Corporate executives need to plan carefully for tax efficiency. Their W-2 income is subject to high tax rates with few available deductions. Their compensation packages also tend to include other types of income such as stock compensation, large bonuses, commissions, and more, which are typically paid outside the routine payroll cycle and may be taxed at different rates. Plus, equity compensation can create a tax liability without a corresponding cash inflow.
Considering that bonuses and equity compensation can often exceed the executive’s salary, taxes can be significantly under-withheld on a large portion of their income and this shortfall can result in a very large tax liability in April. Strategic tax planning and tax-efficient investment strategies are critical for corporate executives who want to avoid overpaying or underpaying throughout the year and owing a large and unexpected lump sum to the government at tax time.
Understanding Executive Compensation and Taxation
If you are a corporate executive, much or most of your income is likely to be W-2 income subject to higher ordinary tax rates. You also need to pay FICA taxes. There are deductions available, but these are limited. You can’t currently deduct home office expenses or other unreimbursed business expenses such as travel costs, and the dollar limits on deductions for local and state taxes and mortgage interest may prevent you from deducting the full amounts you pay.
Another issue with executive compensation taxation is how taxes are withheld, especially for supplemental compensation. The federal withholding rate for most bonuses is currently 22%, but for most employees up to the executive level, employers can combine the bonus with regular wages and use IRS tax withholding tables to figure and withhold the tax on the total paycheck for that period. However, stock compensation, large bonuses, commissions, etc., are typically paid outside the routine payroll cycle, and taxes may not be withheld by your employer on these amounts.
If your supplemental wages exceed $1 million, that excess amount will be taxed at an even higher rate. And these special forms of compensation may push you into a higher marginal tax bracket as well. Considering that bonuses and equity compensation can often exceed an executive’s salary, this shortfall can result in a large unpaid tax liability come tax time.
You can see how important it is in executive wealth management to help mitigate excessive tax burdens and plan for how to pay any tax liabilities.
Equity Compensation: Managing Tax Liabilities
One of the most challenging aspects of tax planning for executive compensation is that equity compensation is often a significant part of an executive benefits package, and it may be taxed in a very different way from your W-2 income.
What Is Equity Compensation and Why Is It Different?
Equity compensation is non-cash pay through investment vehicles that represent ownership in the company. Equity compensation such as stock options can cause you to owe money in taxes even before you’ve received any cash from the transaction, so strategizing these tax issues should be an important part of your planning.
Restricted Stock Awards
Restricted stock awards refer to company stock issued to an employee that vests (becomes fully owned by the employee) at a later date, typically 1–5 years after issuance or after a triggering event.
Tax impact: There is no tax impact at issuance; stock is taxed at vesting. The market value of the stock at the time of vest is taxable as W-2 income. Typically, a portion of the shares are automatically sold at vest to cover tax withholding. The value of the shares received then becomes the tax basis in the stock and the holding period starts on the vest date. The sale of the stock is treated as a capital gain or loss, subject to the holding period at the time of sale.
Performance-Based Restricted Stock Awards
Some companies offer a variation of restricted shares in which the number of shares transferred at vest is subject to a predetermined performance metric.
Tax Impact: The same as restricted stock awards.
What Is a Nonqualified Stock Option?
Nonqualified stock options allow employees to buy stock at a “grant price,” typically the fair market value of the stock on the date of issuance. If the stock price increases during the option term (the time before the option expires), you can exercise your option by purchasing your stock at a discounted rate.
Tax Impact: Nonqualified stock options do not meet certain IRS requirements that provide special tax treatment. The difference between the grant price and the purchase price at exercise is known as the spread. Any positive spread is taxed as ordinary wage income, subject to FICA taxes. The gain or loss when you sell the stock in the future is subject to capital gain/loss treatment (i.e., long-term capital gains are taxed at a lower rate).
What Is an Incentive Stock Option?
Incentive stock options, also known as qualified stock options, are similar to nonqualified stock options in that employees are allowed to purchase stock in the future at a specified grant price, typically the market value on the date of the option’s issuance. However, there is special tax treatment for incentive stock options, so more planning is required to help maximize their benefits.
Tax Impact: Unlike nonqualified stock options, incentive stock options aren’t subject to ordinary income and payroll tax when they are exercised. In addition, if you hold your shares for at least one year after exercise and two years after the option grant date, you can sell the stock and pay only long-term capital gains tax on the difference between your purchase price and your sale price.
However, the tax impact can vary significantly for different individuals because the spread between the grant price and fair market value of the stock at exercise is subject to the alternative minimum tax (AMT) when the option is exercised. This means that the best times to exercise your options and to sell your shares depend on your circumstances. AMT rules are complicated, and you should consult a financial advisor or tax professional to optimize your benefits.
How to Manage Stock Options for Optimal Tax Benefits
There is no simple answer to when to exercise your stock options or sell your exercised shares because it depends on your total financial picture. Here are some of the factors you’ll need to consider:
- Do you need an infusion of cash for some current purpose such as starting a business or purchasing a home?
- Do you expect the value of your options/shares to rise in the next few years?
- Is your portfolio overweight with company shares and in need of diversification?
- What are the tax implications of exercising your options/selling your shares now or in the future?
Tax implications can make a significant difference in the benefit you receive from your equity compensation. You’ll need to consider the potential effects of ordinary income tax, capital gains tax, and alternative minimum tax.
For nonqualified stock options, if your income for the year already places you in a high-income tax bracket, or additional income from stock options could push you into a higher-income tax bracket, you may want to delay exercising your options. This can be beneficial if you expect lower tax years in the future such as during retirement.
Qualified stock options don’t trigger taxation when they are exercised unless they trigger the alternative minimum tax, so look carefully at this potential impact before determining when it’s best to buy and sell.
Executive Tax Planning Strategies for Optimizing Compensation
Fortunately, some strategies can be used to reduce your tax liability and optimize your non-stock compensation.
Deferred Compensation Plans
Deferred compensation is a strategy often used to lower tax liability during the peak earning years for a corporate executive. Deferred compensation plans postpone a portion of your compensation until a later time, such as retirement, to potentially reduce taxes in the year the compensation is earned. They are especially useful if you expect your income and tax bracket to be lower at this future time, enabling you to pay less tax overall on the earnings.
Traditional individual retirement accounts (IRAs) and 401(k)s are examples of tax-qualified deferred compensation plans. Nonqualified deferred compensation plans are available only to certain high-earning employees such as executives. Both types of plans generally defer pretax dollars, with the tax due at distribution. But unlike qualified plans, the IRS does not cap the amount that can be contributed to nonqualified plans each year, maximizing the savings potential. You and your employer must agree on a contract that sets out the amount to be deferred, the distribution timing, and any limitations or terms of forfeiture.
Maximizing Deductions and Credits
The other major tax strategy for executive wealth management is maximizing the allowable deductions and credits on your taxes. Your financial advisor can help you manage your portfolio to be tax-efficient, combining tax-advantaged investment strategies and tax-loss harvesting.
Another popular deduction for ultra-high-net-worth individuals is charitable giving. But IRS rules for deducting charitable donations are both specific and complex, and they vary considerably based on the type of assets to be donated, the amount, timing and structure you set up.
It’s important to understand all the tax consequences before you finalize your giving plan, so be sure to consult with your tax or financial advisor, who can help create a plan that effectively meets your goals.
Financial Planning in Executive Wealth Management
Executive wealth planning is essential for tax optimization, and tax optimization can significantly impact your ability to meet your financial goals. The IRS rules that affect executive compensation are complex and ever-changing, so it’s important to work with a financial advisor who can provide tailored guidance in implementing your tax-saving strategies and help make the most of your income.
To be custom-matched with an advisor you can trust to support your goals with customized wealth planning, explore Carson’s advisor matching program today.
Mike Valenti is a non-registered associate of Cetera Advisor Networks, LLC.
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