Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions
Tim Kochis, JD, MBA, CFP®CEO. Kochis Global
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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
Tim Kochis, JD, MBA, CFP ®
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.
3Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
PurchaseSection 83 (b) Election
Initial value $10,000 $10,000 $10,000
Additional Purchase N/A 2,800 N/AInitial tax @ 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 5 years @ 9.75% per year
5,923 5,923 5,923
Tax @ 40% at lapse of restrictions (6,369) (6,369) N/A
Growth in value on additional shares @ 9.75% per year
N/A 1,658 N/A
Tax on long-term capital gain on sale of initial or additional shares @ 20 %
N/a (331) (1,185)
Best choice $10,501 $10,881 $11,938
Tim Kochis, JD, MBA, CFP ®
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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.
1970’s: 70% marginal rates, but 50% “max tax” on current compensation:o In service deferral periods ariseo Impetus for earnings; initially only an interest rate measure
Equalized rates (before and after retirement) and much lower rateso Deferred compensation institutionalized by theno Return becomes paramount
20% LTCG rates make high absolute earnings rates/opportunities essential
Section 409(a) - 2004
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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Non-Qualified Deferred Compensation
• Superior Investment ReturnsDeferred compensation turns a pre-tax return into an after-tax return
No Deferral DeferralCompensation $10,000 $10,000Current Tax (40%) (4,000) N/ANet Investable 6,000 10,000At 6% After Tax for 5 years 8,029 N/AAt 6% Pre Tax for 5 years 13,382Tax at Receipt (40%) N/A (5,353)Net in 5 years $ 8,029 $ 8,029
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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 1st 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
Tim Kochis, JD, MBA, CFP ®
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“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
Tim Kochis, JD, MBA, CFP ®
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§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
Tim Kochis, JD, MBA, CFP ®
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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®
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Concentration Management Techniques
• Start with the Simplest solution first
• Partial Solution/Combinations are OK… “walk before you run!”
Tim Kochis, JD, MBA, CFP ®
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Concentration Management Techniques
• Sale– Long shares/options– Deferred Compensation Plans
• Gifts: Family…Charity• Margined Diversification• Tax Managed Index Accounts• Exchange Funds• Derivatives
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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
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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.
Tim Kochis, JD, MBA, CFP ®
Sales Under 10b5-1 Plans
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• Authorized by SEC in 2000 to Overcome 10b5, “Inside Information” Problems
• Long Shares and/or Options• Disciplined Diversification Through
Advance Commitment
Tim Kochis, JD, MBA, CFP ®
Managing Concentration… includes not buying more
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• 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
Tim Kochis, JD, MBA, CFP ®
Gifts…To Family
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• Lower tax brackets• Psychic distance• Discount transfer tax costs (FLP’s;
Defective Grantor Trusts)
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
NQSO’s to Charity
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• 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
Tim Kochis, JD, MBA, CFP ®
Managed Retention: Margined Diversification
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• 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)
Tim Kochis, JD, MBA, CFP ®
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
36Tim Kochis, JD, MBA, CFP ®
Exchange Funds
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• Postpones, not eliminates tax liability• Limited diversification
– Stocks within same asset classes/sectors– Required 20% illiquid assets
• Restricted liquidity: 7 years• Relatively high costs (1.5-2.5%)
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
Protective Puts
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• Additional investment in already concentrated position
• Best Case: pay for privilege of selling later at reduced price
Tim Kochis, JD, MBA, CFP ®
Combining Options in a Collar
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• “Costless” Collars: Call premium = Put cost
• “Put-spread” Collars: retain more downside risk to maintain more upside
Tim Kochis, JD, MBA, CFP ®
Prepaid Forward Contracts
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• 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
Tim Kochis, JD, MBA, CFP ®