Planning for Corporate Executive
Compensation and Management of
Concentrated Stock Positions
Tim Kochis, JD, MBA, CFP®
CEO. Kochis Global
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 ®
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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.
Tim 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.
2.
3.
4.
Holding period requirements:
a. At least 1 year from the date of exercise and
b. Two years from grant date
If holding period requirements met, sale is long-term capital gains.
The AMT adjustment increases the AMT basis of the stock. The stock
has a different tax basis for regular tax and AMT purposes.
If AMT results from exercise of an ISO, an AMT credit may be
available in future tax years.
Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
Rate Increase from
28% to 40%
Initial value
$10,000
No Election/Side
Purchase
$10,000
Section 83
(b) Election
$10,000
N/A
N/A
2,800
N/A
N/A
(2,800)
5 years’ earnings on $2,800 (@6% 947
per year after taxes)
N/A
N/A
Cost of additional purchase
(2,800)
N/A
Growth in value on initial shares in 5,923
5 years @ 9.75% per year
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 %
Best choice
N/a
(331)
(1,185)
$10,501
$10,881
$11,938
Additional Purchase
Initial tax @ 28%
No Election
N/A
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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 arise
o Impetus for earnings; initially only an interest rate measure
 Equalized rates (before and after retirement) and much lower rates
o Deferred compensation institutionalized by then
o Return becomes paramount
 20% LTCG rates make high absolute earnings rates/opportunities
essential
 Section 409(a) - 2004
Tim Kochis, JD, MBA, CFP ®
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Non-Qualified Deferred Compensation
• Benefits and Costs
Benefits
For Employer
ROR < Cost of Capital?
… small, young
companies
For Employee
- Superior Investment
Returns
Tim Kochis, JD, MBA, CFP ®
Costs_______
ROR > Cost of Capital?
… large, mature
companies
- Tax Rate Risks
- Collection Risks
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Non-Qualified Deferred Compensation
• Superior Investment Returns
Deferred compensation turns a pre-tax return into an after-tax return
Compensation
Current Tax (40%)
Net Investable
At 6% After Tax for 5 years
At 6% Pre Tax for 5 years
Tax at Receipt (40%)
Net in 5 years
Tim Kochis, JD, MBA, CFP ®
No Deferral
$10,000
(4,000)
6,000
8,029
N/A
$ 8,029
Deferral
$10,000
N/A
10,000
N/A
13,382
(5,353)
$ 8,029
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Non-Qualified Deferred Compensation
• Tax Rate Risks: Tolerable Future Tax Rates
The longer the deferral and the stronger the return, the higher the tolerable future tax
rate
Period of Deferral
Pre-Tax ROR within Deferred Compensation Plan*
6%
8%
10%
2 years
5 years
10 years
20 years
40%
40%
40%
40%
42%
45%
50%
59%
44%
50%
58%
71%
*Assuming 6% after-tax outside the plan
Tim Kochis, JD, MBA, CFP ®
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Non-Qualified Deferred Compensation
• Key Conclusions From Analysis of Tax Risks
 Plans with only modest internal returns are not attractive
 Short deferral periods are especially risky
Tim Kochis, JD, MBA, CFP ®
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Non-Qualified Deferred Compensation
• 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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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Management of Concentrated
Stock Positions
Tim Kochis, JD, MBA, CFP ®
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Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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Concentration Management Techniques
• Start with the Simplest solution first
• Partial Solution/Combinations are OK…
“walk before you run!”
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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.
Tim Kochis, JD, MBA, CFP ®
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Sales Under 10b5-1 Plans
• Authorized by SEC in 2000 to
Overcome 10b5, “Inside Information”
Problems
• Long Shares and/or Options
• Disciplined Diversification Through
Advance Commitment
Tim Kochis, JD, MBA, CFP ®
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Managing Concentration…
includes not buying more
• 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
Tim Kochis, JD, MBA, CFP ®
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Gifts…To Family
• Lower tax brackets
• Psychic distance
• Discount transfer tax costs (FLP’s;
Defective Grantor Trusts)
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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NQSO’s to Charity
• 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
Tim Kochis, JD, MBA, CFP ®
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Managed Retention: Margined
Diversification
• 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)
Tim Kochis, JD, MBA, CFP ®
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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
Tim Kochis, JD, MBA, CFP ®
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Exchange Funds
• 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%)
Tim Kochis, JD, MBA, CFP ®
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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
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Tim Kochis, JD, MBA, CFP ®
Protective Puts
• Additional investment in already
concentrated position
• Best Case: pay for privilege of
selling later at reduced price
Tim Kochis, JD, MBA, CFP ®
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Combining Options in a Collar
• “Costless” Collars: Call premium
= Put cost
• “Put-spread” Collars: retain
more downside risk to maintain
more upside
Tim Kochis, JD, MBA, CFP ®
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Prepaid Forward Contracts
• 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
Tim Kochis, JD, MBA, CFP ®
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Summary of Concentration
Management
• 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
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