Planning for Executives - Section IV.A (10%) (12-13 questions) Flashcards
Incentive Stock Options (ISO)
- More rules and restrictions than NSOs
- Can only be given to employees
- No ordinary income tax at exercise
- Spread between FMV and exercise price is AMT
preference item - Not transferable except in event of death
- Annual $100,000 limit
- Long-term capital gains treatment
If sold more than 1 year after exercise
And if sold more than 2 years after grant.
Disqualifying Disposition
- Results when one does not adhere to the “2-year from grant” and “1 year from exercise” holding requirement.
- Potentential taxation includes orginary income tax treatment as compensation and possible capital gains tax on the transaction.
- There are situations in which this may be a preferred strategy (based on expectation of stock price)
Non-Qualified Stock Options (NSOs)
- Few rules and regulations apply
- Do not qualify for income tax deferral on exercise
- Income tax due on spread between exercise price
and FMV - Can be granted to employees or non-employees
- No holding period requirement for stock
- Can be transferred.
NSO and ISO Comparisons
Stock Option Strategies
NSOs - Exercise and Sell
** Considerations:
- Available cash to pay for stock and taxes
– Risk of remaining invested in stock
– Opportunity to “lock in” gains vs. opportunity for
further appreciation
– Potential for higher marginal tax bracket
** Cashless Exercise
– Simultaneous option exercise and stock sale
– Used any time after vesting and before expiration.
Exercise and Hold - NSOs
- Exercise stock options to buy shares of company stock
and then hold
▪ Applicable:
– Prior to expiration
– To capture dividends
– Recognize income in a specific year
– To produce LTCG on future appreciation
– To meet company requirements.
Stock Swap - Pyramiding
- Plan specific provision - must specifically allow
- Available for NSOs and ISOs
- Client pays exercise cost with existing shares
- Bargain element on options taxable at exercise (same as
with cash exercise) - Avoids capital gain and AGI lift from sale of stock
- “Reload” feature replaces stock used to exercise options,
offers future appreciation opportunity - Works best if client intends to exercise and hold.
Option Gifting to Family
- Plan specific provision
- Can be made outright, to trust, to FLP
- Applies only to NSOs
- Provides significant estate tax benefits
- Shifts future appreciation out of the taxable estate
- Vested options are easiest
- Donor remains responsible for income tax on spread at
exercise
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Tandem Exercise
- For option holders with NSOs and ISOs.
- Goal: AMT Tax minimization on ISO exercise and hold.
- Raise ordinary income to level greater than potential AMT with combination ISO/NSO exercise.
- Potential downside = pay income tax on NSOs.
ISO Tax Ramifications
AMT Planning on ISO Exercise
ISO Sale to pay AMT
- Exercise ISOs in first quarter of year 1
- Triggers potential AMT due April 15 of Year 2
- Hold stock 1 year to meet ISO requirement.
- Sell stock before April 15 to pay tax.
- Downside risk is stock price declines in year.
Personal AMT Exclusion
- Calculate potential regular income tax and AMT to determine upper limit exercised ISOs below trigger point.
NSO Tax Ramifications
Section 83(b) Election
- Plan specific provision
- Exercise stock options prior to vesting
- Must be elected within 30 days of grant
- Stock subject to control and resale restrictions until vesting
- Opportunity to reduce taxes on bargain element with 83(b)
election
– NSOs: tax on bargain element
– ISOs: AMT liability - Big risk if stock declines in value.
83b Election
Section 457 Deferred Compensation Plans
- Must be government organization or 501(c) tax-
exempt organization. - Contribution limit $19,500 (2021), $20,500 for (2022),
$22,500 (2023). - Tax on contributions and tax on account earnings
are tax-deferred. - Section 457 plans can allow for Roth contributions
and in-plan rollovers to designated Roth accounts.
NUA
- A strategy for retirement asset distribution under
Internal Revenue Code 402(e)4 - Applies to employer securities held in a qualified
retirement plan (ESOP, pension, 401K, etc.) - Means to trade ordinary income taxation on
retirement assets for long-term capital gains
treatment.
NUA - How does it work?
- Must elect lump sum, in-kind distribution from plan
(total distribution of all assets in single calendar year) - Original basis (i.e., contributions to plan) immediately
taxable as ordinary income - Remaining value (Net Unrealized Appreciation) taxed at
long-term capital gain rates - Subject to premature distribution penalty rules for
qualified plans (applies only to original basis) - No step-up of basis at death on NUA portion. Subject to
Income in Respect of Decedent (IRD).
Restricted Stock Sale
Advantages:
- Increased liquidity
- Improved diversification
-Reduced price exposure
Disadvantages:
- Capital gains taxes
- Immediate transaction costs
- No upside price participation
- Public disclosure.
Registered Restricted Stok
Restricted Stock Sale - Rule 144
- Holding period: One year if non reporting company, 6 months if reporting company.
-Trading volume: Number of shares sold during 3 month period can’t exceed:
- The greater of 1% of outstanding shares of same class.
- The greater of 1% or the average reported weekly trading volume during the 4 weeks preceding the filing notice of the sale on form 144. - Filing notice with SEC: Must file with the SEC on form 144 if sale involve more than 5000 shares or aggregate is more than $50,000.
Exective Compensation
Matching Solutions to Needs
Hedging: Zero Premium Collar
- Investor wants to continue to own underlying equity but
hedge price risk
▪ Purchases put option and sells call option against holdings
for net zero premium
▪ Specifies option maturities and degree of downside
protection and upside appreciation.
Hedging: Zero Premium Collar
Advantages
▪ Hedges Downside Risk Below Put Strike Price
▪ Retains Ownership Benefits of Dividend Income and Voting Rights
Disadvantages
▪ Interim Price Risk
▪ Limited Upside Price Participation
▪ Collateral Requirements for Payment Due at Maturity
▪ Potential for Capital Gains Taxes on Underlying Stock
Position Upon Exercise
▪ “Hard to Borrow” Risk.
Short Against the Box
- Occurs when an investor borrows shares of stock and sells them short, while at the same time owning shares in the same stock.
- Rules have been established to make this strategy (within certain contraints) illegal, but new strategies have been developed to accomplish the same goals.
Diversification: Prepaid Variable Forward
- Monetizes concentrated position without selling the shares upfront
▪ Diversifies a large, appreciated equity position while deferring taxation
▪ Variable contract to sell a specific value of a security in the future (i.e., the number of shares to be delivered will
depend on the stock’s value at the time of delivery)
▪ Retains appreciation up to an upper limit (cap) as defined by client
▪ Protects against depreciation in stock below a lower limit (floor price).
Prepaid Variable Forward
Advantages:
- Substantial liquidity generated upfront.
- No tax event until maturity
- Provides floor for stock price
- Investor retains ownership, dividends and voting rights until maturity date.
Disadvantages:
- Ceiling on upside exposure; investor does not participate in any appreciation of the stock above the cap.
- Self-financing; No seperate loan vehicle required.
Exchange Fund
- Private placement, exempt from registration
▪ Avoids publicity since contribution is not public sale and does not require Rule 144 filing
▪ Diversifies a large, appreciated equity position while deferring taxation
▪ Diversification occurs because many investors from
different sectors contribute their shares.
▪ Diversification may, however, not be optimal.
▪ Shares of a publicly traded company exchanged for an
interest in the Fund.
Exchange Fund
Advantages
▪ No potential to depress market price
▪ Tax savings compared to open market sale
▪ May accept contributions of restricted securities
▪ Units receive step up basis at death
▪ May offer attractive diversification benefits
Disadvantages
▪ Illiquid for first seven years
▪ May limit total amount of restricted securities
▪ FMV of restricted securities discounted
▪ Acceptance of shares determined by fund manager
▪ May not offer desired diversification benefits.
Charitable Remainder Trust
- Highly appreciated assets gifted to charitable remainder
trust in return for ongoing income stream for life or trust
term - Investor receives income tax deduction for charitable gift in year gift is made
- Concentrated position is liquidated and reinvested in a
diversified portfolio - At end of trust, remainder goes to favorite charity or to
family foundation.
Charitable Remainder Trust
Advantages:
- Beneficial capital gains treatment.
- Increase after-tax, net spendable income.
- Reduction of grantor’s taxable estate.
- Diverdifies investment portfolio.
- Potential income tax deductions.
Disadvantages:
- Irrevocable trust
- Principal passes to charity not heirs.
- Minimal tax deduction reduces benefits for younger investors.
10b5-1 Plans
- Pre-arranged trading plans for insiders and affiliiates, specifies amount, price and date at which securities should be traded.
- Allows trading during “blackout periods”
- May provide public with greater disclosure.
