value (FMV) over any amount paid for the stock at the employee’s ordinary income rate; but you can choose to make an IRC Section 83(b) election to recognize ordinary income on the fair market value when you receive the stock. This election must be made within 30 days of receiving the stock and can be quite beneficial if the income at the grant date of the stock is not substantial or if the stock has a lot of room for appreciation. This election allows you to convert future appreciation from ordinary income to long-term capital gain income while also allowing you to defer recognition of future appreciation until the stock is sold.
You should be aware that there are some disadvantages to the Section 83(b) election in that you must pay tax in the current year, and the taxes you pay cannot be refunded even if you eventually forfeit the stock or sell the stock at a discounted value. However, you still have the ability to realize a capital loss when the stock is forfeited equal to the excess of the amount paid for the property over any amount realized upon the forfeiture.
RESTRICTED STOCK UNITS (RSU’s)
RSU’s are contractual rights that employees have in order to receive an amount of compensation (payable in cash, stock or other property) based upon the value of the company stock once the award has vested. Unlike Restricted Stock, the Section 83(b) election is not available for RSU’s as a means to convert ordinary income to capital gains; however, you would still have the ability to defer income taxes. Unlike Restricted Stock that becomes taxable immediately upon vesting, RSU’s aren’t taxable until the employee receives the compensation. The employee can arrange for the employer to delay the delivery of the stock rather than receiving it immediately upon vesting. All income deferral must satisfy certain requirements of the Internal Revenue Code provided under Sec. 409A.
Under the 2017 Tax Cuts and Jobs Act, Congress provided certain employees who receive employer stock in connection with the exercise of stock options or in connection with the settlement of RSU’s the ability to defer recognition of income for up to five years. This election is referred to as a qualified equity grant. To be eligible, a corporate employer must meet several requirements including providing a written plan under which no less than 80% of all employees who provide services in the U.S. are granted stock options or RSU’s. An election to defer income with respect to the receipt of stock obtained from a qualified equity grant must be made not later than 30 days after the employee’s right to the stock is substantially vested or is transferable, whichever is earlier.
INCENTIVE STOCK OPTIONS (ISO’s)
ISO’s allow an employee to buy company stock in the future at a fixed price equal to or greater than the stock’s FMV at the date of the grant. ISO’s are tax favored in that there is no tax when the stock options are granted, and generally there is no tax when the employee exercises the ISO’s (although the exercise could trigger an alternative minimum tax (AMT) liability). When the employee sells the stock after holding the shares for at least one year from the exercise date and two years from the grant date, the employee is taxed at the long-term capital gains rate on the sale. If, however, the stock is sold before long-term capital gains tax treatment kicks in, the gain recognized is treated as ordinary income. Employees need to plan carefully when they want to exercise the ISO’s and when determining whether they intend to sell or retain the shares. With the market risk to consider, the timing of ISO exercises and stock dispositions can positively or negatively affect your regular tax, AMT and net investment income tax (NIIT) liabilities.
NONQUALIFIED STOCK OPTIONS
An employee may be granted stock options as compensation for services rendered, and certain rules apply when options are granted and exercised. While generally there is no tax liability at the time of grant (unless the options are publicly traded), you typically pay ordinary income tax on the difference between the fair market value of the stock on the date of exercise and the price at which you exercise the option; and upon the sale or other disposition of these options, the taxpayer recognizes ordinary income equal to the consideration received.
It is of utmost importance to exercise careful planning when it comes to executive compensation elections, particularly in terms of fully understanding the tax implications of all options made available to you. In some cases, for example, you may need to ensure that you either make higher estimated tax payments or increase your withholding amounts to fully cover the tax on the exercise of certain stock options. You should also be aware that the tax basis of property received as executive compensation will need to be adjusted following a recognition of income upon the substantial vesting of restricted stock, the payment of compensation upon the vesting of RSU’s as well as upon the occurrence of other taxable compensation events.
Here at FF&F our experienced staff will advise you of the advantages and disadvantages of executive compensation alternatives in light of your particular circumstances enabling you to make informed decisions. For more information on this topic, or to discuss other tax-related matters, please contact us at firstname.lastname@example.org or (212) 245-5900.
Samuel Kang, CPA, MST has 9 years of experience in public accounting as a tax practitioner with expertise in high net worth individuals, closely held businesses, trusts, partnerships, and S-corporations.