Year-end tax guide: Executive compensation

2015 Year-end tax guidePay packages are getting more sophisticated all the time. Managers, executives and owners of both private and public companies should be thinking creatively to attract top talent. But you also should understand the tax consequences of your own options, deferred compensation plans and restricted stock grants.

Q: What’s the difference between restricted stock and stock options?
Stock options give you the option of buying stock at a set price and become valuable when the value of the stock exceeds the price. Restricted stock is granted and vests once certain conditions are met.

Q: Should I make a Section 83(b) election?
An election under Section 83(b) can convert future appreciation from ordinary income into capital gain. The biggest drawback is that you can’t get a refund of any taxes from the election if you forfeit the stock or the value decreases. You can make an 83(b) election for restricted stock but not for stock options.

Q: Do I have to disclose executive pay?
There are a number of new reporting requirements and required shareholder votes on executive pay for public companies. Private companies are not subject to these rules.

Benefiting from incentive stock options
Incentive stock options (ISOs) (click for definition) remain one of the most popular types of incentive compensation. If your options qualify as ISOs, you can take advantage of favorable tax treatment.

ISOs offer several tax benefits:

  • There is no tax when the options are granted.
  • There is no regular income tax when the options are exercised.
  • Long-term capital gains treatment is available on the entire appreciation if the stock is held for at least two years after the options grant date and one year after exercise.

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 potential AMT 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 ultimately sold, you can be left with a large AMT bill in the year of exercise even though the stock actually produced no income. And if you dispose of the stock too early in a disqualifying disposition (before the holding periods described previously), the gain will be ordinary income.

If you’ve received ISOs, you should decide carefully when to exercise them and whether to sell the shares immediately or hold them. Acting earlier can be advantageous in situations like the following:

  • 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 be careful, because 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 price and may create a tax cost if the exercise generates an AMT liability. Tax planning for ISOs is truly a numbers game. With the help of a Grant Thornton professional, you can evaluate the risks and crunch the numbers using various assumptions.

Business perspective: ISOs come with employer costs
The tax benefits of ISOs for employees make them attractive for executives, but they can be less useful to the employer because of the following:

  • The employer receives no income tax deduction for ISOs unless the employee makes a disqualifying disposition.
  • There is a per-employee limit of $100,000 on the amount of ISOs that can first be exercised for the employee during any one year. The limit is based on the value of stock at the grant date.  

ISOs also come with a long list of restrictions:

  • They may be granted only to employees, not board members or contractors.
  • The exercise price cannot be less than the fair market value of the stock at the time the option is granted.
  • The option term cannot exceed 10 years from the date the option is granted.
  • The option can be exercised only by the executive and cannot be transferred to anyone else except upon the executive’s death.
  • At the time the option is granted, the executive cannot own more than 10% of the total combined voting power of all classes of stock of the employer, unless the exercise price is at least 110% of the fair market value on the grant date and the option term does not exceed five years.
  • The option plan must be approved by the employer’s stockholders within 12 months before or after the date the plan is adopted.

Considerations for restricted stock
Restricted stock, which is granted subject to vesting, presents different tax considerations. The vesting is often based on time but can also be based on company and individual performance.

Normally, income recognition is deferred until the restricted stock vests. You then pay taxes on the fair market value of the stock as of the vesting date at the ordinary income rate. There is an election under Section 83(b), however, to recognize ordinary income when you receive the stock based on its value at the time rather than waiting until it vests. This election must be made within 30 days after receiving the stock, and it means that no income is recognized when the stock vests. You recognize income again when the stock is sold and it is treated as capital gain. This deadline is statutory, and the IRS doesn’t offer relief for missed elections for any reason, including reasonable cause. So if you want to make the election, be sure to act fast.

Business perspective: Tie performance to pay with restricted stock
Restricted stock has emerged as a useful tool for providing executive compensation and long-term incentives. In the past, investors and shareholder activists often considered restricted stock  to be a giveaway.  But the vesting of restricted stock doesn't have to be based on time – it can instead be linked to company performance. In the brave new world of executive compensation, performance shares can be a key component to link pay to shareholder interests.

Performance shares link the vesting of restricted stock to company and individual performance. Restricted stock gives employees the option to control taxation with a Section 83(b) election. And the strategy benefits from a number of potential approaches to develop meaningful but achievable performance goals that motivate participants and drive shareholder value:

  • Market performance: Based on meeting a specified target such as stock price.
  • Operational performance: Based on specified operational goals such as increasing operating profits.
  • Absolute performance: Based on absolute performance such as targeted growth or return percentage.
  • Relative performance: Vesting occurs if performance measures are above those of a peer group.
  • Balanced scorecard: Considers both quantitative and qualitative or strategic performance.
  • Corporate focus: Vesting occurs only if corporate goals are achieved.
  • Business unit focus: Vesting conditions are specific to individual business units.

Restricted stock units
You may have found a new element in your pay package recently. Many companies are now granting multiple stock-based incentives, and restricted stock units (RSUs) are growing in popularity. RSUs differ from the restricted stock awards. An RSU is a promise made to an employee to transfer stock in the future and is generally subject to the nonqualified deferred compensation (NQDC) rules under Section 409A (described in the next section).

While restricted stock is generally taxable upon vesting, RSUs are not included in income until the stock is transferred. In other words, the vesting of an RSU is not a taxable event. Instead, the actual transfer of the stock is taxable. Many employers let employees choose when to receive the stock, resulting in tax planning opportunities for individuals. You should think carefully about the best time to receive the stock and recognize the income. The timing election isn’t necessarily all or nothing. You could elect to receive some of the shares now and some later. Consider timing your transfers to avoid tax benefit phaseouts.

Understanding nonqualified deferred compensation
NQDC plans are designed to make payments to employees in the future for services being performed now. But they don’t have the restrictions of qualified retirement plans like 401(k)s. Specifically, NQDC plans can favor highly compensated employees and offer executives an excellent way to defer income and tax.

There are drawbacks, however. Employers cannot deduct any NQDC until the executive recognizes it as income, and NQDC plan funding isn’t protected from an employer’s creditors. Also, employers must be in full compliance with IRS rules governing NQDC plans under Section 409A. 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 vested plan benefits immediately, with interest charges and an additional 20% tax.

Employees generally must make an initial deferral election before the year in which they perform the services for the compensation that will be deferred. So if you want to defer 2016 compensation to 2017 or beyond, generally you must make the election by the end of 2015. Additionally, the following rules apply:

  • Benefits must be paid either on a specified date according to a fixed payment schedule or after the occurrence of a specified event — defined as death, disability, separation from service, change in ownership or control of the employer, or an unforeseeable emergency.
  • The decision about when to pay the benefits must be made at the same time the election to defer the compensation is made.  
  • Once that decision is made, the timing of benefit payments can be delayed, but generally cannot be accelerated.
  • Elections to delay the timing or change the form of a payment must be made at least 12 months before the date the original payment commences.
  • 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 generally are due when the benefits vest. This is true even though the compensation isn’t actually paid or recognized for income tax purposes until later years. Employers can postpone the payment of these payroll taxes only when the value of the future benefit payments cannot be ascertained, which is often the case when the plan uses a formula to define the future benefit rather than basing the benefit on an account balance.

Business perspective: Privately held business strategies
Privately held businesses often face different executive compensation challenges. Many owners want to give key employees and managers the benefits of equity ownership without actually giving up any share of their ownership.

If you have a privately held business, consider a phantom stock plan or a performance-based cash payment plan. They offer opportunities for your company to share the economic value of an equity interest without the equity itself. A typical phantom stock plan simply credits selected employees with stock units that represent a share of the firm’s stock. Essentially, it is a promise to pay the employee the equivalent of stock value in the future. Alternatively, a stock appreciation right (SAR) can be issued to provide an employee with a payment equal to only the appreciation in the stock value between the date the right is granted and some future date, rather than the full value of the stock.  

You can value your stock by a formula or by formal valuation. The phantom stock or SAR can be awarded subject to a vesting schedule, which can be based on performance or time. A phantom stock plan must comply with restrictions on NQDC unless the employee is paid for the value of the phantom stock shortly after vesting. The same holds true for SARs. But unlike phantom stock, SARs can meet certain other conditions that exempt them from the restrictions on NQDC.  

Performance-based cash payment plans similarly promise employees a cash bonus in the future if performance goals are met.

Eddie Adkins
T +1 202 521 1565

All FAQs
Terms and definitions
Download the PDF

<< Previous pageNext page >>

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.