By Mike Valenti, CPA, CFP®, Director, Tax Planning
Corporate executives often receive the brunt of the U.S. tax system. Typically, most or all of their income is W-2 income and subject to the higher ordinary tax rates as well as FICA taxes. W-2 employees currently are unable to deduct home office expenses and other unreimbursed expenses, such as mileage and other travel costs. In terms of itemized deductions, with the $10,000 state and local tax cap in place, having a large mortgage and making charitable contributions are the two main avenues for some tax reprieve, at the surface – and even the mortgage interest deduction is limited.
The second issue with executive compensation packages is how taxes are required to be withheld. Many front-line through middle-management employees receiving annual bonuses that are a small percentage of their salary will see the bonus included in the regular payroll one week and withheld at a higher tax rate than normal. However, stock compensation, large bonuses, commissions, etc., are typically paid outside the routine payroll cycle. Supplemental compensation paid outside the salary payment is subject to a statutory federal withholding rate of 22%. Supplemental compensation in excess of $1 million is subject to a statutory withholding rate of 37%. While higher withholdings for some employees is more than adequate, the 22% statutory withholding can be a problem for executives. Their total income may put them in the higher income tax brackets, which could create up to a 15% withholding shortfall on large chunks of income. Considering that bonuses and equity compensation can often exceed the executive’s salary, this shortfall can result in a very large tax liability in April.
Third, we have a cash-flow puzzle to solve. Other than cash bonuses, equity comp can create a tax liability without a corresponding cash inflow. Paying the tax liabilities stemming from equity comp can and should be an area of focus.
To summarize, we have three main concerns:
1) A substantial amount of income is being taxed at high tax rates with little to no available deductions
2) Taxes are often significantly under-withheld on a large portion of that income
3) How and when to pay for the tax withholding shortfall.
Common Forms of Executive Compensation
Before discussing planning strategies, let’s review some common forms of executive compensation.
Just as the name implies, these are bonuses paid in cash.
Tax Impact: Cash bonuses are taxed in the same manner as regular cash/wage income; may be subject to the statutory withholding rate.
Restricted Stock Awards
Company stock issued to an employee that vests (becomes fully owned by the employee) at a later date, typically 1-5 years after issuance and/or with a liquidity event.
Tax impact: There is no tax impact at issuance, stock is taxed at vesting. The market value of the stock at the time of vest is taxable as W-2 income. Typically, a portion of the shares are automatically sold at vest to cover tax withholding. The value of the shares received then becomes the tax basis in the stock and the holding period starts on the vest date. The sale of the stock is treated as a capital gain or loss, subject to the holding period at the time of sale.
Performance-Based Restricted Stock Awards
Some companies offer a variation of restricted shares in which the number of shares transferred at vest is subject to a predetermined performance metric.
Tax Impact: The same as restricted stock awards.
Nonqualified Stock Options
The employee is given the opportunity to buy stock at a discounted price, typically the market value on the date of issuance.
Tax Impact: The difference between the market price and the purchase price at exercise is known as the spread, or bargain element. The spread is taxed as ordinary wage income, subject to FICA taxes. The gain or loss on the subsequent sale of the stock is subject to the capital gain/loss treatment (i.e., long-term capital gains are taxed at a lower rate).
Incentive Stock Options
The employee is given the opportunity to buy stock at a discounted price, typically the market value on the date of issuance. There are more tax implications and nuances than nonqualified stock options, so more planning is required if you receive incentive stock options.
Tax Impact: If shares are held for at least one year after exercise and two years after the option grant date, the gain is treated as a capital gain. If the shares are sold before either holding period is met, the difference between the sale price and exercise price is treated as ordinary wage income (not subject to FICA tax). If the shares are exercised and sold in separate years, there may be significant alternative minimum tax implications.
Application of Statutory Tax Withholding
Cash bonuses and the ordinary income portion of equity income will be included in W-2 federal wage income and subject to tax withholding. For restricted shares, shares are withheld at vest to cover taxes. For nonqualified options, shares are withheld at exercise.
Tax may be withheld on ISOs only if the shares are sold in a disqualifying transaction. This income is subject to the statutory rate of 22% (37% after $1 million of income). Tax is not withheld on equity transactions treated as capital gain income, nor is tax withheld to account for alternative minimum tax resulting from incentive stock options.
Planning to Pay the Tax
There are three potential drivers for an April tax liability:
1. Under-withholding due to the statutory rate (up to 15%)
2. Capital gains on stock sales (up to 23.8%)
3. Alternative minimum tax on incentive stock option exercises (up to 28%)
The tax bill on these income items can quickly add up. As previously mentioned, the tax on equity income isn’t tied to cash flow. For example: restricted shares are taxed on vesting, but cash will only be received if and when the shares are sold.
With the cashflow problem in mind, there are three ways to pay the tax liability:
1. Increase withholding on salary
2. Make estimated tax payments concurrent with the recognized income
3. Pay the tax in April (may risk underpayment penalties)
Perhaps one of the options is sufficient, but any combination of the three may be the appropriate approach.
Talk to Your Financial Advisor for More Help
To determine which strategy is appropriate for your situation, we recommend working with a financial planner and/or tax advisor who is familiar with nuances of executive compensation.
This communication is designed to provide accurate and authoritative information on the subjects covered. It is not however, intended to provide specific legal, tax, or other professional advice. For specific professional assistance, the services of an appropriate professional should be sought.