Executive Compensation: 7 Costly Mistakes to Avoid
As a busy executive, you might find it challenging to stay on top of the nuances surrounding your compensation package. There are often complex tax rules, regulations, deadlines and unforeseen factors. All of these can make smart financial planning difficult.
Here are seven common examples of costly errors you’ll want to avoid:
1) Not running tax projections before exercising incentive stock options (ISOs)
If you meet the holding period requirements, there is theoretically no tax due when you exercise ISOs. Any gain that would otherwise be taxed at ordinary rates when the ISOs are exercised may be taxed as a capital gain when you sell the stock. The spread on ISO shares held, however, could be subject to alternative minimum tax (AMT). It’s critical to run a tax projection before exercising ISOs and as early in the year as possible. If done early enough, there are ways to reverse AMT.
2) Not knowing how much your plan’s success depends on your stock-based compensation
A common mistake is relying too heavily on the performance of stock-based compensation to meet your goals. There are many factors you cannot control and a lot can go wrong. Even if your company performs well, the market may not cooperate and the stock price might not rise accordingly. It’s important to know how much a slowdown or decline in stock price may impact your financial goals. Diversifying away from concentrated holdings (i.e., also having investments other than your company’s shares) may help manage volatility in your portfolio, allowing you to better pinpoint the probability of achieving these goals.
3) Under-withholding tax
Often, companies will use the flat IRS rate when restricted stock units (RSUs) vest, which is currently 22% for amounts up to $1 million, and 37% for amounts above $1 million. This can be woefully low for executives who fall under this threshold, yet still sit in a higher tax bracket.1 To avoid penalties, run a projection to see what your expected tax bill is, and then decide if extra payments or withholding are necessary.
4) Letting “in-the-money” stock options expire
When options are granted, you generally have 10 years to exercise them before they expire. Do nothing, however, and they’ll expire worthless. Be aware that expiration periods can sometimes be much shorter than that (or reduced if you decide to leave the company), so pay attention to those dates. Never let in-the-money options (i.e., those options where the actual stock price has risen above the strike price) expire without exercising them. If you do, you’ll be throwing away money that you may never recover.
5) Putting tax considerations before the investment
Although it is important to mitigate taxes, they could also be over-emphasized, especially with options where you have some control over when taxes are recognized. If the stock price plummets and your plan relies on these funds for success, you might be better off paying the tax and end up with higher net proceeds.
6) Not receiving deferred compensation payouts in a timely fashion
If you participate in a non-qualified deferred compensation plan and have elected scheduled payouts but find that you aren’t receiving them in a timely manner, don’t ignore this delayed payout. The IRS is punitive in these situations. Follow up with your company to ensure payments are received as scheduled.
7) Missing the 83(b) election
Pay close attention if you receive restricted stock awards (RSAs), as you may wish to opt for an 83(b) election. This allows you to pay tax now on the grant value today, rather than when they vest later. Why do this? Ordinary tax rates apply upon the vesting of restricted stock. If you expect the stock price to rise, you can potentially pay less tax now. You also start the capital gain clock earlier on the held shares, which may be eligible for lower capital gain rates if held for at least a year. Since you must make the election with the IRS within 30 days of RSA issuance, it’s important to analyze the pros and cons quickly. Risks are involved, so be sure to consult a professional, such as your Corient Wealth Advisor or tax consultant, before taking action. Also note that RSAs are different than RSUs. The latter is a promise to pay shares in the future and is not eligible for an 83(b) election.
ABOUT THE AUTHOR
Gary Pattengale, CPA, CFP
Gary is a Wealth Advisor in our Itasca, IL, office. He specializes in executive and stock-based compensation plans, including stock options, restricted stock and deferred compensation. He combines his tax knowledge, executive compensation experience and capital markets expertise to help clients reduce their tax burdens and achieve each of their unique goals.
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