Planning for Executives

Question 1

What are the implications of executive stock options on client’s potential for AMT?

Answer 1

• Executive stock options provide an alternative way to compensate an executive
• ISOs have an AMT adjustment that goes into the calculation of AMTI. NQSOs are just considered income
• For clients that have executive stock options, particularly options that may impact AMT, it is important to plan and think through the exercise/sale of these holdings to mitigate some of the tax burden

Question 2

What are the tax treatments of ISOs?

Answer 2

• ISOs have preferential tax treatment if they are sold after two years since grant date, 1 year since exercise date. Otherwise, will be taxed as income
• The difference between the FMV of the shares at exercise and the exercise price is considered the AMT adjustment
• The difference between the price of the shares when they are sold and the FMV at exercise is considered the AMT gain amount. The difference between the price of the shares when they are sold and the exercise price is considered the regular long-term capital gain (loss)
• ISOs are included in the AMTI calculation, so it may increase the AMT amount that you are required to pay

Question 3

What are the tax treatments of NQSOs?

Answer 3

• NQSOs are taxed at the exercise date and are treated as ordinary income. The difference between the FMV of the holding and the exercise price is considered compensation for the individual
• When the shares are sold, the difference between the FMV when they are sold and the exercise price is considered a long-term capital gain (loss) if the position was held for more than one year. If held for less than a year, then taxed at ordinary income

Question 4

Describe the consequences, and advantages and disadvantages of making a Section 83(b) election as it pertains to executive stock options

Answer 4

• Electing a section 83(b) allows an executive to pay the income tax of the shares up front. The difference between the FMV at the date the election is made and the price the employee paid is considered the income element
• The holding period begins at election, and if held for more than one year begins receiving preferential tax treatment for capital gains
• If the individual believes the value of the shares will go up significantly in the future, it’s an opportunity to pay less taxes on the holding now and receive capital gains treatment in the future
• In the event that the shares actually go down in value, the individual ends up paying more tax on the holding

Question 5

Identify different types of equity compensation plans

Answer 5

• NQSOs - Purchase shares at a pre-determined, fixed price, pay income tax on it
• ISOs - Purchase shares at a pre-determined, fixed price, pay capital gains tax on it if sold after a qualifying disposition
• Restricted Stock Shares - Awarded to compensate employees via company issued shares
• RSUs - Awarded to compensate employees via units linked to performance of stock
• ESPP - Allows participating employees to purchase company stock at a discount of up to 15% from FMV using after payroll tax deductions
• NQDC - Allows selected employees opportunity to defer a portion of annual income above qualified plan limits until a specific date in the future
• Phantom stock - Stock option plan that provides the benefits of employee ownership without granting stock

Question 6

Describe the tax implications of equity compensation of phantom stock

Answer 6

• Stock option plan that provides the benefits of employee ownership without granting stock. Executives and outside members of the board of directors are the most common recipients
• A form of compensation that confers the beneficiary of owning company stock without the actual ownership of transfer of shares
• One type - an appreciation only plan - does not include the value of underlying shares and pays out the value of any increase in price over a period
• Full value on the other hand, pays the value of the underlying stock and appreciation
• Unit payouts are taxable at ordinary income levels

Question 7

Describe the tax implications of equity compensation of restricted stock

Answer 7

• Restricted stock shares and units are taxed at the ordinary income level
• Only shares are eligible for 83(b) option
• Shares are given to compensate employees and are subject to a vesting schedule
• Units are given to compensate employees and are linked to the performance of stock

Question 8

Describe the tax implications of equity compensation of ESPP and NQDC

Answer 8

• ESPP - Taxed at ordinary income on discount when the shares are sold
• NQDC - Taxed at ordinary income that is deferred until distribution

Question 9

What are regulatory rules and restrictions around short swing profits?

Answer 9

• Section 16b
• Prohibits senior officers/directors/beneficiary owners of >10% from profiting from the purchase or sale of company shares within any period of less than 6 months

Question 10

What are regulatory rules and restrictions around insider information?

Answer 10

• Can’t act on insider information for financial gain

Question 11

What are regulatory rules and restrictions around exercise windows?

Answer 11

• For executives that have nonpublic information that is going public, there maybe blackout dates on when individuals that have this material information can buy/sell shares. There are windows in which they can place transactions, and the windows are typically short
• Exercise window (exercise period) is the period during which a person can buy shares at the strike price (For ESOs). Options are only exercisable for a fixed period of time, until they expire, typically seven to ten years as long as the person is working for the company

Question 12

What are the desired outcomes of utilizing cashless collars in concentrated stock situations?

Answer 12

• Freeze the value of the stock by buying protective puts while writing covered calls to collect a premium equal to the cost of the puts bought. Purchase put option below market price and sell call option above current market price against holdings for net zero premium
• The puts freeze/eliminate the downside movement while the covered calls reduce/eliminate the upside
• Investor wants to continue to own underlying equity, avoid tax recognition but hedge price risk
• Hedges downside risk below put strike price and retains ownership benefits of dividend income and voting rights
• Interim price risk, limited upside price participation, collateral requirements for payments due at maturity. Potential for capital gains taxes on underlying stock position upon exercise. Hard to borrow risk and market liquidity

Question 13

What are the desired outcomes of utilizing prepaid variable forwards in concentrated stock situations?

Answer 13

• Type of contract where the client agrees to sell a specific dollar amount or variable number of shares at a predetermined date in the future. In exchange, they’ll receive an upfront payment without paying any capital gains tax
• Constructed in a similar way as a costless collar while also receiving a loan for a portion of the value of the postion
• Monetizes concentrated position without selling the shares upfront
  Diversifies a large, appreciated equity position while deferring taxation
• Variable contract to sell a specific value of a security in the future
• Retains appreciation up to an upper limit as defined by the client. Protects against depreciation in stock below a lower limit
• Substantial liquidity generated upfront, no tax event until maturity, provides floor for stock price, investor retains ownership, dividends and voting rights until maturity date
• Ceiling on upside exposure; investor does not participate in any appreciation of the stock above the cap. Self-financing; no separate loan vehicle required

Question 14

What are the desired outcomes of utilizing portfolio margins strategies in concentrated stock situations?

Answer 14

• Borrowing against assets in a portfolio to fund the purchase of more shares or provide liquidity without selling the shares
• Varying degrees of leverage, risk, and payment terms

Question 15

What are the desired outcomes of utilizing exchange funds in concentrated stock situations?

Answer 15

• A fund structure either public or private that allow holders of a concentrated stock position to diversify into a basket of other stocks without directly selling their stock
• Usually strict rules about the type of stock, the holding periods, liquidity
• Can be an effective way to diversify a large position while deferring a large tax bill
• Private placement, exempt from registration
• Avoids publicity since contribution is not public sale and does not require Rule 144 filing
• Diversifies a large, appreciated equity position while deferring taxation
• Diversification occurs because many investors from different sectors contribute their shares
• Shares of a publicly traded company exchanged for an interest in the fund
• IRC 721 requires minimum 20% exposure to non-liquid holdings to avoid constructive sale
• No potential to depress market price, tax savings compared to open market sale, may accept contributions of restricted securities, and units receive a step-up basis at death
• Illiquid for first seven years, may limit total amount of restricted securities, FMV of restricted securities discounted, and acceptance of shares determined by fund manager

Question 16

What are the desired outcomes of utilizing charitable remainder trusts in concentrated stock situations?

Answer 16

• Type of irrevocable trust funded with assets upfront that generates an income stream for the donor as well as some tax benefits
• After a stated period of time, the remaining assets are donated to charity deemed as beneficiaries
• Highly appreciated assets irrevocably gifted to charitable remainder trust in return for ongoing income stream for life or trust term
• At the end of the trust, the remainder goes to favorite charity or to family foundation

Question 17

What are the desired outcomes of utilizing 10b-5(1) plans in concentrated stock situations?

Answer 17

• A way for company executives or insiders to periodically sell their stock holdings at regular intervals
• Involves a written plan to sell at a predetermined price and date
• A structured plan to sell shares avoids the appearance of acting on material nonpublic information and signals to the public market that the transactions are routine

Question 18

Rule 144

Answer 18

• A regulation that provides for the sale of restricted stock and control stock. Filing with the SEC is required prior to selling restricted and control stock. The number of shares that may be sold is limited
• Must be held a minimum of 12 months before they can be publicly sold; 6 months if a reporting company
• The number of shares that can be sold for any 3 month period is limited to the greater of 1% of outstanding shares and the average of the weekly trading volume of the shares during the previous 4 calendar weeks
• Exemption under Sec Act 1933 allowing the sale of restricted securities