©2013, college for financial planning, all rights reserved. module 8 deferred compensation &...

©2013, College for Financial Planning, all rights reserved.

Module 8Deferred Compensation & Stock Plans

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Learning Objectives

8–1 Identify characteristics of a nonqualified deferred compensation plan.

8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan.

8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan.

8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election.

8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs).

8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans.

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Questions to Get Us Warmed Up

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Learning Objectives







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Definition of Nonqualified Deferred Compensation

“A nonqualified deferred compensation plan means any plan that provides for the deferral of compensation.”

American Jobs Creation Act of 2004

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Nonqualified Deferred Compensation Overview

409A—Increased restrictions on deferred compensation•Nonqualified plans are ideal for business owners and key employees who want to provide benefits for themselves in excess of qualified plan limitations.•The historically low personal income tax brackets make nonqualified deferred compensation less attractive than previously.•The prospect of rising taxes in the future also makes nonqualified deferred compensation less attractive.

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Nonqualified vs. Qualified Plans

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Characteristic Qualified Plan Nonqualified Plan

Internal Revenue Code Requirements

Discrimination Plan may not discriminate Plan may discriminate

ERISA Requirements

All plans must satisfy ERISA and IRC requirements

Certain plans are partially exempt from ERISA

Tax Treatment

Employer deduction

Available in year of plan contribution

Available in year of employee taxation

Employee deferral Tax deferred until plandistribution; rollovers allowed

Tax deferred only if unfunded or funds are at risk; no rollovers

Fund earnings Earnings accrue tax deferred until distribution

Earnings usually are currently taxable to employer

Distributions Taxed at ordinary rates;averaging may be available on lump sums

Taxed at ordinary rates; averaging not available on lump sums

Types of Nonqualified Deferred Compensation

• Pure deferred compensation (employee funded)

• Supplemental plans (employer funded)o Excess benefit plano Supplemental Executive Retirement

Plan (SERP)o Death Benefit Only plan (DBO)—

provides a survivor benefit

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Excess Benefit Plans

• An excess benefit plan is linked indirectly to the qualified plan or plans in place and provides for benefits in excess of the amount to which the employee would otherwise be entitled under the qualified plan.

• The payment is typically made when the employee retires and is usually paid out the same way that benefits are paid under a qualified retirement plan.

• The plan may be funded, informally funded, or unfunded.

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Supplemental Executive Retirement Plans (SERPs)

• A SERP (or top hat plan) is an unfunded plan providing benefits for select employees (generally only high-level executives) in excess of those provided by the employer’s qualified retirement plan. o Benefits are usually based on elements of

compensation not otherwise provided under the qualified plan (such as a benefit formula with a higher multiple of earnings or ignoring altogether Social Security integration levels).

• SERPs can be used for a broader range of purposes than excess benefit plans.

• Unfunded SERPs are exempt from all but the reporting and disclosure requirements of ERISA.

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Learning Objectives







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Nonqualified Deferred Compensation Tax Implications

To employer•Deduction when taxed to employee•Earnings taxed to employer

To employee•Taxed when benefit constructively received•Subject to FICA taxes when constructively received

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ERISA Requirements for Nonqualified Deferred Compensation Plans

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ERISA

Reportingand Disclosure

Participation,Vesting, andFunding

FiduciaryResponsibility

PlanTerminationInsurance

Unfunded Plan or Trust

Must comply Exempt if top-hat plan; must comply if plan includes rank and file

Exempt if top-hat plan; must comply if plan includes rank and file

Exempt if top-hat plan; must comply if it includes rank and file

Funded Plan or Trust

Must comply Must comply Must comply Must comply

Government, Church, Unfunded Excess Benefit Plans

Exempt Exempt Exempt Exempt

Nonqualified Deferred Comp Funding

Unfunded•Promise to pay

•Agreement executed prior to service performance

•Available to company creditors

Funded•Not available to employer’s creditors

•Currently taxable to employee unless substantial risk of forfeiture

Informally Funded •Employer “informally” dedicates assets to through accounting device or segregating assets to a trust

•Rabbi Trust an example

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Rabbi Trust

• A rabbi trust is an employer-sponsored irrevocable grantor trust

• Trust has two beneficiaries:o the employee ando creditors of the

company• Trust earnings are

currently taxable to the employer

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Secular Trust

• Irrevocable fully funded trust established for an employee

• Employee is vested in contributions, so current taxation to employee results

• Assets are not subject to the claims of an employer’s creditors

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Requirements for Deferral of Taxation

IRS Regulations stipulate three principles that must be followed for deferred compensation:1.The agreement to defer compensation must be made before the dollars are earned2.The agreement must represent only an unsecured promise3.The agreement cannot be funded (i.e., any funds used to provide the benefit must be held by the employer as a general asset available to creditors)

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Substantial Risk of Forfeiture

• Employee’s right to payments must be contingent upon future performance of substantial services (death or disability are not considered substantial services)

• Plan must provide for loss of rights to payments if substantial services are not performed OR if employment terminates for reasons other than death or disability

• Generally only relevant in funded plans

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Constructive Receipt

• The constructive receipt issue isn’t whether the taxpayer has actually received the income, but whether he/she has access to it

• To avoid constructive receipt, agreements usually contain specific provisions establishing substantial risk of forfeiture (funded plans), or availability of funds to company’s general creditors (unfunded plans)

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Economic Benefit

• Economic benefit relates to the receipt of non-cash property that can be valued in cash

• When the employee’s benefit is treated as the equivalent to the receipt of cash, current income taxation will result

• In unfunded and unsecured plan, mere promise to pay does not confer economic benefit

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Learning Objectives







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“Stock” Plans

• Restricted stock• ISOs• ESPPs• NSOs• SARs• Phantom stock• Performance unit

or share plans• Junior stock

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Restricted Stock Plans

• Shares of stock are granted to the employee at no cost or at a bargain price, subject to restrictions

• There is no taxable transaction when shares are granted (unless 83(b) election)

• They are taxed as compensation when constructively received

• Capital gain holding period begins when restrictions are lifted (or when taxed under 83(b) election)

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Employee Stock Options: The Option Agreement

The option agreement specifies:•the number of shares of stock that can be purchased,

•the price of the stock,

•the date when the options will expire, and

•terms under which the options can be used

The terms under which the optionscan be exercised include:

•the dates when the options can be exercised,

•specific requirements that must be met before the options can be exercised, and

•whether the option holder must be employed by the company when the options are exercised

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Learning Objectives







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Incentive Stock Options (ISO)

Requirements•Can only be offered to employees

•Must be issued under a written plan approved by the stockholders of the corporation

•The option term and exercise period cannot exceed 10 years

•The option price must equal or exceed the FMV of the stock at the time of the grant1

•The options must expire no later than three months after employment is terminated

•The option can only be exercised by the option holder and cannot be transferred, except at the death of the option holder

•No more than $100,000 can be exercised in one year1 If the employee owns more than 10% of the voting stock of the company, the option price must be at least 110% of the FMV.

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Tax Treatment of Incentive Stock Options

• No income tax is owed when the ISOs:o are granted ando are exercised

• The difference between grant and exercise price is AMT income in year of exercise (if stock is disposed of in same year as exercise, no AMT income)

• Income tax is owed when the stock purchased with the ISOs is sold

• How the gain will be taxed depends on whether the disposition is a “qualifying disposition” or a “disqualifying disposition”

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$10

$15

$25

Price

Understanding Stock Option Terms

Time

Disposition date

Grant date Exercise date

Exercise price

FMV at exercise

Disposition price

Price

Holding Periods and Taxation of ISOs

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Time

Disposition date


$10

$15

$25

Exercise price

FMV at exercise

Disposition price

2 years from grant

1 year from

exercise

Price

Taxation of ISO Disqualifying Disposition

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Time

Disposition date


$10

$15

$25

Exercise price

FMV at exercise

Disposition price

Holding period requirement not met

Held less than 1 year – entire gain taxed as ordinary income

$5

$10

The tax treatment of a disqualifying disposition is the same as for an NQSO (except for FICA and withholding rules). Disqualifying dispositions generally do not have AMT ramifications.

Employee Stock Purchase Plans (ESPPs)

• $25,000 annual maximum• Shares can be sold at up to a 15%

discount• Same holding period requirement as ISOs

for capital gains treatment

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Nonqualified Stock Options (NQSOs)

• Options can be given to both employees and non-employees

• Exercise price must equal or exceed FMV of stock at time of grant

• The company can set the requirements for exercising the options

• The company can determine the conditions under which the options are forfeited

• No holding period rules apply

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Tax Treatment of NQSOs

• The options are not taxed when granted unless they have an ascertainable value

• Taxed as compensation (W-2 income) upon exercise of the option (bargain element)

• The employer receives a deduction for the amount taxed to the option holder

• Any change in value between the FMV at exercise and the disposition price is taxed as a long-or short-term capital gain or loss

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Price

Taxation of Nonqualified Stock Options

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Time

Disposition date


Exercise price

FMV at exercise

Disposition price

Compensation

Capital gains

$5

$10

$25

$10

$15

Stock Option Comparison (1)

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The plan must: ISO NQSO

Be a written document Yes Yes

Declare the number of shares subject to grant Yes No

Declare employees or classes eligible Yes No

Obtain shareholder approval 12 months before or after adoption Yes No


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The options must: ISO NQSO

Be granted within 10 years of approval or adoption of plan Yes No

Be exercisable no later than 10 years after the grant (5 years for >10% owner) Yes No

Be exercisable at no less than FMV on date of grant (110% for >10% owner) Yes No

Be nontransferable Yes No

Be limited to no more than $100,000 a year in FMV of shares per year Yes No


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Recipient must meet holding period of:

ISO NQSO

From date of grant 2 years None

From date of exercise 1 year None

Be an employee on date of grant Yes No

Exercise options within timeframe3 months following

terminationNo

Employee Stock Options

Gives the employee the right to purchase shares of stock in the employer’s company for a set price during a specified time period•Employee stock options are not free company stock

•The recipient isn’t required to use them

•They have no risk in and of themselves

•They have value only when used

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Other Stock Plans

• Stock appreciation rights (SARS)

• Phantom stock plans (employee cannot choose exercise date)

• Performance unit or share plans

• Junior stock plans

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Parachute Plans

• Golden Parachutes (typically for executives)o Payment has an aggregate present

value of not more than three times the individual’s base amount (safe harbor)

o Excess payments are not deductible to employer and subject to 20% excise tax

• Tin parachutes (typically for middle-management)o Similar to golden parachutes, but on

a much smaller scale

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Multiple Choice Question 1

Rex works for Titan Industries, which is currently trading at $12 per share. The company awards him incentive stock options (ISOs) for 2,000 shares with an exercise price of $12. Rex exercises (but does not sell) the options three years later when the stock is trading at $45 per share. Which of the following statements is correct?

a. Upon exercise, Rex will owe taxes (W-2 income) on $24,000(2,000 shares x $12 exercise price).

b. Upon exercise, Rex will owe taxes (W-2 income) on $66,000 ($33 difference on 2,000 shares—difference between the $45 current price and $12 grant price).

c. Upon exercise, Rex will be subject to AMT taxes of $45 per share.

d. Upon exercise, Rex will not owe any regular income taxes.

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Rex was also granted some nonqualified stock options (NSOs), with an exercise price of $15 per share (issued when the company stock was trading at $15 per share). His grant was for 4,000 shares, which he exercises (but does not sell) two years later when the stock is trading at $50 per share.

Which of the following statements is correct? a. Upon exercise, Rex will owe taxes (W-2 income and

payroll taxes) on $200,000 (4,000 shares x $50 per share).

b. Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $140,000 ($35 difference on 4,000 shares – difference between the $50 current price and the $15 grant price).

c. Upon exercise, Rex will be subject to AMT taxes on $140,000.

d. Upon exercise, Rex will not owe any regular income taxes.

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Multiple Choice DataJim Dandy, the CEO of Dandy Industries, was awarded the following stock options from his company:

During the current year, 2013, Jim has the following transactions with the stock options:

During the current year, Jim has the following transactions with the stock options:

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Stock Option

Grant Date Type Grant Price # of shares

AA 2006, Mar 1 NSO $15 5,000BB 2007, Feb 1 ISO $20 1,000CC 2008, Oct 1 ISO $30 1,000DD 2009, Aug 1 NSO $35 ,5000

Stock Option Date Action

Number of Shares

Mkt Price on Action Date

AA 2013, Jan 1 Exercise 3,000 $77 BB 2013, Feb 1 Exercise 1,000 $78 BB 2013, Feb 1 Sold 1,000 $78 CC 2013, Mar 1 Exercise 1,000 $80 DD 2013, Apr 1 Exercise 2,000 $82 DD 2013, Oct 1 Sold 2,000 $85


Which of the following is correct for options AA for 2013? a. Jim has W-2 income, subject to payroll

taxes, of $186,000. b. Jim has a short-term capital gain of

$186,000. c. Jim has a long-term capital gain of

$186,000. d. Jim has no tax liability since the shares

were exercised but not sold.

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Which of the following is correct for options BB for 2013? a. Jim has a short-term capital gain of

$58,000. b. Jim has a long-term capital gain of

$58,000. c. Jim’s sale is a disqualifying disposition,

and he has W-2 income of $58,000. d. Jim has AMT income in the amount of

$58,000.

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Which of the following is correct for options CC for 2013? a. Jim has no tax liability since the shares

were exercised but not sold. b. Jim has a $50,000 long-term capital gain

since the shares have been held more than two years since the grant date.

c. Jim’s exercise is a disqualifying disposition, and he has W-2 income of $50,000.

d. Jim’s exercise will result in AMT income of $50,000.

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Which of the following is correct for options DD for 2013? a. Upon exercise, Jim will have W-2

income of $94,000. b. Upon exercise, Jim will have W-2

income, with payroll taxes of $94,000. c. Upon exercise, Jim will not owe any

taxes since the shares have not been sold yet.

d. Upon exercise, Jim will have AMT income of $94,000, but no regular income taxation.

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Which of the following is correct for options DD for 2013? a. Upon sale of the stock, Jim will have W-2

income, with payroll taxes, of $100,000. b. Upon sale of the stock, Jim will have W-2

income of $6,000. c. Upon sale of the stock, Jim will have a

short-term capital gain of $6,000.

d. Upon sale of the stock, Jim will have AMT

income of $100,000.

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Which of the following statements is true? I. Upon exercise, W-2 income is reported, and

payroll taxes due, for NSOs.II. Upon exercise, W-2 income is reported for

ISOs.III. Upon exercise, AMT taxable income will be

created if the ISO is not sold by the end of the year.

IV. If an ISO is sold in the same year as exercised, there will not be any AMT income reported.a. I and III only b. II and III only c. I, III, and IV only d. II, III, and IV only

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Which of the following does not describe an instance when an employer is generally allowed to take a deduction for its contribution to a nonqualified deferred compensation arrangement?a. When the employee becomes vested.b. When the contribution is actually made

to the plan.c. When the employee has constructive

receipt.

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Manning Manufacturing wants to implement a nonqualified deferred compensation plan that will enable the company to set aside the same 10% they are contributing into the profit sharing plan for amounts executives earn above the $250,000 Section 415 limit. You would recommend a(n) a. SERP.b. death benefit only plan.c. rabbi trust.d. excess benefit plan.

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©2013, college for financial planning, all rights reserved. module 8 deferred compensation &...

Documents

restricted stock plan

plan dbo

incentive stock plans

deferral of compensation

irc requirementscertain

employee r

survivor benefit

qualified plans8