Executive compensation: Tax planning considerations

As your career progresses, so do your choices for managing different types of executive compensation. While these types of benefits are welcome incentives, they also come with practical and tax planning considerations that require specialized knowledge and experience.

My team, in coordination with a tax professional, can help you evaluate the key choices associated with your executive compensation and shed light on how they can be effectively applied to support your financial goals — today and tomorrow.

Here’s an overview of the different types of executive compensation and some of their unique tax planning considerations:

In this article:

• Nonqualified deferred compensation plans
• Company stock held in a 401(k)
• Employee stock options
• Restricted stock grants
• Questions to discuss with us

Nonqualified deferred compensation plans

What is it? Many companies offer certain key executives and senior leaders the opportunity to participate in a nonqualified deferred compensation plan (NQDC) to give them more flexibility over their taxable income. If they choose to participate, they are given an annual opportunity — often in November or December — to defer a portion of the following year’s pay, in what is known as a deferral election. For each deferral election, the participant selects when and how the deferred amount is to be distributed (from the options provided by the employer), which can be in one or more future years. Nonqualified deferred compensation plans are often offered in addition to qualified retirement plans, such as a 401(k), to enable personal savings beyond what is allowed each year within just a qualified retirement plan.

Executive compensation tax planning consideration: A typical contributory NQDC plan allows you to restructure when certain taxable income is to be incurred, because the salary, bonus, commission or other compensation you elect to defer is not generally subject to taxation until it is distributed to you. This gives you the opportunity to receive the deferred compensation, along with any accrued gains or losses, in a year when your overall income may be lower (such as in retirement) and you are therefore subject to a lower tax bracket. However, deferred amounts held in an NQDC plan are unsecured and not guaranteed if the company runs into financial trouble.

Company stock held in a 401(k)

What is it? As part of their benefit package, many public and private employers offer their employees the opportunity to purchase and hold company stock via their 401(k) plans or another type of qualified retirement savings plan.

Executive compensation tax planning consideration: If company stock, while held within in your 401(k) plan, has appreciated significantly, taking advantage of a tax treatment called net unrealized appreciation (NUA) can potentially provide meaningful tax advantages. When implemented properly, this strategy can enable you to distribute all or some of the company stock into a taxable account (such as a brokerage account), while rolling other (non-company stock) investments into a traditional IRA.

The main benefit of this strategy is that upon a subsequent sale of such shares, gains at the time of the NUA distribution would be taxed at the (typically lower) long-term capital gains tax rate instead of as ordinary income.¹ Although, you will have to pay ordinary income tax on the cost basis of the company stock in the tax year the NUA distribution occurs.

In addition, removing company stock (and its possible future appreciation) from your 401(k) plan could make your future required minimum distributions (RMDs) more manageable and enable you to better control your gross income throughout retirement.

Employee stock options

What is it? With stock options, employees are given the opportunity to purchase shares of company stock (usually after meeting certain vesting criteria) at a predetermined exercise price during a specified timeframe. Generally, the exercise price will, and in some instances must, equal the company stock’s fair market (or appraised) value on the grant date. This means stock options generally don’t provide a significant financial benefit for the employee unless the company stock appreciates after the grant date.

Executive compensation tax planning considerations

Employee stock options are generally issued in two forms: nonqualified stock options (NQSOs) and incentive stock options (ISOs). NQSOs and ISOs primarily differ in how they are treated by the IRS. The tax implications of NQSOs and ISOs can be especially complex, so consult with a tax professional for guidance specific to your situation.

• NQSOs: You are subject to ordinary income taxes on any appreciation realized when you exercise your shares.
• ISOs: You are not subject to “regular” income taxes on any appreciation involved when you cash exercise and hold your shares.² Further, if you hold your ISO-acquired shares for more than two years from when the ISO was granted and more than one year after the date the options were exercised, gains from any subsequent sale will be subject to the more favorable long-term capital gains tax rate. Selling before that period, however, means any gains you’ve realized will likely be taxed as ordinary income.

Restricted stock grants

What is it? Restricted stock grants are a common incentive offered by a wide range of public and private companies to retain and motivate key employees. With restricted stock grants, the company commits to either deliver a certain number of shares to an employee at one or more points in the future, or remove restrictions on already delivered shares, once the grant’s stated vesting criteria are met. While most vesting provisions require the employee to remain with the company for a certain time period, they may also have performance-based conditions. 

Unlike employee stock options, restricted stock grants do not have an exercise price and are not exercised. As a result, they can still be financially beneficial to the recipient, even if the company’s stock price declines between the date of grant and vesting.

Restricted stock grants are generally issued in two forms: Restricted stock units (RSUs) and restricted stock awards (RSAs), with RSUs becoming more prevalent in recent years.

Executive compensation tax planning consideration: You will not owe income taxes upon receiving a restricted stock grant (apart from an 83(b) election with an RSA). However, as shares from restricted stock grants become vested and delivered (for RSUs, which usually occurs simultaneously) or have their restrictions removed (for RSAs), their entire value — based on the stock’s value on the vesting date — will generally be taxed as ordinary income. Any subsequent sale of the “net” (after tax withholding) shares is then taxed in accordance with IRS capital gains tax rules.

Overall, as restricted stock grants vests, it’s important to be aware of the potential impact to your taxes for the current withholding year, so that you can plan for any taxes you owe when filing your return.³ Work with a tax professional to help manage the possibility of owing substantial additional federal income tax.

For those investors who are not comfortable with a high concentration of company stock in their portfolio, it may make sense to sell your shares shortly after vesting to diversify and minimize the potential impact of taxes.

Make the most of your executive compensation

The decisions around executive compensation can be complex, but my team — along with a tax professional — can help you understand and evaluate your choices to find the right balance between today’s needs and tomorrow’s goals.