5 Things to Know About Executive Compensation and Taxes
It’s tax season, which means you should be receiving ‘Important Financial Documents’ from your employer and financial providers. And, with financial documents in hand, it’s an opportune time to review your sources of compensation to better understand how your income is taxed and identify potential ways to keep more of your money. To inform your tax strategy for the future, here are five ways executives may be compensated and the tax implications of each.
1. Base pay and performance bonuses are subject to income tax based on your rate. Some actions that can reduce your taxable compensation include funding your (and your spouse’s) retirement plan, participating in a health savings account (HSA), contributing to flexible spending accounts (FSA) to save for health care expenses, dependent care expenses or parking, and making charitable contributions via payroll deduction. Another common way to reduce taxable compensation is through participation in a non-qualified deferred compensation plan, which allows employees to delay paying taxes on a portion of their earnings until they are received, often in retirement, when you may be in a lower income tax bracket.1
2. Incentive stock options (ISOs), grant employees the right to purchase a certain number of shares of stock during a predetermined period for an option cost, determined on the date the options are granted. ISOs are granted to employees as a way to align company and employee goals and to improve employee retention. The tax treatment of ISOs depends upon when you exercise the options and when you sell the shares, with profits taxed at the long-term capital gains rate when held for the appropriate period of time before they are exercised and sold.3 There is a catch with ISOs, however, as you do have to report the difference between the exercise price and the market price for Alternative Minimum Tax purposes.
3. Non-qualified stock options (NSOs), like ISOs, give employees the right to buy a certain number of shares of company stock at a fixed option cost. However, unlike ISOs, you pay income tax on the difference between the exercise price and the market price when you exercise these options, and this amount is included in your W-2 as part of your taxable compensation. If you sell the shares of stock obtained in the exercise within 12 months or less, any growth will be taxed as short-term capital gains which is based on ordinary income tax rates. However, if you hold the shares of stock obtained in an exercise for more than a year, any gains are taxed as long-term capital gains.4
4. Restricted Stock is a promise made to grant a given number of shares of the company’s stock to an employee at predetermined times in the future. The shares become transferrable to the employee and may be paid in net shares or in net cash when they vest. Vesting occurs upon the satisfaction of certain conditions such as continued employment and meeting financial milestones. The value of restricted stock is taxed in the year it vests at ordinary income tax rates. This is the opposite of stock options, which are taxed when options are exercised rather than at vesting.
5. Fringe benefits are an alternative form of payment for the performance of services, according to the IRS. Unless officially excluded, fringe benefits are taxable as wages and must be counted as part of an employee’s pay for tax purposes. Some taxable perks include club memberships, prizes and awards, automobile allowances and payment of financial advisory or tax preparation fees. Nontaxable perks include benefits such as frequent flyer miles earned for business travel (unless converted to cash), educational assistance (dollar limits apply) and on-premise athletic facilities.5
An understanding of how your earned, investment and passive income are taxed is integral to developing a coordinated tax strategy that maximizes your wealth and aligns with your objectives. Your Luma Wealth advisor will work with you and your tax advisor to create a plan tailored to your situation, with a vision toward your future and your overall goals.
1 Should You Take Advantage of a Deferred Compensation Plan? The New York Times, Ann Carrns, June 30, 2017 https://www.nytimes.com/2017/06/30/your-money/should-you-take-advantage-of-a-deferred-compensation-plan.html
2 IRS provides tax inflation adjustments for tax year 2019, IR-2018-222, November 15, 2018. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2019
3 Incentive Stock Options, Intuit Turbo Tax, updated for Tax Year 2019 https://turbotax.intuit.com/tax-tips/investments-and-taxes/incentive-stock-options/L4azWgfwy
4 Non-Qualified Stock Options, Intuit TurboTax, updated for Tax Year 2019 Non-Qualified Stock Options, Intuit TurboTax, updated for Tax Year 2019. https://turbotax.intuit.com/tax-tips/investments-and-taxes/non-qualified-stock-options/L8zsxRi7B
5 Publication 15-B (2020), Employer’s Tax Guide to Fringe Benefits for use in 2020, https://www.irs.gov/publications/p15b
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