Taxpayers with incomes over $250,000 received an early Christmas gift when the President signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (TRA 2010). This was welcome relief for all taxpayers, because all income levels were facing a tax increase when the Bush Tax Cuts expired at the end of 2010. However, the 3% of taxpayers with the higher incomes were originally not expected to participate in the extension. The deal worked out in Congress only extends the current tax structure until the end of 2012. All taxpayers will again face a huge tax increase in 2013 if nothing is done, but the 3% making over $250,000 will also have to deal with a new set of taxes that were part of the health care reform bill. TRA 2010 is more of a stay-of-execution than a Christmas gift.
Fortunately, we have a little time on our side to prepare for the huge tax increase. We know what tax rates are going to be for the next two years which gives us time to structure our income to minimize the higher taxes coming our way. In this article I will focus on one source of income that effects mainly upper income – stock compensation.
Stock compensation is an important tool of corporations today in attracting and retaining key employees. Many executives find a significant portion of their compensation being paid in the form of stock options. This provides a benefit to the company, because the stock options are tied to performance. An executive maximizes his income when the company does well. The executive can usually make more with a pay package that combines salary, bonus, and stock options.
Unfortunately, many executives don’t really understand how their compensation packages work or the significant tax implications of exercising their options. It is estimated that more than 10% of valuable options expire unexercised each year.
Stock options come in two forms: non-qualified stock options (NQSOs) and incentive stock options (ISOs). Both forms of options come with expiration dates and price targets, but they differ significantly in their tax treatment.
NQSOs are the most common form of option mainly, because they are the most favorable for the company. The options are considered compensation and are therefore tax deductible for the company that issues them. The employee pays tax on the gain at the time the option is exercised and the gain is taxed as ordinary income like wages. They pay the tax regardless of whether they sell the stock or not. For example, Mr. Jones has options to buy his company stock at $20 per share. He exercises the options when the stock is trading at $30 per share. He will pay tax on the difference in price ($10 per share) at ordinary income rates which can be as high as 35% this year. When he sells the stock it will create another taxable event. This time he will pay tax on the difference between the stock price on the day the option was exercised and the final sale price. If the stock is sold within a year of exercising the option it will be treated as a short-term capital gain which also has a maximum rate of 35%. Once the stock is held for more than one year, long term capital gains tax treatment applies with a maximum rate of 15%.
ISOs are not issued very often and are typically reserved for the high level executives. They are governed by very strict IRS criteria regarding exercise limits and timing, but they can have very favorable tax treatment when handled properly. Exercising an ISO is not a taxable event. This gives the executive a tax deferred window to work within that could delay the tax treatment or even eliminate it altogether if the stock is ultimately gifted to a charity. Even if the stock is ultimately sold the gain can qualify for long-term capital gains tax treatment if the stock has been held for one year after exercising and at least two years after the option was granted. This makes ISOs the most desirable form of option to receive. There is one snag that cannot be overlooked. The unrealized gain when the option is exercised (the difference between the market price and the grant price) is subject to the Alternative Minimum Tax. It is very important that you work with an adviser that understands this implication when planning your option strategy.
Planning for potentially higher tax rates in 2013 begins with putting a strategy in place to maximize the value of your options while minimizing the tax implications. You will want to exercise as many of your NQSOs as possible before December 31, 2012 in order to pay tax at the lower ordinary tax rates and avoid paying the additional 3.8% Medicare tax that begins in 2013. ISO holders will want to exercise their options before the end of 2011 so they can reach the one year holding requirement to get long-term capital gains treatment before the end of 2012. Long-term capital gains rates will go from the current 15% rate to 20% in 2013 plus the 3.8% Medicare tax for households with income over $250,000.
In addition to minimizing taxes, your plan should also include a strategy to make sure none of your options expire by mistake. Your adviser should be familiar with SEC rule 10b5-1. This is a trading plan that allows the employee to sell a specific number of shares at a predetermined price. The sales happen automatically, so you never miss an expiration date. The sale will even happen during a black out period. This is a relatively simple plan that your adviser can help you establish. Keep in mind that Rule 144 forms will still need to be filed within 24 hours of the sale.