OVERVIEW OF EXECUTIVE COMPENSATION TAXATION

Executive compensation is a multifarious and complicated issue, enveloped in acronyms and legalese and usually involves perplexing statistics that baffle outsiders. Ordinary income tax is triggered when stock options are exercised. A part of the exercised shares is usually sold promptly to pay the recipient’s income tax burden. Selling existing common stock shares to offset the tax burden of an option exercise seems irrational since such sales will be subject to further capital gains tax.

IMPORTANCE OF EXECUTIVE COMPENSATION

A well-thought-out executive compensation plan enables companies in attracting, rewarding, and motivating important personnel by aligning their pay with the company’s objectives, eventually resulting in increased shareholder value. It is perhaps one of the most critical aspects of a company’s success. An executive pay scheme must function within the limitations of tax laws and regulations as well as compliance obligations, in addition to being competitive and driving performance. Executive compensation is often scrutinized by the public, particularly in big, public firms. Compensation that is regarded to be excessive may attract unfavorable public opinion, despite the fact that there are no hard and fast criteria that define “reasonable” compensation.

Understanding the legislation assists businesses and executives in navigating the complexity of tax planning and optimization. Due to the diversity and complexities of executive compensation arrangements, both the firm and the individual should extensively examine available possibilities in order to maximize their respective circumstances.

An executive compensation package normally includes at least some (if not all) of the following components:

– a basic salary

– yearly or short-term incentives (bonus)

– yearly or short-term incentives (bonus)

– fringe benefits (or “perks” including subsidized health insurance, business trips, and meals)

Unlike most other workers, an executive’s compensation, particularly the deferred component, is subject to risk. This implies that it is contingent on meeting certain criteria, such as completing certain service terms or meeting performance goals. As a result, if the CEO’s and/or the company’s performance falls short of expectations or plans fall through, the executive may only earn a portion of their prospective salary. While deferring remuneration does not remove the duty to pay taxes, it does postpone the payment of income taxes to a later date. The deferred components of an executive compensation package will definitely provide the most enticing tax planning alternatives for the CEO. If one can modify the timing of revenue to decrease one’s final tax burden, deferrals may have a major influence. The most typical reason for deferral is because the receiver anticipates being in a lower tax rate in the future, in which case tax deferral would be an excellent tax planning tool.

Cash compensation is generally taxed in the year it is received by the employee or service provider. Stock and other property transfers are taxed in the same way, depending on their fair market value (“FMV”). Employers may deduct compensation given to, received by, and recognized as income by the recipient in the year it is paid. What about compensation to which an executive has a legally enforceable entitlement but has not yet been paid? 

$1 Million Deduction Limit [Section 162(m)]

For starters, the Internal Revenue Code (IRC) limits the deductibility of compensation given to some “covered workers” of publicly listed firms to $1 million per year. Section 162(m)(3) defines “covered personnel” as the company’s chief executive officer, chief financial officer, and anybody who served in either job during the taxable year, as well as three additional highest-paid workers. Individuals who were covered employees for a tax year starting after December 31, 2016, will continue to be covered employees for all future taxable years, according to the guidelines. This effectively means that an employee’s status as a covered employee will never end, even if she or he no longer works for the company or is no longer among the company’s five highest paid employees, and any compensation, including post-termination compensation, paid by the company to the individual in excess of $1 million per year will not be deductible and will be subject to the corporate tax of 21%. (i.e., current corporate tax rate). For tax years starting after December 31, 2026, the American Rescue Plan Act (P.L. 117- 2, 3/11/21) amended the phrase “covered workers” to include an additional five of the highest paid employees.

Eversince the implementation of the Tax Cuts and Jobs Act (“TCJA”) in 2017, qualified performance-based compensation, which was previously excluded from the deduction limits, has been included in the remuneration subject to the $1 million deduction limit. However, the TCJA has a provision that permits some written contractual employment agreements in place on November 2, 2017, to be grandfathered under the previous system provided they have not been considerably amended or renewed since then. Accurate recordkeeping is essential for monitoring and substantiating payments to workers under grandfathered agreements from year to year until retirement, ensuring that such payments may be deducted in excess of the $1 million cap.

Income Tax Treatment of Nonqualified Deferred Compensation [Section 409A]

Nonqualified deferred compensation (“NQDC”) arrangements are governed by IRC section 409A. If a nonqualified deferred compensation plan fails to fulfill the requirements of section 409A at any point during a taxable year, the law states that any pay deferred under the plan must be included in the employee’s or service provider’s taxable income for the year, plus a 20% excise tax. There may also be late payment penalties and interest on the taxable amount, all of which are due by the deferred compensation recipient. Section 409A is complicated and broad, affecting the design of benefit programs, severance compensation arrangements, and employment contracts, to mention a few.

It is necessary to grasp the concept of constructive receipt in order to fully understand section 409A. The employee’s income is taxed at the time of his or her constructive receipt. The compensation must be exposed to a high risk of forfeiture to prevent constructive receipt. In other words, “entitlement to the amount is contingent on the execution of substantial future services by any person or the occurrence of a condition relevant to a compensating purpose, and the risk of forfeiture is significant.” [IRC Reg §409A-1(d)(1)] Compensation is considered vested when there is no longer a significant danger of forfeiture. Deferred compensation, on the other hand, is pay earned in one year but paid out later, i.e., an employee or service provider has a “legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the service provider in a later taxable year.” [IRC Reg §1.409A-1(b)(1)].

There are certain exceptions, including one for short-term deferrals [IRC Reg §1.409A-1(b)(4)]. The primary distinction between qualified and nonqualified plans is that qualified programs [IRC §401(a)] , including as 401(k) plans, are designed to offer benefits to a wide range of workers. A qualifying plan requires the creation of a trust, which is supported by contributions from either the employer or the employee. An unfunded NQDC plan, on the other hand, does not have its own separate trust established, and the funds for deferred compensation are mixed in with and paid out of the employer’s general assets, which have little to no protection from the employer’s general creditors and would be subject to a creditor’s claim in the event of the company’s insolvency. NQDC plans are a useful method for distinguishing CEO salary from that of normal workers. In comparison to qualified plans, a company has more freedom in designing NQDC plans. Corporations may choose which of its workers are eligible to enroll in such plans, and deferrals from contributions to NQDC plans are limitless. Employer-owned life insurance policies and supplementary executive retirement plans, or SERPs, are examples of NQDC plans.

The income tax obligation for remuneration earned under a NQDC plan that conforms with the rules of section 409A may be delayed to a later date. These are the specific provisions:

– The plan must be written down.

– The plan document(s) must state at the time an amount is deferred: the payment amount,  the payment plan; and the event(s) that will cause payment to occur.

– Before the year in which the compensation is received, the employee must make an irreversible option to postpone compensation. There are usually no possibilities for early withdrawal, and payment cannot be accelerated.

 

While income tax is postponed until the funds are given to the beneficiary (constructive receipt), employment tax (such as social security and Medicare) is due at the time of vesting. However, since nonqualified deferred compensation plan members are often highly paid workers, their incomes are typically substantially over the social security pay base, therefore, the Medicare tax may be the only employment tax that applies during the year of vesting.

 

Employers may not claim a current deduction on their contributions to NQDC plans until the benefits are given out to participants and the participants are taxed on them, in the same way that income tax is postponed for participants. Furthermore, rather than compounding tax-deferred, all investment returns under the programs are taxed immediately to the employer.

Section 409A and Equity-Based Compensation

Stock-based compensation, such as restricted stock units, phantom stock, and the like, is also subject to section 409A because it represents an unencrypted, unfunded guarantee by the employer to grant a set number of shares of stock or pay the cash equivalent to the employee or service provider upon the fulfillment of set performance criteria. If the exercise price of nonqualified stock options (“NSOs”) or stock appreciation rights (SARs) is less than the fair market value, they are called NQDC. They must comply with the requirements of Section 409A outlined above to avoid taxes at the time of grant. Stock rights, including stock appreciation rights, do not allow for income deferral since they are not subject to a considerable risk of forfeiture as defined by Reg 1.409A-1.

To put things in perspective, section 409A was enacted in 2005 in response to years of corporate mismanagement of deferred compensation programs, most notably in the instance of Enron, which saw its leaders’ deferred compensation payouts accelerated on the eve of the company’s implosion. Section 409A attempted to address the then-common practice of firms giving workers stock options that were already “in the money,” or options having a strike price lower than the FMV of the underlying shares at the time of issuance, in addition to banning unethical payment acceleration. For example, if a firm’s stock is worth $10 but the corporation offers an option to purchase it for $8, the employee receives $2 in value right away, which the government will wish to tax. The exercise price of a stock option must be set at or above FMV for it to be considered as a tax-free event for a firm’s workers, and the corporation must establish that the FMV used is fair [IRC Reg §1.409A-1(b)(5)(iv)(B)].

The FMV of a stock may not be simply determinable for privately owned corporations whose stock is not regularly traded. When private firms provide equity rewards to its workers, including founders, a valuation is necessary to establish the right exercise price for an option. In the past, a corporation would determine on its own what price they thought was reasonable. A correct value is necessary after section 409A, which requires considerable supportable evidence. If there has been a change in the company that might have substantially altered the corporation’s worth, an updated valuation must be acquired every twelve months or sooner. Determining if a major change has occurred that may have made a company’s present value outdated may be a difficult task, therefore organizations should obtain legal advice and proper valuation skills. The infusion of additional cash is perhaps the most typical occurrence that affects a startup’s value. Other occurrences, such as the introduction of a new product, macroeconomic developments (for example, as a result of COVID), or the unexpected entrance into a substantial contract, may need a fresh valuation analysis for a firm.

According to the regulations, valuations must be performed by a qualified independent appraiser with “at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.” [IRC Reg §1.409A-1(b)(5)(iv)(B)(2)(iii)]

Equity-Based Compensation Exempt from 409A

Certain statutory stock options, such as incentive stock options (“ISOs”), are exempt from Section 409A. Stock options must meet the conditions of section 422, which include, but are not limited to:

– Only workers may be given the option.

– The price of an option (exercise) cannot be less than the stock’s FMV at the time it is given (110% of FMV if granted to employees who are 10%  shareholders).

– The FMV of options vesting in a calendar year cannot exceed $100,000 (all additional options vesting will be classified as NSOs).

Employees are given favorable tax treatment by ISOs. When an ISO is granted or exercised, no compensation is recorded, and the employer does not obtain a tax deduction for the compensation. While there is no income tax on the option grant or exercise, the difference between the FMV and the exercise price is considered income for the purpose of computing the employee’s alternative minimum tax.

When it comes to executive compensation, ISOs are less common than NSOs due to the $100,000 cap. In a qualified disposal, the whole gain on sale may be taxed as long-term capital gains provided the holding period criteria are fulfilled (i.e., the employee retains shares for at least two years from the date of award and one year from the date of exercise). Compensation is deemed wages and is deductible by the employer in a disqualifying disposition if the holding time criteria are not fulfilled. Section 409A does not apply to stock options given via an employee stock purchase plan, just as it does to ISOs (ESPP). This article will not dig deeper into the mechanics of ESPPs since their objective is to promote employee ownership of company shares on a larger level and is less relevant for executive compensation. Employment taxes (such as FICA, FUTA, and FITW) do not apply to the exercise of an ISO or ESPP option, regardless of whether the exercise was a qualifying or disqualifying disposition. [Notice 2002-47]

Section 83(b) – Special Election on Restricted Stock

Section 83(b) allows the receiver of property (such as restricted stock) to elect to pay taxes on the complete FMV of the restricted shares at the time of award rather than upon vesting. If made, a section 83(b) election must be made within 30 days of the restricted stock award date.[IRC §83(b)(2)]

In essence, if the value of the stock is likely to grow in future years, a section 83(b) option allows the recipient to pay ordinary income tax on a low valuation. This also permits the recipient to begin the long-term capital gains holding period sooner, allowing any appreciation between the grant date and the vesting date to be taxed at the capital gain rate rather than the ordinary income tax rate. However, if the value of the stock drops in future years or the stock is forfeited, the employee may suffer financial consequences. If the restricted stock is forfeited later, the forfeiture is viewed as a sale of the shares for no compensation. In addition, the recipient is not entitled to a deduction or credit for taxes paid as a consequence of the section 83(b) option or the property’s subsequent forfeiture. [IRC §83(b)(1), IRC Reg §1.83-2(a)]

Section 280G – Golden Parachute Payments

The final point to examine is executive compensation under section 280G, also known as “golden parachute payments” because of the high payouts. Compensation made to ineligible people in connection with a change in control of the company, including severance payments, (accelerated) stock compensation, and any other sorts of benefits (i.e., change in the ownership of effective control or of a substantial portion of the assets of the corporation). Shareholders, corporate executives and directors, and highly paid persons who offer services for the business are all disqualified. [IRC §280G(c)]

Section 280G is activated if parachute payments reach three times yearly includible compensation for a base period, or base amount.  The business will lose its tax credit for the extra amount, and the disqualified person would incur a nondeductible 20% excise tax on the “excess parachute payment.” Annualized includible pay, as defined by Section 280G, is the average yearly compensation paid by the company to the employee for the previous five years (as reported on Form W-2). The amount by which combined parachute payments surpass the basic amount is known as the excess parachute payment. Simply stated, any amount of an executive’s parachute payments in excess of his or her base salary is normally liable to a nondeductible 20% excise tax after Section 280G is activated.

Evidently, invoking Section 280G restrictions may be very costly for both the company and its personnel. Companies may incorporate gross-up clauses in their severance agreements, or they may adopt such measures in preparation of a deal, from a planning standpoint. Bulk up provisions, on the other hand, may be costly and result in extra non-deductible expenditures since they effectively compel companies to gross up parachute payments in order to offset the tax impact on the CEO. There are also laws that provide shareholders an advisory vote on the topic, which will undoubtedly attract public and shareholder attention. Base amount planning, which involves exercising stock options or accelerating stock awards within the base period to effectively boost the base amount. Executives should be careful not to unintentionally trigger the 20% excise tax under Section 409A in certain situations.

KEY TAKEAWAYS

We’ve highlighted here the (i) essential terms and principles of the aforementioned tax regulations, as well as (ii) a description of the most frequent kinds of equity-based pay given in executive compensation plans, as well as their corresponding tax treatment:

Corporations that offer publicly traded securities are included (debt or equity)
– Compensation deductibility is restricted to $1 million per “covered employee” (all current or former principal executive or principal financial officers during the year and the three highest paid executives)
– For tax years starting after December 31, 2016, the “Once a covered employee, always a covered employee” principle applies.
– Since the TCJA, performance-based remuneration has been included in the $1 million maximum, unless grandfathered under the prior norm.”

Nonqualified deferred compensation programs are affected. Documentation requirements (i.e., plan papers must indicate the amount to be paid, payment schedule, and triggering events) and an irreversible choice by the participant about the timing and method of payment made before the year in which the compensation is received are among the provisions.

– If 409A requirements are met, tax deferral until payment or constructive receipt of income. – If 409A requirements are not met, compensation is includible in the current year with an additional 20% excise tax, as well as potential penalties and interest payments – all of which are imposed on the employee, not the corporation.
– Short-term deferral exemption for pay given within two and a half months following the end of the year – Equity-based remuneration provided with an exercise price less than FMV also subject to 409A – In some cases, independent appraisal of equity securities necessary to assess FMV

Applies to property given to workers and service providers in the course of providing services.

– Special election to expedite taxation on the complete award in the year in which it is made, depending on the award’s FMV at the time.
– Ordinary income tax and tax deduction for executive and employer triggered on award, respectively, and “start of clock” for long-term capital gain treatment triggered upon election.

Pertaining to parachute payments in excess of three times the average annual compensation of a base period granted to an executive in conjunction with a change in control of the business.

– In addition to relevant state and federal income taxes and employment taxes, a 20% nondeductible excise tax is applied on excess parachute payments.
– Employer cannot deduct excess parachute payments.

AWARD TYPE

DESCRIPTION

TAX TREATMENT

Incentive Stock Options (“ISO”)

421 and 422 of the Internal Revenue Code.

The following restrictions apply:

– Only available to employees

– Requires shareholder approval

– Limited to $100,000 in annual grant value 

– Only available to employees
– Requires shareholder approval

– Limited to $100,000 in annual grant value
– Exercise price must not be less than FMV of underlying stock on date of grant (110% of FMV of underlying stock if granted to a 10% shareholder) 

– Plan and option have a 10-year lifespan (5 years for >10% shareholders)

Employee:

– If holding periods are satisfied, there is no income upon option grant or exercise; nonetheless, the difference between the FMV and the exercise price is regarded as income for the purposes of computing the employee’s alternative minimum tax.
– Capital gain treatment on stock sales if the holding period is satisfied (more than 1 year after exercise AND more than 2 years after grant)
– There are no employment taxes imposed on ISOs.

Corporate employer:

– There is no deduction for ISOs.

Nonqualified Stock Options (“NQSO”)

Any service provider may be provided any option that does not qualify as an ISO (employee or nonemployee)

– The exercise price cannot be less than the fair market value of the underlying shares on the day of award (otherwise subject to section 409A penalties)

– Greater flexibility in terms of option lifespan (although companies typically apply 10-year lifespan)

Employee or Service Provider:

-Amount equivalent to excess of FMV of shares (on date of exercise) above exercise price is subject to income and employment taxes on option exercise.

– Capital gain on stock sale if selling price is more than FMV on exercise date.

Corporate employer:

– Employee or service provider receives a tax deduction equal to the amount of regular income earned.

Restricted Stock

The right to complete stock ownership vests over time.

Employee or Service Provider:

– Election under Section 83(b) is possible

– Income and employment taxes are due at the time of award (if a section 83(b) election is made) or vesting based on the stock’s current fair market value (FMV).

Corporate employer:

– Depending on whether an 83(b) election is made, a tax deduction equal to the amount of ordinary income recognized by the employee or service provider is available.

Restricted Stock Units

Promise to pay stock or cash upon vesting in the future

There will be no tax until the settlement is completed.

– Amounts received by the service provider are classified as regular income and are deductible by the employer.

– Because it is not deemed property for the purposes of Section 83(b), no election under that section may be made at the time of issuance.Employee or Service Provider:

– Election under Section 83(b) is possible

– Income and employment taxes are due at the time of award (if a section 83(b) election is made) or vesting based on the stock’s current fair market value (FMV).

Corporate employer:

– Depending on whether an 83(b) election is made, a tax deduction equal to the amount of ordinary income recognized by the employee or service provider is available.

Stock Appreciation Rights

Right to enjoy a rise in the value of the employer’s stock (the service provider can only gain from the stock’s worth increasing).

Same as in RSUs

Phantom Stock

Deferred amounts are calculated using fictitious “phantom” shares of the employer’s stock.

Same as in RSUs and Stock Appreciation Rights

Elon Musk’s Unique

Compensation Package

You might have heard when Elon Musk captured the headlines with his series of  Tesla (TSLA) stock sales which he began in November 2021. Musk famously polled his 60+ million Twitter followers on whether he should sell any of his TSLA shares in a tweet, promising to follow the results of the vote. He has now sold more than $10 billion worth of share), with further sales predicted as he faces a $15 billion tax liability on TSLA stock options that are slated to expire in the coming months. Interestingly, the manner in which Musk has sold TSLA stock has prompted some Twitter users to question his reasoning for selling existing common stock rather than executing stock options and selling a part of those shares. One striking comment on his tweet then stated that it’s possible Musk was selling current common shares to enhance the taxes he’s providing to the government, on which Musk comment to confirm: “A skilled observer would see that my (low basis) share sale rate far surpasses my 10b (high basis) option exercise rate, so closer to tax maximization than reduction”.

Read More

It’s not every day that you encounter someone who seems to be wanting to pay extra taxes on purpose. Musk, as the company’s chief executive officer, has consistently received a minimum wage base income, according to the company’s proxy statement for 2021. He never took the monetary remuneration, and the corporation finally did away with it at his request. Musk’s salary at Tesla has always been equity-based and connected to the company’s success. The shares in question were awarded as performance-based stock option awards in 2012 and are slated to expire in 2022.

Musk beneficially held 244,018,640 shares (or 23.1%) of the company’s common stock as of June 30, 2021, according to the company’s proxy statement declarations. This includes outstanding common stock, common stock with options, and other convertible instruments.

Although Musk is not your usual CEO and his compensation package is clearly unique, executive compensation has soared to previously unheard-of levels in recent years. How many of us can imagine receiving millions, if not billions, of dollars in compensation?

CONSULT WITH CREDO

Executive compensation is undeniably complicated. The gap between ordinary income taxed at 37% (the highest marginal tax band in 2021) and capital gains taxed at 20% has a significant financial effect.

The tax laws and regulations governing executive compensation are complex and constantly changing, and there are numerous exceptions and special rules that have not been addressed in this article. While this article provided an overview of major ideas and rules of the tax law that impact CEO compensation, companies and their executives will always be best served by seeking competent tax and legal counsel when selecting the best course of action.

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