Mid-year Tax Planning Considerations for Executive Compensation Plans

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Executive Compensation – Tax Planning to Increase Take-home Amounts

As we near year-end, it is important to consider some tax planning approaches that can apply in the context of executive compensation plans. This article covers a few planning ideas that may apply to your situation, or to highly-compensated employees in your business. FGMK’s Compensation Advisory Services practice can guide you in applying these planning ideas and reducing the tax cost of your compensation arrangements.

Payroll Taxes and Deferred Compensation

The “Special Timing Rule” in the Internal Revenue Code (“Code”), which is unique to non-qualified deferred compensation (NQDC) plans, results in a different date for the payment of payroll (FICA) taxes vs. income taxes. This rule impacts plans such as elective deferral and phantom stock plans, also referred to as “account balance plans,” as well as supplemental executive retirement plans (SERPs,) also referred to as “non-account balance plans.”

By way of background, FICA comprises two components: OASDI (Social Security) and HI (Medicare). In addition, most employees who participate in the NQDC plans noted above also are subject to the Medicare excise tax. FICA taxes are due with respect to account balance plans when the balance in the account becomes vested, and may be accelerated under certain rules for non-account balance plans. The vested balance, when distributed, is not subject to FICA at the time of distribution. If the special timing rule is not met, then the payroll taxes become due upon distribution of the account balance, along with any income taxes that may be payable at that time. Most employees that participate in such plans are above the OASDI limit in the year that the amount becomes vested or payable, but not when the compensation is distributed in later years. The savings from meeting the special timing rule can be significant for both the employer and the employee.

For plans that include elective deferrals with interest accrued or investment credited on the deferred account, and for phantom stock plans that can appreciate significantly in value over time, complying with the special timing rule can result in significant payroll tax savings.

ExamplePhantom Stock Plan (Account Balance Plan):

  • Special timing rule is met; account is worth $100,000 on vesting date in 2016: 
    • Payroll taxes due: $3,800 ($100,000 x 1.45% employer share + 1.45% employee Medicare + 0.9% employee Medicare excise tax.)
  • Special timing rule is missed, account is worth $500,000 upon distribution in 2020 when employee is retired and has no other source of income:
    • Payroll taxes due: $74,194 ($500,000 x 1.45% employer share + 1.45% employee Medicare + 0.9% employee Medicare excise tax + 6.2% employer share + 6.2% employee OASDI.)
  • Payroll tax savings: $70,394.

The rule works differently for SERPs because the actual benefit cannot be determined until the employee’s retirement date is set (SERPs combine length-of-service and age to determine how much the employee will receive post-retirement.) Thus, even if the employee is vested in the SERP benefit, payroll taxes are not due until both the benefit amount and the commencement date are known. At that point, the payment of FICA taxes can be accelerated by computing the estimated present value (PV) of the SERP benefit, using the actuarial equivalent amount of the vested accrued benefit by applying “Reasonable Actuarial Assumptions” as to the discount rate and mortality rate.

ExampleSERP (Non-account Balance Plan):

  • Special timing rule is met; PV of benefit is $1,000,000 upon retirement date in 2016:
    • Payroll taxes due: $38,000 ($1,000,000 x 1.45% employer share + 1.45% employee Medicare + 0.9% employee Medicare excise tax.)
  • Special timing rule is missed; benefit payable is $1,100,000 upon distribution beginning in 2017, payable over 10 years when employee is retired and has no other source of income:
    • Payroll taxes due: $168,300 ($110,000 payable each year for 10 years x 1.45% employer share + 1.45% employee Medicare + 6.2% employer share & 6.2% employee OASDI.)
  • Payroll tax savings: $130,300.

Payroll tax withholding on NQDC plans can be complicated, and most payroll services generally are not familiar with the tax rules or the plan’s particular facts and circumstances. In addition, if structured correctly, FICA taxes can be paid from the deferred compensation without violating Code section 409A, thus avoiding a cash out-of-pocket cost to the executive who would otherwise have to pay taxes prior to actually receiving the distribution from the plan.

Nonqualified Stock Options / Stock Appreciation Rights (SARs)

If you or your spouse/ life companion are fortunate enough to hold stock options or SARs that are “in the money,” now may be an opportune time to exercise them in order to avoid paying taxes on the spread at potentially the same or higher tax rates in the future. By doing so, future appreciation from the date of exercise to the date of disposition will be taxed at capital gain rates (as in effect at that time.)

Example: In 2015, the executive holds vested stock options:

  • Aggregate exercise price is $6,000
  • Aggregate fair market value (“FMV”) of the stock is $9,000
  • The executive intends to sell the stock in 2017 and believes the FMV of the stock will be $12,000 at that time
  • Highest marginal tax rates and capital gains rates:
Type of Income 2015 2017
Ordinary Income 35% 39.6%
Capital gains 20% 20%

If executive exercises in 2015 and sells in 2017:

  • Income tax in 2015 is $1,050 ($3,000 income X 35% tax rate)
  • Capital gains tax in 2017 is $600 ($3,000 capital gain X 20% tax rate)
  • Total tax paid is $1,650

If executive exercises and sells in 2017:

  • Income tax in 2017 is $2.376 ($6,000 income X 39.6% tax rate)
  • No capital gain
  • Total tax paid is $2,376
  • Benefit: $726 by exercising in 2015

The opportunity cost associated with the potential tax savings is the time value of money associated with the $6,000 paid to exercise the options in 2015 (which would need to be paid whenever the option is exercised) and the $1,050 of taxes paid in 2015. Although the example only considers the impact of federal income taxes, state and local taxes as applicable would result in increased tax savings.

Plan for Parachute Payments in Future Transactions

Do you work for a company that might be sold in 2016 or 2017? It might be possible to avoid or minimize “golden parachute” excise taxes that are imposed by Code section 280G, applicable to “excess payment” that may be due an employee when there is a change in control of the company. This golden parachute tax arises when payments such as severance and benefits continuation, sale bonuses, post-close earn-outs, and accelerated vesting of stock options, phantom stock, or deferred compensation are made as a result of a business transaction.

Under Code section 280G, a 20% excise tax is imposed on the employee with respect to the golden parachute payment, and the employer or acquirer cannot obtain a tax deduction for the amounts paid. The tax arises if the total parachute payments exceed three times the base compensation amount, defined as the average W-2 compensation over the prior 5 years. If an excess payment is made, the 20% excise tax is imposed on the total payments less the base compensation amount.

If you can foresee a change-in-control business transaction, one planning approach to mitigate the impact of this excise tax is to increase the base amount in a year or years prior to the tax year of the business transaction, by exercising in-the-money stock options or stock appreciation rights, accelerating annual bonuses, or accelerating the vesting of deferred compensation, stock options or phantom stock. For example, in the case of a change in control that occurs in 2017, stock option exercises that occur in 2016 will increase the base amount as well as the parachute payments that can be made without triggering excess parachute payments for excise tax purposes, all other things being equal.

Another planning idea is to draft or amend employment agreements with executives who could be impacted by the excise tax and include restrictive covenants (such as a non-competition clause,) which may reduce the taxable value of the potential parachute payment when it is actually triggered.

Privately held companies have the ability to use the “shareholder waiver” procedure in order to avoid the excise tax even if there is an excess payment. The parachute payment must be calculated correctly in order for the waiver to be valid for tax purposes. The company must obtain 75% shareholder approval of the payments to be made in connection with a change in control, and the executive must give up their right to receive the payment, subject to shareholder approval. Depending on the shareholder mix and the size of the payment, there may or may not be some risk with the waiver process, so careful planning for the reduction of the potential future excess payment is highly recommended.

These are a few of the most beneficial ways in which timely tax planning can help make your executive compensation program more cost effective. If you have questions regarding these, please contact the author Donald S. Nemerov


About FGMK

FGMK is a Chicago-based assurance, tax and advisory firm. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. As a leader among the top Regional Accounting firms in the Midwest, FGMK is ranked one of the 10 largest accounting firms in Chicago by Crain’s Chicago Business and is amongst the 100 largest accounting firms nationally. Our clients include privately held businesses, global public companies, private equity firms and entrepreneurs. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.

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