Minimizing Taxes on Executive Compensation

By: Brian Seay, CFA

Founder, Capital Stewards

Each year, executive compensation packages become more complex with many moving parts. You may receive a significant portion, if not the majority, of your compensation in the form of stock or stock options. Our Huntsville financial planning team has helped optimize many forms of executive compensation. Below are a few strategies for managing your compensation to achieve your long-term wealth management goals.

Negotiate Types of Pay When Taking a New Role:

The best way to minimize taxes is to have some control over your income. If you are simply receiving income on a w-2 that you do not control, your ability to implement strategies that reduce taxes will be diminished. Here are a few negotiating points to consider:

• Consider asking for restricted stock instead of RSUs or options; restricted stock allows you to recognize the income immediately and pay reduced capital gains tax rates on future appreciation. Note, you may need cash to pay the initial tax bill.

• Negotiate deferred compensation. This moves some of your income to future years, typically retirement, when your taxable income is lower.

• Ask for ISOs or Incentive Stock Options instead of NQSOs or Non-Qualified Stock Options. ISOs receive preferential capital gains tax treatment.

Your compensation typically becomes an expense to your employer when you recognize the income on your tax return. Deferring your income may also defer expenses for your employer, which may be desirable in some situations. Your employer may also want to recognize as much income as possible as soon as possible for their own tax purposes, which hurts your case. That’s why this is a negotiation.

Reduce Taxes for Restricted Stock Vesting (RSA and RSU):

First and foremost, the difference between actual restricted stock and “restricted stock units” matters greatly. Actual restricted stock comes with voting rights, dividend distributions and other benefits of stock ownership. RSUs are merely a promise by your employer to provide shares at a future date, usually according to a vesting schedule. As we mentioned above, you may elect to realize actual restricted stock income immediately and future gains will be taxed at capital gains rates, which are significantly lower than ordinary income tax rates for high income earners. If you do have RSUs, their value is included in your ordinary income in the year of vesting (usually when you can sell). To reduce the income tax hit, comprehensive financial planning is required. Here are three ideas:

1. Spread vesting periods out over multiple years to keep your effective tax rate lower each year

2. Manage your outside income and deductions to reduce income in years with significant vesting. Owning real estate with depreciation benefits, selling investments with losses  and “bunching deductions” may be helpful ways to reduce your total taxable income for a particular year. Your financial advisor or tax professional can help identify strategies for your situation.

3. Consider charitable contributions. If were planning to give to an organization, vesting years may be a good opportunity for strategic gifts. Also, consider creating and funding a private foundation or public charity to build a philanthropic base for your family. If you have less than $500,000 to contribute, a community foundation or donor advised fund may provide similar benefits with less administrative overhead.

Managing Stock Options Efficiently (ISO and NQSO)

There are two forms of stock options for tax purposes, Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs).  ISOs receive preferential tax treatment. By meeting holding period criteria, the entire grant may qualify for reduced capital gains tax rates. ISOs have annual limits because of the tax treatment, so while helpful for taxes, these will likely be a smaller portion of your total compensation. If an option doesn’t meet the qualifications for ISO treatment, it is a “Non-Qualified Stock Option” or NQSO. The profit on the option exercise (difference between the stock’s market price and the strike price) is included in your income when the option is exercised. If you continue to hold the stock, subsequent gains are taxed at reduced capitals gains rates. Like RSUs, the best strategy for NQSOs is to spread out the exercise timeline and reduce your total income for years with significant options activity. Our professional financial advisors in Huntsville can help build a plan to minimize the tax burden from stock options.

If you have executive compensation in Huntsville and would like to discuss your situation further, we would be happy to schedule a short intro call to better understand your situation.