Maximizing Executive Compensation

Complex and varied, executive compensation packages require highly specialized understanding and advanced wealth planning strategies.

Along with the challenge of leading a company comes the responsibility of long-term wealth planning complicated by the nuance of an executive compensation plan. One of the greatest benefits available to you as an executive is equity-based compensation, which can be an extremely advantageous vehicle for wealth creation. Yet, each element of your compensation package demands highly specific wealth planning treatment. Take time to understand the wide-ranging attributes of these offerings and create effective strategies.

Below, we discuss several primary building blocks of executive compensation, including fixed-base salary and cash bonuses, equity-linked compensation, and non-qualified deferred compensation plans.

For a more in-depth discussion on the topics discussed here, including their associated tax treatments, read A Guide to Maximizing Corporate Executive Compensation.

Fixed-base Salary and Cash Bonus

By far, your salary and short-term incentives are likely to pale in comparison to the wealth you stand to acquire from long-term incentive programs and equity-based compensation. However, salary and short-term incentives are the most predictable aspects of your compensation plan, and neither rests on stock valuation or vesting. Although base compensation and bonuses do not necessarily require specialized planning, the key is to take advantage of the certainty they provide. Consider how best to utilize them for financial objectives:

• Build cash reserves to establish liquidity in your portfolio

• Pay off nondeductible debt

• Minimize mortgage debt on your primary home or vacation property

• Fund a 529 Plan for future education costs
  

• Elect to defer a portion of compensation in your company’s deferred compensation plan

• Pay the premium on an individual life insurance or disability income policy separate from your company

• Establish a charitable gifting plan for the causes and organizations important to you

Equity-linked Compensation

The majority of executive compensation is comprised of equity in the form of company stock, which exposes your portfolio to risk but also rewards you as the value of your company increases. For each of the offerings described below, be meticulous in your understanding of vesting periods, deliberate in your exercise strategy, aware of expiration dates and mindful of company retention guidelines. 

Stock options

Options provide the opportunity to participate in your company’s growth without placing personal wealth at risk. When granted an option, you have a right to purchase the stock at a predetermined price (strike price) for a defined period of time. Once the option vests, you then determine when to exercise that right. Two of the most common options are qualified incentive stock options and non-qualified stock options. The primary difference between the two is tax treatment with ISOs offering a potential tax benefit:

• With ISOs, which are generally only available to executive management, there is no regular tax at grant, vesting or exercise (although there could be alternative minimum tax consequences). Upon disposition and given that holding requirement periods are met, the gain is taxed as long-term capital gain, which is usually lower than the income tax rate.
  

• With non-qualified stock options, ordinary federal income tax, state income tax and payroll tax are due upon exercise.

Restricted stock awards

Rather than provide an opportunity to purchase stock, a restricted stock award (RSA) grants stock subject to vesting – usually dependent on the continuation of employment or specified goals. Many public and private companies offer RSAs due to the strong retention characteristic nature of such grants. 

One of the key considerations with RSAs is whether or not to make an IRS Section 83(b) election, which allows you to pay taxes on the stock at present value at the time of receipt. This can be advantageous from a tax perspective if you believe in the long-term value of the stock and are confident it will be vested. We illustrate the use of an 83(b) below.

Assume an executive is awarded restricted stock in 2020, which will vest in 2025. 

• At the time of the award the stock has a value of $200,000.

• Upon vesting the stock has a value of $250,000.

• The executive sells the stock in 2026 when it is valued at $350,000.

Executive pays $8,500 less in taxes by making an 83(b) election

83(b) election

If the executive makes a Section 83(b) election, the executive will pay ordinary income tax on $200,000 for the year of grant. Upon vesting, no tax is owed on the appreciation of $50,000. However, when the stock is sold, the executive will owe long-term capital gains tax on the entire stock appreciation in the amount of $150,000 ($350,000 fair market value at sale, less $200,000 cost basis).

No 83(b) election 

If the executive decides not to make a Section 83(b) election, the executive will pay ordinary income tax on $250,000 – the value of the stock when it vests. When the stock is later sold, the executive will owe long-term capital gains tax on $100,000 ($350,000 fair market value at sale, less $250,000 cost basis).

Non-qualified Deferred Compensation Plans 

A non-qualified deferred compensation plan is not a type of compensation, but a plan that allows you to earn your salary, bonus or any other compensation in one year and receive and pay income taxes in the future – typically during retirement when taxable income is expected to be lower. Many companies will also match a portion of the compensation deferred.

Because non-qualified deferred compensation plans are not subject to qualified plan regulation, they vary widely from company to company and can be specially customized to an executive.

A non-qualified deferred compensation plan can be a powerful tool to minimize tax while accumulating wealth, especially for executives who are maximizing 401(k) contributions. As a high income taxpayer, balance the benefits of tax-deferral against potential risks: 

• Since any income deferred remains an asset of your company, if your company endures financial distress you may suffer a loss because your company’s creditors may be first in line for payment.
  

• Another challenge is that when you defer you are required to specify the date and manner in which you will receive payment. Although you may elect payment over a period of years or at retirement, you run the risk of needing the payments sooner and potentially incurring penalties to access your money.

Next Steps

• Use predictability to plan
  Salary and cash bonuses likely will be the smallest component of your compensation package, yet the consistent receipt of salary and cash bonuses provides an opportunity to build cash reserves and forms the foundation of your compensation arrangement.

• Mitigate concentrated positions
  Develop a long-term plan for reducing your options holding – for example, based on your retirement date. Sell enough shares to pay the strike price, tax liability and transaction fees, yet hold a designated amount of net shares to demonstrate ongoing confidence in the company and satisfy the minimum stock ownership requirement.

• Time the distribution period of deferred compensation
  Federal tax rules dictate whether a state may tax a distribution. If you select a distribution period less than 10 years, income will be taxed in the state earned. On the other hand, payments made over 10 years or more are taxed in the state of domicile. 

For more on cash flow planning and maintaining sufficient liquidity, read Cash Flow: Planning to Fund Major Purchases.