Equity-Based Compensation

NQSO vs ISO: Tax Treatment

*Grant Date:* -NQSO: no taxable event -ISO: no taxable event *Exercise Date:* -NQSO: compensation income to employee (deduction for employer) -ISO: AMT adjustment item to employee (no deduction for employer) *Stock Sale Date:* -NQSO: short-term or long-term capital gains depending on holding period -ISO: long-term capital gains if meeting special holding period rules

Flexible Spending Accounts (FSAs)

-a cafeteria plan consisting of various tax-free benefits that are funded through salary reductions elected by employees each year -for a health xxx to be a qualified benefit under a cafeteria plan, *the maximum amount available for reimbursement of incurred medical expenses of an employee* (and dependents and other eligible beneficiaries) *under the health xxx for a plan year* (or 12 month coverage period) *cannot exceed $2,550* -the maximum salary reduction election for the dependent care xxx is $5,000 -employee salary reductions applied to the nontaxable benefits offered under these accounts are not subject to either income tax or payroll (FICA) tax

Prepaid Legal Insurance

-a fringe benefit that makes legal services available to employees Ex of benefits possibly included: -bankruptcy assistance -adoption assistance -divorce legal fees assistance, and -preparation of estate planning documents -the employer fully pays the cost of the legal services and deducts the expenses necessary to maintain the plan

Unfunded Plan

-a nonqualified deferred compensation lan in which the benefits typically do not vest until the employee retires from the company 2 Types: 1.) Pure Unfunded Plan 2.) Informally Funded Plan

Excess Benefit Plan

-a nonqualified plan that focuses on providing retirement income to executives -specifically, the plan *provides the executive with a benefit over and above* the IRC Section 415 defined benefit plan limit *($210,000 in 2016)* -the plan provides the executive with the difference between the amount payable under a qualified pan and the potential amount received if the Section 415 plan limitation did not exist -a *major advantage* is that, *as a purely unfunded plan, it is not subject to the reporting and disclosure rules of ERISA* -in addition, *the plan can discriminate in favor of highly compensated individuals* -however, from a exec's standpoint, the principal problem with these types of plans is the lack of security that arises from the employer's mere promise to pay the additional retirement benefit Ex: defined benefit plan promises all employees 80% of their salary at retirement, provided they have worked for the company for 20 years -you have worked 30 years, and current salary of $300k. So at retirement, you would be entitled to $240k/yr -however, because of Section 415 benefit limitation of $210,000, you are limited by law to the smaller amount -therefore, to bring up the promised benefit amount, your company installs an xxxxxx xxxxxx xxxx to fund the difference ($30,000)

Cafeteria Plan

-a plan in which employees make within limits, choose the form of employee benefits from options provided by their employer -such a plan must include a cash option (in lieu of noncash benefits of equal value) which is taxable as W-2 compensation income (ordinary income) -this plan is most appropriate to implement when the employee benefit needs vary within the employee group Ex: -a young unmarried individual may have only a limited need for medical insurance benefits whereas an older employee with a family may need maximum medical insurance benefits -highly compensated employees may lose the tax-free nature of included benefits if the lan discriminates on their behalf *tax-free benefits* that may *NOT* be offered through the plan include: -scholarships and fellowships -educational assistance -employee discounts and -retirement or nonqualified plan benefits -xxxxxx plan that is funded entirely through employee salary reductions (with no employer contribution whatsoever) is known as a *flexible spending account*

Junior Class Shares (JCSs)

-a separate class of common stock whose voting and dividend rights are subordinate to the regular class of common stock issued by a corporation -are typically convertible into regular shares upon certain specified events, such as the attainment of performance goals by the employee -conversion may be automatic if stated in the issuing document, or at the option of the employee

Alternative Minimum Tax (AMT)

-a system designed to ensure that individuals with large deductions and other tax benefits pay at least a minimum amount of tax

Voluntary Employees' Beneficiary Association (VEBA)

-a type of welfare benefit plan into which employers make deposits that will be used to pay specified employee benefits in the future -the most common type of benefit included in the xxxx is a severance pay plan for selected executives -however, vacation and employee sabbatical benefits may also be included -operationally, a tax-exempt trust is established by the employer to maintain the funds needed to pay the future benefit to employees -the income from the trust is exempt from regular income tax if the xxxx meets certain requirements -thus, the xxxx permits the employer's income tax deduction for certain employee benefits to be accelerated (or prefunded) while also generating tax-free income to assist in the payment of those benefits

Gifting Nonqualified Stock Options

-a viable planning technique is for the employee/executive to gift the NQSO to either a family member or qualified charity before the option's exercise date -in this manner, *the employee recognizes no gain on the transfer date* and may potentially remove the option and shares of stock from the taxable assets of the estate -however, when either the family member or qualified charity exercises the option, *the employee will have W-2 compensation income, which is a type of ordinary income, and this income will be subject to FICA or payroll taxes at the exercise date* -if the recipient is a qualified charity, the employee will be permitted a charitable income tax deduction on the transfer date (or the option's vesting date, if later)

Substantial Risk of Forfeiture

-a xxxxxxx xxx xxxxx xxxxx exists if the arrangement provides that the employee will forfeit the stock in any of the following circumstances: *The employee*: -does not remain with the employer for a specified period -does not meet certain sales or performance goals -goes to work for a competitor -works for a corporation that is not controlled by immediate family members

Cashless Exercise

-a xxxxxxxx xxxxxx of either an NQSO or an ISO involves the selling of employer stock (rather than a cash outlay by the employee) to satisfy the exercise price and any other costs associated with the exercise, such as income taxes -as a result, the employee receives the net amount of the stock (the stock remaining after the sale of shares) or all cash -this technique is normally suitable for employees who do not have enough cash to satisfy the exercise price an any other costs associated with exercising the option

Rabbi Trust

-an arrangement under which *the employer places assets into an irrevocable trust to fund the payment of promised deferred compensation to selected employees* (usually valued executives) -agreement states that the assets placed in the trust remain *subject to the claims of the employer's general creditors* in the event of its insolvency or bankruptcy -the *employer must still pay tax each year on the trust earnings*, unless the trust assets consist of cash value life insurance or some similar asset -*taxation occurs to the executive when the payments are received from the trust*, and the *employer is entitled to a commensurate income tax deduction at the same time* -an executive may also consider purchasing a surety bond if there is concern with regards to receiving the payment of the deferred compensation from the former employer

Secular Trust

-an irrevocable trust established for the exclusive benefit of the employee/executive -as such, it is *not really a deferred compensation vehicle at all*, but rather an investment management vehicle used to grow the assets within the trust -the funds inside the trust are *not subject to the claims of the employer's general creditors* -as might be expected, the executive who benefits from such a trust also does not have a substantial risk of forfeiture and *is taxed immediately on the employer contribution and annually on the trust earnings* -the *employer also receives an immediate income tax deduction for amounts contributed to the trust* -these are a more *popular* planning vehicle *when corporate marginal income tax rates are higher than those for individuals* -however, when the corporate and individual income tax rates are more level, this type of trust is not widely used

Non-qualified Deferred Compensation Plan Structure: Salary Continuation

-approach for structuring a non-qualified deferred compensation plan (NQDC) -in this approach, the plan is funded with money that the employer has set aside from its current earnings to benefit the executive -as might be expected, this approach is preferred by most executives because they are not sacrificing any of their own compensation to fund the ultimate benefit

Non-Qualified Deferred Compensation Plans

-arrangements that do not meet the requirements of IRC Section 401(a) or qualified retirement plans -these lans are normally used to benefit key executives to the exclusion of rank-and-file employees, hence the term "executive compensation" that is often used interchangeably -the major advantage of these plans is that it does not have to comply with the general nondiscrimination rules that apply to qualified plans -also, these plans are not subject to all reporting and disclosure requirements that pertain to qualified plans Tax benefits? -employee deferral of income -deferred employer deduction Distributions? -taxable as ordinary income (no exception for employer stock)

Issues with FSAs

-because of employer administrative costs, xxxx are usually impractical for businesses with only a few employees -in addition, xxx benefits cannot be provided to self-employed persons or partners -an issue with health xxx was the "use it or lose it" rule -recently, this issue has been addressed by legislators who have decided to allow for cafeteria plans to be amended to allow up to $500 of unused amounts remaining at the end of a plan year in a health xxx to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year, provided that the plan does not also incorporate the grace period rule

Section 83(b) Election

-by making this selection, an employee who receives restricted stock *may elect to recognize the compensation (W-2) income immediately* rather than wait until the substantial risk of forfeiture expires -if this is elected within 30 days of receiving the restricted stock grant, the employee includes as W-2 income the FMV of the stock at receipt less any amount paid for the stock -as a result, *any subsequent appreciation in the value of the stock is treated as capital gain* and may be taxed at lower capital gain rates when the stock is sold

Phantom (Shadow) Stock

-closely held corporations that wish to reward their highly valued employees, but do not want additional shareholders, use xxxxxx xxxxx xxxxxxxxxx -such arrangements are structured as fictional deferred compensation accounting entries where the base value is equal to the current value of the corporation's common stock -the plan then provides for adjustments to the fictional entries to track the real appreciation of the corporation's common stock -each year, the employee/executive becomes bested in the shares, and lump-sum payments normally are made at the executive's retirement or some other specified event -*the payment is made in the form of cash* -employee/exec is *taxed as ordinary income tax rates when payment is received at retirement or some other event*, and the *employer receives an income tax deduction at that time* -major drawback of establishing this type of plan involves having to determine a value for the closely held stock at various times -these appraisals of stock value can be expensive, and given volatility, somewhat unreliable

Restricted Stock

-employer stock (not a stock option) that is forfeited by the employee/executive if the employment performance is not satisfactory or if employment terminates before a requisite period -once the requisite period ends, and the company stock has *vested* (becomes non-forfeitable), the stock is the employees -if you are granted 100 shares @ $10/share, and after the holding period, the shares are trading @ $20/share... -you must report $20,000 of compensation (W-2) income and pay income tax on this amount at your current marginal income tax rate

3 Basic Income Tax Doctrines

-for a non-qualified plan to defer the taxable compensation of the executive from the current year to sometime in the future, it must not run afoul of three basic income tax doctrines: 1.) Constructive Receipt 2.) Economic Benefit Doctrine 3.) Substantial Risk of Forfeiture

Stock Options

-give the employee (usually an executive) the right to purchase a fixed number of shares of employer stock: -at a predetermined price -over a stated period -the grant or award of a xxxx xxxxxx is generally a nontaxable event because the option's exercise price is usually equal to the stock's trading price on the day of the award -therefore, the option has no readily ascertainable value, and there is no economic benefit to the employee to tax 2 Types: -nonqualified stock options (NQSOs) -incentive stock options (ISOs)

Unfunded Plan: Pure Unfunded Plan

-in this type of plan, only a mere promise is made by the employer to pay the benefit to the executive -in other words, no assets re set aside to make good on this promise -obviously, this places the executive in a difficult position because he is trading the uncertainty of future payment for the income tax deferral of current compensation

Substantial Risk of Forfeiture

-income tax doctrine that must be considered when implementing a nonqualified plan -if there is a xxxxxxx xxxx xx xxxxxx with respect to the set-aside assets in a nonqualified plan, the deferred compensation will not be treated as constructively received -in turn, the executive will not have any currently taxable income

Unfunded Plans: Informally Funded Plan

-more popular type of unfunded nonqualified deferred compensation plans -xxxxx xxxxx is considered as unfunded because the underlying assets funding the plan are owned by the employer (rather than the executive) and are subject to the claims of the employer's general creditors -therefore, these plans essentially meet the executive halfway -- that is, it provides some security of future payment (absent the employer's bankruptcy or acquisition by another company) while also deferring taxation on the exec's current compensation -most popular type of this plan is the so-called "rabbi trust"

Employee Stock Purchase Plan (ESPPs): Requirements

-must be a written plan approved by the shareholders -the option grant price must not be less than the lesser of: -85% of the fair market value on the grant date, -85% of the fair market value of the stock on the exercise date -no employee can acquire the right to buy more than $25,000 of stock per year, valued at the time the option is granted -shares must be held *at least 2 years from the date of the grant of the option* and *1 year from the date of exercise* -if employee does not remain employed, any outstanding stock options must be exercised within 3 months after leaving the company

Funded vs Unfunded

-nonqualified plans may be either funded or unfunded -because the income tax implications of a funded plan are generally inconsistent with the goal of tax deferral by the executive, *most nonqualified plans are unfunded* -if the plan is funded (typically where the fund set aside on behalf of the exec is held in trust or in escrow) The executive is taxed at the later of: -the date the employer contributions to the trust or escrow fund are made; or -the date there is no longer a substantial risk of forfeiture associated with the fund

Dental and Vision Insurance

-normally provided on a group basis -as with health insurance, *premiums paid by an employer are tax-deductible to the employer* and *benefits received by employees are income tax free* Vision Insurance: -covers care and treatment for the eyes -often provided by employers with health insurance plans, vision plans generally cover annual eye exams, glasses, contact lenses, and other services such as glaucoma screening -other plans may be much more restrictive, covering only annual eye exams -the taxation regarding premiums is similar to that of health and dental insurance.

Nonqualified Stock Options (NQSOs)

-not tax-qualified -employee is not taxed until the date of the exercise of the option -on the exercise date, the "bargain element" represents income to the employee -this bargain element is taxed *at the date of the option's exercise* as W-2 compensation income, which is a type of ordinary income, and *is subject to payroll or FICA taxes* (b/c the option was granted originally in lieu of salary compensation) -employer also receives a deduction for the amount of the bargain element when the employee brings the amount into income -the stocks *holding period*, for purposes of determining long or short-term capital gains treatment to the employee, *begins with the exercise date* -the taxable basis in the stock is equal to the option's exercise price plus the ordinary income recognized on the exercise date

Incentive Stock Options (ISOs): Requirements and Taxation

-numerous requirements must be met under the IRC Code for a stock option to qualify for tax-favored status as an incentive stock option (ISO) -these requirements are also referred to as *the special holding period rules* Rules and Requirements Include: -ISO must be part of a written plan approved by the stockholders -exercise date of the option *cannot exceed 10 years* from the date of its grant -exercise price of the option cannot be less than the market price of the stock at the date of the grant -there is an annual limit of $100k on the value of the ISOs granted in any one year of the employee -shares received through the exercise of the ISOs *cannot be sold within two years from the date of the option's grant* and *one year from the date of the option's exercise*, otherwise the favorable tax treatment will be lost

Constructive Receipt

-tax doctrine which occurs within a non-qualified plan if the exec has unrestricted access to the funds set aside by the plan -the funds deemed to be constructively received are required to be reported immediately as taxable income to the executive, *thus defeating a primary tax advantage of a deferred compensation arrangement* -indicates when income is taxable -indicates *what* constitutes income (economic benefit doctrine)

Employee Stock Purchase Plans (ESPPs)

-plans that provide employees with options to purchase employer stock through payroll deductions -in addition to other requirements, the plans must be nondiscriminatory and often limit the amount of employer stock that an employee can actually purchase -however, if the plan meets all the necessary requirements, there are *NO income tax implications to the employees at either the grant or exercise date fo the options* -unlike ISOs *which are designed for key employees*, ESPPs are generally intended for rank-and-file employees -the plan must be nondiscriminatory -generally, to participate in an employer stock purchase plan, *employees agree to have a percentage of their income or specific dollar amount of their income deducted from their paychecks* -this money is typically accumulated over months with a prevailing *accumulation period as short as 6 months but as long as 27 months* -at the end of the accumulation period, the employee's funds are used to purchase shares of the employer's stock -the price is typically *85% of the lesser* of the price at the beginning of the accumulation period or at the end of the accumulation period

Corporate-Owned Life Insurance (COLI)

-provide funds to pay the benefit in the event of the executive's death before retirement while also accumulating cash value to pay the benefit at retirement (or some future date) if the executive is still alive -the employer is neither allowed a deduction for the premiums paid on XXXX, nor may deduct interest paid on any loans borrowed from these policies, except under limited circumstances -cash value life insurance is a very popular funding vehicle for nonqualified plans because its cash value buildup is not currently taxed to the executive -thus, insurance policies may be purchased on the executive's life and still be owned by the employer to fund the promised benefit -*DO NOT* place this product in a trust or in escrow for the unconditional payment to the executive -if the policy is owned by a trust, the strategy triggers the economic benefit doctrine and results in *immediate taxation of the cash value accumulation to the executive/trust beneficiary*

SIMPLE Cafeteria Plans

-qualifying small businesses can adopt xxxxxxxxx xxxxxx plans -eligible employers include those that employed, on average, 100n or fewer employees during either of the preceding two years -generally, all non-excludible employees with at least 1,000 hours of service during the preceding year must be allowed to participate *Advantage* -their reduced administrative burden Ex: -these plans that meet certain minimum eligibility, participation, and contribution requirements are not subject to the complex nondiscrimination requirements that otherwise apply to cafeteria plans

Junior Class Shares (JCSs) vs NQSOs

-similar to NQSOs, but xxxs are taxed more favorably -although both JCSs and NQSOs give employees the right to acquire company stock at a price below FMV, *the employee receiving JCSs is not taxed on the date the JCSs are converted to regular common shares* -rather, *taxation is deferred until the sale of the regular shares*, and the *difference between the sale price of the stock and the employee's basis in the stock* (what was paid for the JCSs, if anything) is taxable *as capital gain*

Stock Appreciation Rights (SARs)

-similar to phantom stock plans except that XXXs give the employee/exec a choice of when to exercise the right to share in the appreciation of the closely held company's stock -in addition, with XXXs, *only the appreciation on the stock is awarded* (not the full value of the stock as in a phantom stock arrangement) NOTE: -XXXs are used heavily by closely held businesses that are unable to offer traditional forms of ownership such as limited liability companies (LLCs) and/or S corporations, which are restricted from having more than 100 shareholders/owners by law

Bargain Element

-the difference between the market value of the stock at any particular time, and the option's exercise price Ex: -you are granted NQSOs with right to purchase, no earlier than five years from the date of the grant: 1,000 shares of company stock at $50/share = *$50,000* -five years later, you purchase the 1000 shares, while the actual market price of the stock is currently $150/share = *$150,000* -when you purchase the stock, your basis is $50,000, *plus the $100,000 bargain element* -you *must report* this bargain element *as ordinary income and pay FICA taxes at the same time* -YOUR COMPANY also receives a $100k income tax deduction at that time *Finally* your taxable basis in the stock now becomes $150,000 -you will need to hold the stock for *more than one year after the exercise date* before becoming entitled to long-term capital gains treatment on any appreciation of the stock

ESPPs Tax Treatment

-the employee will recognize ordinary income based on the lesser of the FMV of the stock at the grant date *less* the option price, or hte FMV of the stock on the disposition date (or date of death, if sooner) *less* the option price -the balance of any gain is treated as capital gain -if the option price is equal to the FMV of the stock at the date of grant, all gain at disposition will be capital gain (if the shares are held by the employee for at least two years from the grant of the option and one year after the exercise)

Supplemental Executive Retirement Plan (SERP)

-the prototypical nonqualified salary continuation plan -this plan provides benefits to executives over and above the benefits available from a qualified plan and is funded entirely with employer money -these plans can be either completely unfunded (like an excess benefit plan) or informally funded -most are informally funded and reward continued employment or encourage the early retirement of the executive -may also be established to protect the executive from involuntary termination if the company changes ownership by awarding an increased benefit from the plan -unlike an excess benefit plan, a XXXX is designed to provide a specified percentage of retirement income to the executive without regard to the Section 415 benefit limit Ex: -Joe is an exec with a company that offers her a XXXX with a benefit equal to 60% of his highest three years' average compensation -if Joe's average compensation under this formula is $400,000, her average annual XXXX benefit is $240,000 ($400,000 x .60), which is higher than the maximum Section 415 benefit limit

Surety Bond

-this bond ensures that the benefit will be paid if, for any reason, the employer is unable to make good on its promise -however, the executive must pay the premium for the bond without being reimbursed by the employer -if so, the IRS has ruled that the purchase of the bond does not create a current vested right to the deferred compensation which would result in current income taxation

FSA Applicable Use

-this type of cafeteria plan is most appropriate *when costs of employee benefit plans, such as health insurance, have increased and the employer must impose additional employee cost sharing* -it is also appropriate *when there is a need for benefits that are difficult to provide on a group basis, such as dependent care* -as a result, most xxx provide for salary reduction dollars to pay: -deductibles on group health insurance policies -coinsurance provisions on group health policies; and -dependent care (child care) expenses

Economic Benefit Doctrine

-while the constructive receipt indicates *when* income is taxable; the xxxxxx xxxxx xxxxx defines *what* constitutes income -one of the tests for determining whether the xxxxx xxxxx xxxx applies to NQDC is whether the plan grants to the executive greater rights to the employer's property than those of other parties, most notably the general creditors of the employer In practical terms: -if funds placed in a nonqualified plan remain subject to potential attachment by the employer's general creditors, the xxxxxxx xxxxxx xxxxxxx *will not apply*

Non-qualified Deferred Compensation Plan Structure: Salary Reduction

AKA Pure Deferred Compensation -approach for structuring a non-qualified deferred compensation plan (NQDC) -in this approach, the plan *uses some portion of the exec's current compensation* to fund the promised compensation benefit, usually payable at the executive's retirement date

Incentive Stock Options (ISOs)

AKA Statutory Options -tax-qualifed -numerous requirements must be met under the IRC Code for a stock option to qualify for tax-favored status as an incentive stock option (ISO) -these requirements are also referred to as *the special holding period rules*

Excluded from ESPPs Participation

All employees must be included in the plan, except the following: -employees with less than two years of employement -highly compensated employees -*part-time and seasonal workers*

ISO Tax Treatment

In exchange for satisfying the above requirements, ISOs receive favorable income tax treatment as follows: -there is no regular taxable event at the ISOs exercise date -HOWEVER, an individual AMT occurs, whereby the employee must report the bargain element of the ISO as of the exercise date as an AMT adjustment item -the employee's taxable basis for regular income tax purposes is the ISO's exercise price -for AMT purposes, this basis is the *ISO's exercise price plus the bargain element* -NOTE: the employer does *not receive an income tax deduction when the employee exercises an ISO -if holding requirements are met, once the employee sells the stock, any gain in the value of the stock is treated as *long term capital gains to the employee -if employee does not meeting holding requirements, the bargain element (difference between the fair market value of the stock on the date of exercise and the option price) is taxed as ordinary income, reported by the employer on the employee's W-2, but is *NOT* subject to FICA or payroll taxes

Informal Funding: Taxation to Sponsoring Employer

Informal funding of a nonqualified plan creates taxation to the sponsoring employer in two ways: -1.) the employer owns the underlying asset used to fund the plan, so any earnings generated from these assets are taxed to the employer and, if the employer is a regular corporation, *taxed at separate corporate income tax rates* -2.) depending on the type of asset used to fund the plan, the set-aside reserve may create an additional tax -if a nonqualified annuity is owned by a non-natural person such as a corporation, the earnings on that annuity do not receive the tax deferred status and are taxed currently to the employer/corporation -to avoid generating any additional tax on earnings within the plan, many employers prefer to fund NQDC plans with a tax-favored vehicle such as cash value life insurance

Nonqualified Deferred Compensation Plans: Funding Vehicles

NQDC Plan Funding Vehicles include: -Corporate-Owned Life Insurance (COLI) -Rabbi Trust -Secular Trust

Unit 9

Nonqualified Deferred Compensation

Distributions from a Nonqualified Plan

The American Jobs Creation Act of 2004 (AJCA) impacts distributions made from nonqualified plans effective January 1, 2005. Provisions include: -1.) a participant can no longer determine, immediately before leaving the company, when he will receive distributions from the plan; rather, *the period over which the distribution will be paid must be specified in the plan document* -2.) plan distributions are generally payable only upon separation of service, death, disability, change in ownership of the company, or unforeseeable emergency (as defined by the IRS) -3.) *key employees who leave* the company *cannot take a distribution from the plan for at least six months* after the date of separation -4.) the act imposed a significant restriction on the use of offshore rabbi trusts that are designed to avoid U.S. income tax

Nonqualified Plan: Suitability

The following situations describe when a nonqualified plan is most appropriate for a corporate executive client: -1.) when an employer wants to provide a deferred compensation benefit to an exec or group of execs, *but the cost of a qualified plan would be prohibitive b/c the large number of rank-and-file employees who would need to be covered* -2.) when an employer wants to provide additional deferred compensation benefits to an executive who is already receiving the maximum benefits or contributions under the employer's qualified retirement plan -3.) when the employer wants to provide certain key employees with tax-deferred compensation benefits different from those provided to other employees -4.) when an exec wants the employer to help with meeting certain financial planning goals -5.) when an employer needs to recruit, retain, or reward certain executives or other key employees

Business Uses of Life Insurance

Unit 10