Is there such a thing as “too much” compensation? Perhaps not, according to Mae West, who reportedly once said, “Too much of a good thing is wonderful!” Nevertheless, highly compensated executives can sometimes find themselves facing unexpected tax consequences stemming from “too much” in the way of taxable income accumulated during the year as a result of vested company stock and other forms of executive compensation.
That said, mid-year is a good time for corporate leaders and other highly compensated executives to pause and assess their likely end-of-year position with respect to vesting of restricted stock units (RSUs) and other forms of executive compensation. Because the vesting or exercise of various forms of executive compensation can come with tax implications—both liabilities and opportunities—now is a good time to look ahead in order to avoid either an unexpectedly large tax bill or a missed chance to save on taxes due next April.
RSUs, Vesting, and Taxation
Often, eligible executives receive company stock in the form of restricted stock units (RSUs). Typically, RSUs are awarded according to a vesting schedule that may be based on years of service, productivity benchmarks, or other criteria as established in the company’s plan. For eligible recipients, the important point is that when RSUs are vested, their fair market value is taxable to the recipient at fair market value. So, depending on your vesting schedule, in any given year the value of RSUs vesting during the period can significantly increase your taxable income—sometimes even bumping you into a higher tax bracket.
So, it may make sense for those receiving RSUs to examine their plans and their vesting schedule, multiplying the number of units to be received by the current fair market value per share, to estimate what kind of impact the vesting will have on taxable income for the year. Next, it’s probably a good idea to revisit your current withholding to see if the current rate is sufficient to cover the potential increase in liability. Many employers withhold taxes on such supplemental income at a flat 22% rate up to $1 million. Is that likely to be enough to cover your additional tax liability?
If not, you may want to inquire whether your employer allows higher withholding on RSUs. You may also want to begin considering other strategies for reducing your tax liability, such as deferring receipt of your RSUs into a non-qualified deferred compensation plan (NQDC; if your company offers such a plan) or even donating previously vested, appreciated company shares to charity (to make such a donation, shares must have been held for at least a year after vesting). Another alternative is to increase your contributions to your company’s tax-advantaged plan (such as a 401(k)), if you aren’t already contributing the maximum.
Stock Options
Incentive stock options (ISOs) and non-qualified stock options (NSOs) are also popular forms of executive compensation. Rather than representing direct receipt of equity in the company like RSUs, they give the recipient the right to purchase company stock at a certain price (the “strike” or “exercise” price). Such options can become very valuable if the company experiences strong growth, since the strike price may be well below the stock’s then-current fair market value.
ISOs may offer the recipient a tax advantage if certain holding period requirements are met. If the options are held for at least two years after they are received by the employee (the “grant date”) and then exercised, with the subsequent stock held for at least a year after the exercise date, any gain between the strike price and the employee’s sales price will be treated as long-term capital gains. This may be advantageous, since the long-term gains rate is often less than the recipient’s marginal rate on ordinary income. However, care should be taken that exercise of the options and sale of the stock does not subject the employee to the alternative minimum tax. For this reason, it’s important to consult with your tax expert prior to taking such actions.
NSOs differ from ISOs principally in how they are taxed. While no taxes are due on ISOs until the underlying shares are sold, NSOs can generate tax liability when they are exercised (used to purchase the underlying shares). In other words, when an NSO is exercised, the difference between the exercise price and the fair market value of the shares is considered to be ordinary income for the recipient, even though the shares have not been sold. This means that if an executive expects to exercise NSOs during the tax year, they should have a plan in place to cover the taxes that will be due. This might be accomplished by selling a portion of the shares to generate the necessary funds (although any gains achieved by selling shares within a year of receipt may be taxable at the short-term capital gains rate, which is typically the same as the employee’s marginal rate on ordinary income). Here again, careful consultation with your tax expert is advisable, to make sure you are planning adequately for the tax liabilities that could be incurred.
At Optima Asset Management, we understand that complicated decisions must sometimes be made by those who are accumulating significant wealth. By acting as your personal “chief financial officer,” we can help you deal with the complexities and stay on course for achieving your most important financial goals. To learn more, Please schedule a call by visiting our website.
