Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions. Tim Kochis, JD, MBA, CFP CEO.

Transcription

1 Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions Tim Kochis, JD, MBA, CFP CEO. Kochis Global

2 Overview Stock Options Non-Qualified and Incentive Stock Options Restricted Stock IRC Section 83b Deferred Compensation Plans IRC Section 409A Golden Parachutes IRC Section 280G 2

3 Non-Qualified Stock Options/NQSOs The spread is taxable as ordinary income at exercise (wage income, so payroll taxes also apply). The employer gets a payroll deduction at time of exercise. 3

4 Statutory Stock Options/ISOs Incentive Stock Options The spread is not taxable at exercise (i.e. deferred until sold), instead it is an adjustment for AMT purposes. 1. Holding period requirements: a. At least 1 year from the date of exercise and b. Two years from grant date 2. If holding period requirements met, sale is long-term capital gains. 3. The AMT adjustment increases the AMT basis of the stock. The stock has a different tax basis for regular tax and AMT purposes. 4. If AMT results from exercise of an ISO, an AMT credit may be available in future tax years. 4

5 Statutory Stock Option/ISOs If the holding period requirements are not met, a disqualifying disposition occurs 1. The spread is taxed as ordinary wage income in the year of the disqualifying disposition. 2. The employer gets a compensation deduction. 5

6 Restricted Stock Popular (but flawed) alternative to options. Responded to concerns regarding stock option abuses: No leverage Rewards without (or even despite) performance Relatively inefficient for taxes and for investment planning. 6

7 Restricted Stock: Benefits and Risks of the IRC Section 83(b) Election Avoiding 83b elections Confidence in no forfeiture Confidence in compensation for opportunity cost Side purchase is usually better 7

8 Restricted Stock: Benefits and Risks of the IRC Section 83(b) Election Side purchase is better unless No opportunity to purchase; or sufficiently higher future tax rate Rate Increase from 28% to 40% No Election No Election/Side Purchase Section 83 (b) Election Initial value $10,000 $10,000 $10,000 Additional Purchase N/A 2,800 N/A Initial 28% N/A N/A (2,800) 5 years earnings on $2,800 (@6% per year after taxes) 947 N/A N/A Cost of additional purchase N/A (2,800) N/A Growth in value on initial shares in % per year 5,923 5,923 5,923 40% at lapse of restrictions (6,369) (6,369) N/A Growth in value on additional 9.75% per year N/A 1,658 N/A Tax on long-term capital gain on N/a (331) (1,185) sale of initial or additional 20 % Best choice $10,501 $10,881 $11,938 8

9 Non-Qualified Deferred Compensation Historical Evolution The old days of 90% tax rates and very steep graduation. Lower rates in retirement was a realistic expectation. Tax deferral enough; often no earnings within plan s: 70% marginal rates, but 50% max tax on current compensation: o In service deferral periods arise o Impetus for earnings; initially only an interest rate measure Equalized rates (before and after retirement) and much lower rates o Deferred compensation institutionalized by then o Return becomes paramount 20% LTCG rates make high absolute earnings rates/opportunities essential Section 409(a)

10 Non-Qualified Deferred Compensation Benefits and Costs Benefits Costs For Employer ROR < Cost of Capital? ROR > Cost of Capital? small, young large, mature companies companies For Employee - Superior Investment - Tax Rate Risks Returns - Collection Risks 10

11 Non-Qualified Deferred Compensation Superior Investment Returns Deferred compensation turns a pre-tax return into an after-tax return No Deferral Deferral Compensation $10,000 $10,000 Current Tax (40%) (4,000) N/A Net Investable 6,000 10,000 At 6% After Tax for 5 years 8,029 N/A At 6% Pre Tax for 5 years 13,382 Tax at Receipt (40%) N/A (5,353) Net in 5 years $ 8,029 $ 8,029 11

12 Non-Qualified Deferred Compensation Tax Rate Risks: Tolerable Future Tax Rates The longer the deferral and the stronger the return, the higher the tolerable future tax rate Pre-Tax ROR within Deferred Compensation Plan* Period of Deferral 6% 8% 10% 2 years 40% 42% 44% 5 years 40% 45% 50% 10 years 40% 50% 58% 20 years 40% 59% 71% *Assuming 6% after-tax outside the plan 12

13 Non-Qualified Deferred Compensation Key Conclusions From Analysis of Tax Risks Plans with only modest internal returns are not attractive Short deferral periods are especially risky 13

14 Non-Qualified Deferred Compensation Collection Risks Insolvency: Must be an unsecured (even if funded) general obligation of the employer Recalcitrance: Especially after a change in control The Role of Rabbi Trusts: Independent custody of funded resources 14

15 Non-Qualified Deferred Compensation Some Impacts of Section 409(a) All unmodified deferrals, as of 12/31/04, grandfathered Options or SARS issued at a discount are deferred comp subject to 409(a) Must fix exercise date Reduced flexibility for new deferrals Separation from service Specified date Change in control, unforeseeable emergency Must elect before close of preceding year Or 30 days after 1 st eligible or 6 months in advance of performance period end No acceleration but further delay if >12 months in advance and at least 5 yr. delay from original election 20% Excise tax for violations 15

16 Golden Parachute Constraints 280G Golden Parachute Constraints 280G Requires both a change in control and an acceleration of value Acceleration: Severance payments Early release of restrictions on restricted stock Early vesting of options Employer gets no deduction Employee pays an additional 20% tax 16

17 280G Safe Harbors Payments related to actual performance of services Qualified plans For other amounts: 3 x average of prior 5 years But if amount equals or exceeds 3x, 20% tax applies to anything over 1x. Thus, possible early exercise of NQSO s 17

18 Management of Concentrated Stock Positions 18 18

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20 Overview of Managing Concentration Limit downside risk or Opportunistic Concentration? Avoid knee-jerk response; client s actual tolerance for risk and overall planning context Special problems Taxes Lock-ups, post IPO SEC Constraints: 16b; 10b5 Executive holding requirements and SARBOX Psychological constraints Tim Kochis, JD, MBA, CFP 20

21 Psychological Barriers 21

22 Concentration Management Techniques Start with the Simplest solution first Partial Solution/Combinations are OK walk before you run! 22

23 Concentration Management Techniques Sale Long shares/options Deferred Compensation Plans Gifts: Family Charity Margined Diversification Tax Managed Index Accounts Exchange Funds Derivatives 23

24 Sale Worst case: Keep 70-75% of pre-tax value (assumes zero basis) Can be about the same as a sales tax (5% or so) with a basis of 75% (33.3% appreciation). Waiting for Basis Step-Up is a bad bet 24

25 Distinct Sales Strategies Long shares: sell to protect against downside risk After tax exposure to downside: say, 75cents/dollar; no leverage Hold Options to capture upside Downside exposure, say, only 55cents/dollar; leverage, especially young, high priced options 25

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27 Cashless Option Exercises Allows option holder to exercise without incurring hard dollar costs or liquidating current investments Minimizes concentration risk because fewer net new shares are purchased 27

28 Coordination With Deferred Compensation Plans Indirect Deferral of Sales Proceeds Defer Salary/Bonus: Spend option/restricted stock proceeds. Disciplined Diversification Through Advance Commitment Can t spend what isn t there; must spend what s available to sell. 28

29 Sales Under 10b5-1 Plans Authorized by SEC in 2000 to Overcome 10b5, Inside Information Problems Long Shares and/or Options Disciplined Diversification Through Advance Commitment 29

30 Managing Concentration includes not buying more Avoid IRC Section 83b Elections Confidence in no forfeiture Confidence in compensation for opportunity cost Side purchase is usually better unless no public market, or tax rate change > 6 percentage points 30

31 Gifts To Family Lower tax brackets Psychic distance Discount transfer tax costs (FLP s; Defective Grantor Trusts) 31

32 Transferring NQSO s Opportunistic upside Discounted wealth transfer Retained income tax liability Discount for non-transferability May need to ignore IRS guidance on timing and on valuation (Black-Scholes) Trade-off for sale of long shares 32

33 Gifts to Charity Net cost of gift can be as little as 30cents/dollar (at zero basis; higher basis raises cost since lesser LTCG) 30% AGI limitation; 5-yr Carryover Lowest basis shares first; don t wait for Basis Step-up. Outright; CRT s; CLT s 33

34 NQSO s to Charity Black-Scholes to advantage: income tax deduction for inflated value Charity only receives actual spread: maybe too opportunistic Better?: Consume options and transfer other assets to charity 34

35 Managed Retention: Margined Diversification Simplest means of managing retained concentration Enhanced liquidity Likely reduced risk (believe it or not!) Enhanced net returns (after-tax returns greater than after tax margin costs) 35

36 Tax Managed Index Proxy Accounts Low tracking error to desired index Harvest tax losses from diversified envelope to offset gains in concentrated core Substitutes high tax-exposed, diversified portfolio for high tax-exposed concentrated portfolio Tax on sale and/or transfer to charity may still be ultimate solution 36

37 Exchange Funds Postpones, not eliminates tax liability Limited diversification Stocks within same asset classes/sectors Required 20% illiquid assets Restricted liquidity: 7 years Relatively high costs ( %) 37

38 Options and Hedges: Selling Covered Calls Low risk strategy Diversifiable premium Sets attractive, pre-committed target sale price Worst case: sell later at higher price 38

39 Protective Puts Additional investment in already concentrated position Best Case: pay for privilege of selling later at reduced price 39

40 Combining Options in a Collar Costless Collars: Call premium = Put cost Put-spread Collars: retain more downside risk to maintain more upside 40

41 Prepaid Forward Contracts Upfront cash payment (80-90%) Settlement 1 to 3 years later Partial upside (20-30%) through partial share retention Tax postponed to settlement (but no lending of shares to counter-party) Use competition among Brokers/IBanks to protect client 41

42 Summary of Concentration Management Tie to client s objectives within comprehensive plan Opportunistic concentration could be OK Partial solutions/combinations are OK often essential Simplest solutions usually the best 42