Many corporate executives receive stock as part of their total compensation package. This not only helps align personal goals and company objectives while rewarding top talent with appreciable assets, but many executives enjoy tying their finances, in part, to their employer. They believe in their company and in their own ability to help that company grow. But as total compensation becomes skewed toward stock rewards, new risks emerge. Stock concentration, tax liability, and cashflow issues can all negatively impact your overall financial health if you don’t have a proper plan in place. By taking a thoughtful and measured approach to tax planning for stock compensation, executives can achieve tax efficiency and accomplish long-term financial goals.
Different types of stock compensation
For the purposes of this article, stock compensation is defined as restricted stock grants, stock options, long-term incentive compensation, or any other non-cash compensation a corporate executive may receive. Each of these different types of stock compensation carry various tax implications that require careful consideration to ensure you are balancing risk appropriately across your portfolio.
Tax planning for stock compensation
Here are some important issues to consider as you decide how best to manage stock compensation for tax planning purposes:
Balancing stock concentration
When stock rewards become a significant part of your employer compensation, it’s good to take into consideration how much stock concentration you have in the rest of your portfolio, and how much you have allocated to the company you work for. In other words, evaluate how much you have riding on the promises of one company. In general, the recommendation is to limit exposure to any one stock to 2% of your total liquid net worth. Of course, facts and circumstances differ by individual, so be sure to consult with your advisors about the proper threshold to consider.
To avoid becoming overly dependent on stocks, anyone receiving significant stock compensation should evaluate their personal portfolio and determine whether selling and diversifying would be in their best interest. For executives, this often invokes rule 10b5-1. This provision in the tax law provides a defense for companies and those executives who transact in the relevant company securities. The rule essentially allows insiders of publicly traded companies who hold company stock to sell a predetermined number of shares at a predetermined future date. For example, an executive could set a plan in place to sell stock when it vests in five or 10 years. This helps avoid the perception of insider trading and also helps for tax planning purposes because you can anticipate those windfalls and respond accordingly.
Reducing tax liability
A major part of tax planning for stock compensation is finding ways to reduce tax liability in those years when stock grants will vest and you will experience a significant windfall.
One option is to use a section 83b election. This option allows an individual to pay taxes on the value of stock compensation at the time it is granted, not the time it vests. This can be beneficial if you feel confident the value of the stock will appreciate over the holding period.
Another way to reduce tax liability is to maximize all tax deductions in the year your stock grants vest, including maximizing contributions to qualified retirement plans. You can also look at potentially moving other deductible expenses into that year. For example, you could pay two years’ worth of property taxes or find ways to ensure you don’t realize significant capital gains, to the extent possible, on your other investments. You can also look at charitable donations and accelerate those to match variable income and offset some of that tax liability.
Regardless of the strategy you choose, the important thing to remember is that sound tax planning can help reduce tax liability in years stock rewards are realized to help you achieve tax efficiency across your portfolio.
Planning for liquidity
Often, when stock rewards are vested, some pay will be withheld, but it won’t be at the same rate as the tax liability you carry. So, if you receive a large stock grant that vests and pushes you into the top marginal bracket, you may end up owing additional tax that’s not being withheld from your pay. That could create a cash need that you should plan for.
Overall, it’s important for executives to know the true cashflow ramifications of the stock awards they receive. For example, if your total compensation is tied to your company stock price and that price suddenly drops, what would that mean for your overall liquidity? Those receiving stock compensation have to decide how much stock they actually want to hold after it vests. Forecast your future cashflow needs and incorporate that into tax planning for all compensation sources so you can ensure you have the necessary liquidity when it's needed most.
Other areas of potential tax exposure
Stock awards aren’t the only thing that contributes to concentrated tax exposure. You could have company stock in your 401(k) or cash compensation could be tied to the stock price. Executives need to consider all the places where they may own company stock and what that means for their overall tax exposure.
Consider the bigger picture
Many investors want to hit that “home run” on a single stock that takes off and provides unbelievable returns. When that stock is the company you work for, there can be an additional emotional component. Unconscious bias can lead individuals to overextend themselves and become too heavily invested in their employer, potentially opening them up to unnecessary risk.
Instead of concentrating on the performance of one stock, the more prudent path is to maintain focus on your goals and priorities. When you consider tax planning and stock compensation strategies as ways to build the ideal future for you and your family, you can make the right wealth management decisions and achieve your ultimate goals.
Granite Harbor Advisors offers comprehensive planning for families that have significant stock compensation. Contact us today and we’ll set up a call to learn more about how we can help you achieve your goals.