Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions Tim Kochis, JD, MBA, CFP® CEO. Kochis Global

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.


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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.


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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.


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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


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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


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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


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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


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• 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


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• 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


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• Key Conclusions From Analysis of Tax Risks

Plans with only modest internal returns are not attractive

Short deferral periods are especially risky


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• 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


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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


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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


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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


Management of Concentrated Stock Positions

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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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Psychological Barriers


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Concentration Management Techniques

• Start with the Simplest solution first

• Partial Solution/Combinations are OK… “walk before you run!”


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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


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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


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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



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.


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


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


Gifts…To Family

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• Lower tax brackets• Psychic distance• Discount transfer tax costs (FLP’s;

Defective Grantor Trusts)


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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


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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


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


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)


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


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%)


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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


Protective Puts

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• Additional investment in already concentrated position

• Best Case: pay for privilege of selling later at reduced price


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


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


Summary of Concentration Management

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• Tie to client’s objectives within comprehensive plan

• Opportunistic concentration could be OK

• Partial solutions/Combinations are OK…often essential

• Simplest solutions usually the best

Documents

Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions Tim Kochis, JD, MBA, CFP® CEO. Kochis Global