Executives are often rewarded for their business acumen with nonqualified deferred compensation (NQDC) and stock options. To keep taxes to a minimum, it’s important to be just as smart when it comes to tax planning for these complicated forms of compensation. This means both understanding the unique rules that apply to each compensation type and taking steps to use them to your advantage.
These plans pay executives in the future for services currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from an employer’s creditors. One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture - even though compensation may not be paid or recognized for income tax purposes until much later. So, your employer may withhold your portion of the employment taxes from your salary or ask you to write a check for the liability. Or your employer may pay your portion, in which case you’ll have additional taxable income. Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues.
Incentive stock options (ISOs) receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant. Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods.
Here are the key tax consequences:
In the year of exercise, a tax preference item is created on the difference between the stock’s FMV and the exercise price (the “bargain element”) that can trigger the AMT (Alternative Minimum Tax). If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or to hold them. Waiting until just before the expiration date to exercise ISOs (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. There are several situations in which acting earlier can be advantageous:
The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item. You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Also consider state tax estimated payments.
Our Burlingame, CA tax advisors assist high net worth individuals with employee stock option strategies, tax planning for selling, and investing for diversification of ISO, RSU, ESPP, and NQ option programs. Call us at 650-684-0800 to schedule a free consultation today.