Deferred Comp and Stock Plans

Question 1

When can employers claim deductions for contributions to a non-qualified compensation plan?

Answer 1

When the benefit is claimed, often in retirement (not when the contribution is made)

Question 2

When are earnings taxed on non-qualified compensation plans?

Answer 2

Throughout the life of the compensation plan - not tax deferred

Question 3

What is the biggest advantage of non-qualified pension plans?

Answer 3

They can discriminate in order to be offered to individuals whom a company wishes to retain

Question 4

What benefits does a non-qualified comp plan provide besides retirement?

Answer 4

Life insurance
Incentive pay
Severance benefits

Question 5

What is constructive receipt doctrine?

Answer 5

States that any money that the executive has unrestricted access to, regardless of whether or not they received it, is taxable as long as there is no substantial risk of forfeiture.

Question 6

What classifies as substantial risk of forfeiture?

Answer 6

THIS IS A KEY COMPONENT OF DEFERRED COMP

Compensation subject to:

• future performance of substantial services
• the occurrence of a condition related to organizational goals

Question 7

What is economic benefit doctrine?

Answer 7

This is for a funded comp plan - the opposite of constructive receipt.

This occurs when the employer irrevocably places funds for the benefit of the employee beyond the reach of the employer’s creditors, even if the employee doesn’t have actual or constructive receipt.

Question 8

What is the IRC regulation for non qualified deferred comp plans and what does it do?

Answer 8

IRC section 409A provides the rules about allowing deferral of income which includes participants access or control to that income. Violations will result in penalties and immediate taxation of the compensation.

Question 9

What are the 3 principles that must be followed to postpone taxation in a deferred comp plan?

Answer 9

The agreement to defer comp must be made before dollars are earned

The agreement must represent only an unsecured promise

The agreement cannot be funded - the company holds the funds and creditors have access

Question 10

What are unfunded plans?

Answer 10

AKA “Pay as you go” plans

Backed simply by the promise (not secured) that the company will pay a stated benefit. That benefit is in control of the company and subject to creditors

Question 11

What are informally funded plans?

Answer 11

These are plans which build a general reserve to fund a future benefit obligation. They are more preferred than unfunded plans because they are more likely to actually be paid.

Question 12

What is a Rabbi trust?

Answer 12

To alleviate concerns that a hostile takeover (or any takeover) of a company would result in a promised benefit not being paid, a company can establish a Rabbi trust with an independent bank or trust company and trustee to be responsible for holding contributions that will ultimately satisfy a company’s obligations to a deferred comp plan.

Creditors have access

Question 13

What is Company-Owned Life Insurance (COLI)?

Answer 13

A way to build-up cash value, tax deferred or tax free, reduce strain on company cash flow when distributions are made, and a way for the company to recover some of the plan costs

Question 14

What are surety bonds and how do they relate to informally funding a deferred comp plan?

Answer 14

These bonds are purchased by the employee from a third-party guarantee. Letters of credit and indemnity insurance are two other methods for the employee to own a company debt to be repaid later.

This will not be treated as constructive receipt as long as the employee pays for it out of his own [pocket and is not reimbursed by the company.

Question 15

What is a secular trust?

Answer 15

The ultimate security for an employee. An irrerevicable trust fully funded with the employee’s benefits. It is however full of costs for both the employer and the employee. It is taxes immediately, it is subject to ERISA’s requirements related to reporting and disclosure, participation and vesting, and fiduciary obligations - making it costly.

Creditors do not have access

Question 16

What are section 83 plans?

Answer 16

Funded deferred comp plans

Question 17

What is an elective or pure non qualified plan?

Answer 17

The employee chooses to receive less salary or bonuses, postponing receipt until a future tax year

Question 18

What is a salary reduction plan?

Answer 18

Part of an elective plan. AKA “in lieu of plan” The employee agrees to give up a portion of his salary. In turn, the employer agrees to pay a benefit in a future tax year equal to the deferred amount plus interest

Question 19

What is a non-elective or supplemental non qualified plan?

Answer 19

The employee does not agree to reduce/contribute a portion of salary, but instead the employer simply funds the benefit. This is a fringe benefit plan used to recruit and retain top talent.

Excess benefit and supplemental executive retirement plans (SERPs) are supplement plans.

Question 20

What are excess benefits plans?

Answer 20

It allows employees who participate in qualified plans, to exceed the limitations imposed by Section 415. They usually “make whole” the amount that the employee would have been able to contribute, had there not been limitations.

Question 21

What is a SERP?

Answer 21

A supplemental executive retirement plan. Used to increase benefits beyond qualified plans. Often referred to as golden handcuffs because the SERP is contingent on the executive staying and a move to another job might risk that benefit.

Question 22

What are the two ways a SERP works to avoid current taxation?

Answer 22

Vested, but unfunded.

Funded, but not vested.

Question 23

What are top hat plans?

Answer 23

A type of SERP established to provide unfunded deferred compensation to a select group of management.

Must be unfunded
Must be maintained primarily for certain individuals
Must provide deferred comp for a select group of management or highly compensated employees

Question 24

What is the death benefit only (DBO) plan?

Answer 24

A type of ERISA welfare plan (not a nonqualifed deferred comp plan). It is a benefit that is kept out of the estate of a highly compensated employee who owns less than 50% of the employer’s company stock. Issued to a designated beneficiary, payments are considered ordinary income.

Question 25

What is the Economic Benefit Doctrine?

Answer 25

States that any property received or any financial benefit received as compensation for services, is includable as taxable income

Question 26

What are the two major determinants of taxation under Code Section 83?

Answer 26

1) An employee is not taxed on property until it is transferable

or

2) An employee is not taxed on property as long as it is subject to a substantial risk of forfeiture

Question 27

What is a 83(b) election?

Answer 27

Within 30 days of receipt of property, the employee can elect to be taxed on the spread between the fair market value and the price at which the property is offered. The employee would then only realize capital gains (not ordinary income) on any sale further down the road

Question 28

What are stock options?

Answer 28

Gives the employee the right to purchase a fixed number of shares of employer stock at a predetermined price over a stated period. Usually, there is no tax impact because the stock is bought at the price of trading that day.

Question 29

What is the purpose of an Incentive Stock Option (ISO) and how does it work generally?

Answer 29

Provides a significant tax savings and discounted stock purchase option. Employer (board) grants ISO, good for 10 years. Employee exercises option and does not pay tax unless the stock is sold prior to 2 years after grant or 1 year after exercise. (If sooner, then bargain difference is reported as ordinary income.) When sold after required timelines, gains are taxed at long-term capital gains rates.

Question 30

What is the alternative minimum tax?

Answer 30

The tax on the bargain rate of an ISO. Stock selling price - company grant discounted stock price = AMT

Question 31

What is a non qualified stock option (NQSO) and how does it generally work?

Answer 31

The employer will grant the employee a NQSO with an exercise date. At the exercise date, the basis become the discounted price paid, but what the stock is at exercise. The bargain element is taxed at ordinary income. After one year, any gains at sell are long-term capital gains.

Question 32

What is the bargain element?

Answer 32

The difference between the discounted stock price and the full market value (FMV) of that stock at exercise.

Question 33

What is a cashless exercise of a non qualified stock option?

Answer 33

It uses the sale of the stock itself to pay for any taxes associated with the exercise. Any remaining stock is then only taxed at short or long term capital gains rates depending on when it is sold after the exercise date.

Question 34

Formula for cashless exercise of NQSO

Answer 34

Exercise cost = number of shares x discounted cost

Ordinary income tax = (FMV - exercise price) x (# shares) x tax rate

Determining number of shares to cover cost = (exercise cost + income tax) / FMV

Question 35

What is the tax calculation for employee stock purchase plans?

Answer 35

Discount (difference between FMV and discounted price) x number of shares = ordinary income

FMV at sell - FMV at exercise x number of shares = capital gains

Question 36

How do Employee Stock Purchase Plans work?

Answer 36

Employees are offered ESPP and set aside up to 20% of their pay into a brokerage account. On the purchase date, employer will use saved money to purchase stocks at up to 15% discount from either the purchase price or offering price (loopback provision). When sold, assuming at least 2 years from purchase, the discounted (up to 15%) amount will be taxed at ordinary income and the rest as long-term capital gains.

Question 37

What is the concept of equity-based compensation plans?

Answer 37

That the success of the company is reflected in the compensation paid to the executive

Question 38

What is a restricted stock plan?

Answer 38

A form of equity compensation that gives an executive the right to receive stocks at some point in the future when conditions are met (restrictions lifted) or a vesting period is over. If those conditions are not met, the stock is forfeited.

Question 39

What are the taxation rules on restricted stock plans?

Answer 39

Stock sold to the employee is not taxed within the restricted period because the restricted status put the stock at substantial risk of forfeiture. Although the employee may opt to pay taxes at grant under a 83(b) election.

There is risk to that. Stocks could tank, executive could leave, etc.

Once exercised, ordinary income tax is levied if previous election was not made. If sold under a year, gains are ordinary income. After a year, they are LTCG.

If 83(b) was made, then no taxes are owed when exercised and when sold, the sale is considered LTCG.

Question 40

What is a Stock Appreciation Right (SAR)?

Answer 40

It is a grant of stock which only pays the difference between the FMV at grant and the FMV at exercise. The SAR either pays out in cash or additional stock at FMV. Ordinary income rates apply either way.

Question 41

What is a performance unit or share plan?

Answer 41

A performance-based plan is reward-based where compensation is earned as a result of stock growth from the time of grant to the specified term period. The compensation for growth is a percentage of company stock, cash, or both. This is taxed as income tax in the year it is received.

Question 42

What are phantom stock plans?

Answer 42

A form of a long-term incentive used to award executives with potential value and is cashless. A phantom stock grant is recorded in the financial records and that stock earns gains and losses, dividends, etc. When exercised, the entire amount is ordinary income

Question 43

What is a junior stock plan?

Answer 43

A performance incentive plan which defers taxation. A new class of stock is established with diminished rights and at a diminished cost. Very little value in the company. After a certain time, the shares are automatically converted into regular stock after the incentive goals are reached. Best case, no taxes are realized until the stock is ultimately sold at LTCG.

Question 44

What are the golden parachute tax rules?

Answer 44

Base amount = average compensation received over last 5 years

Safe harbor is given to severance payments when the payments are less than the three times the base amount

When the payments are greater than three time the base amount, then it is a parachute payment and the excess (above the base amount) is subject to 20% excise tax for the employee and the employer cannot take an expense deduction for the excess.

Ex: $400,000 severance, base amount $100,000. Severance is over by $100,00 so the entire excess, $300,000 is now subject to a 20% excise tax

Question 45

What are tin parachutes?

Answer 45

Similar to golden parachutes, but less likely to be subject to the excise tax because these are for middle management and less likely to be valuable enough to exceed 3x base amount.