Retirement Planning: Deferred Compensation And Stock Options

Question 1

Why are deferred compensation plans established?

Answer 1

To provide benefits to a select group of employees without the limitations, restrictions, and rules of a qualified plans

Generally discriminate in favor of key employees

If employer does not have a qualified plan, because they don’t want to cover a large group of employees. They can provide benefits only to key executives with a deferred compensation plan.

Question 2

What are examples of deferred compensation plans?

Answer 2

Golden handshake - severance package, designed to encourage early retirement

Golden parachute - payments made to executives being terminated due to changes in ownership

Golden handcuff - designed to keep employee with the company.

Question 3

What is IRC section 409A?

Answer 3

• to provide clear structure and guidance for deferred compensation plans
• penalties applied to plans that fail to meet these requirements

Question 4

What are the tax benefits for employers and employees for deferred compensation plans?

Answer 4

Employee - executive defers income until he is expected to be in a lower tax bracket,

Employer - $1,000,000 limit on a public companies deduction for compensation payable to any of the top five executives of a publicly traded company, can claw that back later if the employee contributes over the amount

Question 5

What income tax provisions must be satisfied for deferral of income tax to be realized?

Answer 5

• constructive receipt doctrine - avoided with deferred comp plan
• substantial risk of forfeiture - not required to include in income
• economic benefit doctrine - if plan holds funds in a trust and they are partially or fully vested, they are taxed, exception to this is a rabbi trust
• IRC section 83 - applies to stock grants, restricted stock, employee stock options. Difference between FMV and amounts paid for the property are taxed as ordinary income to the employee.

Question 6

What are the rules surrounding deferred compensation and payroll tax?

Answer 6

• deferred compensation is considered earned income at the time it is earned or at the time substantial risk of forfeiture expires (RSU’s), therefore subject to payroll taxes at that time.
• when the income is later paid to the executive, it will be subject to income tax. Not earned income and does not apply to earned income tax for IRAs and other qualified plans

Question 7

Do employers receive an income tax deduction for contributions to a deferred compensation plan?

Answer 7

Employer is entitled to receive an income tax deduction for contributions to the plan only when the employee is required to include the payments as taxable income.

Question 8

What are the advantages of deferred compensation plans for the employer?

Answer 8

1. Cash outflows deferred until the future
2. Employer will save on payroll taxes
3. Employer can discriminate and provide benefits to a select group of key employees

Question 9

What are the three deferred compensation funding arrangements?

Answer 9

1. Unfounded promise to pay
   - Promise of employer to pay executive at some point in the future.
   - compensation is successfully deferred as substantial risk of forfeiture is met.
2. Secular Trust
   - irrevocable trust that hold funds and assets for purpose of paying benefits under deferred compensation agreement.
   - eliminates risk of substantial risk of forfeiture since assets are secured in a trust so income may not be deferred.
   - to meet standards of substantial risk of forfeiture, vesting schedule or term of employment required to defer income taxation.
3. Rabbi Trust -
   - balance between risk of an unfounded promise to pay and lack of risk of forfeiture in a secular trust.
   - assets placed in trust, but still have risk of forfeiture as they may be seized and used for the purpose of paying general creditors in the event of liquidation of the company

Question 10

Why would an employer fund a NQDC plan with life insurance?

Answer 10

• for plans that have funds set aside, employer is responsible for paying the income tax attributable to earnings in assets held in the plan.
• employers use insurance products because the increase in cash surrender value is not taxed if payments are not made from the policy

Question 11

What is phantom stock?

Answer 11

Arrangement where the employer grants fictional shares of stock to a key employee that is initially valued at the time of the grant.

At termination or retirement, employee is payed in cash for the fictional value of the stock (no stock actually exchanges hands)

Question 12

What are the type of NQDC plans?

Answer 12

1. Salary reduction - allows employees to elect to reduce their current salary and defer it until retirement or termination
2. Salary continuation plan - provides benefits after retirement and in an ongoing basis for a set amount of time.
3. Supplemental executive retirement plans (serps) - top hat plans. Excess benefit plans are common type of serp designed to provide benefits in excess of benefits available in qualified plans

Question 13

Non qualified deferred compensation plans, employer vs employee.

Answer 13

Question 14

NQDC employer vs employee viewpoint

Answer 14

Question 15

What is a stock option?

Answer 15

• gives employee a right to buy stock at a specified price for a specified period of time.
• option price is equal to the price at the grant date
• stock options vest over time, therefore giving the executive an incentive to remain with the employer and be productive.
• two standard types of employer stock options: incentive stock options (ISO’s) and Non-qualified stock options (NQSO’s)

Question 16

What is an incentive stock option (ISO)?

Answer 16

• iso is the right given to an employee to purchase an employers common stock at a stated exercise price.
• at the date of exercise, the employee is not subject to ordinary income tax on the difference between the fair market value of the stock and the exercise price. (Bargain element)
• the bargain element IS a positive adjustment for AMT
• when employee sells the stock, difference between sales price and exercise price is long term gain, negative adjustment for AMT calculation.

Question 17

What are the holding period requirements for a ISO to qualify for good tax treatment of the gain?

Answer 17

A qualified sale requires waiting:

2 years from grant date
1 year from exercise date

-sales prior to either holding period being met disqualify option and tax benefits

Question 18

What are the requirements for an incentive stock option?

Answer 18

1. Aggregate fair market value of ISO grants at the time of the option is first exercisable must be less than or equal to $100,000 based on the grant price per year per executive. Any excess grant over $100,000 is treated as a NQSO.
2. To qualify as an ISO, the executive must not dispose of the stock before the later of two years from the grant of the ISO or within one year of the exercise of the ISO.

Question 19

What is a disqualifiying disposition and how is that treated for tax purposes?

Answer 19

• Disqualifying disposition occurs when you dispose of an ISO within two years of the grant or one year of the exercise.
• Gain on the sale of the stock attributable to the difference between the exercise price and the FMV a the date of exercise will be considered ordinary income, Instead of LTCG

Question 20

What is a cashless exercise?

Answer 20

• Third Party lender lends the executive the cash needed to exercise the option and the lender is immediately repaid with the proceeds of immediate sale of the stock.
• holding period is not met so it triggers at least a partial disqualifiying disposition dependent on how much stock was purchased with borrowed cash.

Question 21

What are Non-Qualified Stock Options (NQSO’s)?

Answer 21

• Bonus program - additional compensation, Nothing More.
• do not receive favorable capital gains treatment, but also are not subject to the holding period associated with ISO’s.
• No Risk to executive, if stock falls below the exercise price, they dont exercise, if stock appreciates they can exercise and sell immediately or hold.

Question 22

How are NQSO’s Taxed?

Answer 22

• if option has a readily ascertainable value at the date of grant, the executive will otherwise have W-2 income equal to the value and the employer will have an income tax deduction.
• when exercised the executive will recognize w-2 income for the appreciation of the fair market value of the stock over the exercise price (Bargain Element), paryoll and income taxes will apply and employer will receive an income tax deduction.
• Fair market value of the stock at Exercise is the executives basis for the stock.
• When the stock is sold, it will be either long term or short term gain/loss dependent on their holding period.

Question 23

What are restricted stock plans?

Answer 23

• Plan pays executives with shares of the employers stock. Executive does not pay any amount towards the allocation of the stock, 0$ exercise price.
• Employee is restricted by the employer from selling or transferring the stock.
• restriction most often gives the employer ability to repurchase the stock during a set period of years or until a defined occurrence or event (executive attains 10 years of service).
• at receipt of the stock, executive does not generally recognize any taxable income (Section 83b), as the restrictions generally create a substantial risk of forfeiture.
• Employer does not have a deductible expense.
• when substantial risk of forfeiture is eliminated, the executive recognizes w-2 income equal to the value of the stock at that date, and the employer will have a tax deductible expense for an equal amount.

Question 24

What is the section 83(b) election?

Answer 24

gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting.

The 83(b) election applies to equity that is subject to vesting.

you pre-pay your tax liability on a low valuation, assuming the equity value increases in the following years. However, if the value of the company instead declines consistently and continuously, this tax strategy would ultimately mean that you overpaid in taxes

Question 25

What is an Employee Stock Purchase plan (ESPP)?

Answer 25

• intended for all or most employees, cannot be discriminatory.
• gives employees an incentive to buy employer stock by allowing the employees to purchase the stock at a discounted price and receive favorable tax treatment for any gains if the stock meets certain holding period requirements.
• employee is able to purchase the ESPP For a price equal to no less than 85% of price.

Question 26

What is the limit on ESPP stock that can be purchased every year?

Answer 26

-employee is limited to purchasing $25,000 of employer stock per year as determined based on the fair market value at the date of grant of the employer stock through ESPP.

Question 27

Qualifying and Disqualifying Disposition for ESPP’s?

Answer 27

Qualifying:

Holds 2 years from Grant Date
1 Year from Exercise Date

Employees gain on the sale of stock will be ordinary income to extent gain is attributable to discount at date of purpose. Any gain in excess will be LTCG.

Disqualifying:

when stock does not meet qualifying requirements.

gain attributable to the discount will be w-2 income rather than ordinary income. and either short term or long term depending on holding period.

Question 28

What happens if shares purchased through an ESPP are sold at a loss?

Answer 28

-either short term or long term capital loss as determined based up on the holding period at the date of exercise and the difference between the exercise price and the sales price.