Non-Qualified Deferred Compensation (NQDC) & Compensatory Stock Options

Non-Qualified Deferred Compensation (NQDC) & Compensatory Stock Options Robert S. Keebler, CPA, MST, AEP Keebler & Associates, LLP 420 South Washington Street Green Bay, WI 54301 Robert.keebler@keeblerandassociates.com All Rights Reserved 1

Overview Advantages & Disadvantages of NQDC Advantages Company Can be discriminatory Generally non-regulated by ERISA, DOL and IRS Customized and unlimited benefits Can be forfeited Disadvantages Company No current income tax deduction for accrued liability and expense of benefits All Rights Reserved 4

Overview Advantages & Disadvantages of NQDC Advantages - Employee Deferral of tax until benefits are received Disadvantages - Employee Security of future benefits Risk of forfeiture Subject to Social Security and Medicare payroll taxes No rollovers available All Rights Reserved 5

Overview NQDC Definition Non-qualified deferred compensation ( NQDC ) is a type of legally binding agreement between an executive (or other highly-compensated employee) and his/her employer whereby the executive chooses to defer a portion of his/her compensation to be paid in a later tax year. As a result, the employee does not pay income tax on the compensation at the time it is earned. Rather, the compensation is generally taxed when it is received at a later date. However, between the time of deferral and the time of receipt, the compensation is subject to a substantial risk of forfeiture. NOTE: Payments made within 2½ months after the year end in which the benefits vests are not considered NQDC. All Rights Reserved 6

Overview Elements of NQDC Designed to cover a group of employees or just one employee May be incorporated into an employment contract Stipulates a certain time for payment (e.g. termination, retirement, disability, death, etc.) Amount paid is normally stated as a specified amount or a percentage of a compensatory item (e.g. salary or corporate profits) Subject to the claims of the employer s general creditors Contains a forfeiture clause which will cause the employee to lose his/her benefit if a certain event occurs (e.g. early termination for gross misconduct, voluntary termination, etc.) Specifies the period of time over which the payment is to be made (or as a lumpsum) Precludes right of the employee to borrow, pledge or assign his/her interest in the plan All Rights Reserved 7

Vesting 3 to 5 years common Cliff vesting Overview Typical NQDC Features Vesting usually immediate for employee contributions Forfeiture provisions Non-compete provisions Misconduct, lack of cooperation, etc. Usually no forfeiture for employee contributions Distribution options Lump-sum Annuity/term of years Change in control All Rights Reserved 8

Severance pay Overview Items Considered to be NQDC Change in control (CIC) agreements Supplemental Executive Retirement Plan (SERP) Restricted Stock Units (RSUs) Phantom stock plans Stock Appreciation Rights (SARs) Only to certain types of arrangements Discounted compensatory stock options Non-Qualified Stock Option (NQSO) Split-dollar arrangements IRC 457(f) plans All Rights Reserved 9

Overview Items Not Considered to be NQDC 401(a) qualified employer plans (e.g., 401(k), SEP, SIMPLE, ESOP and profit-sharing plans) 403(a) contracts and 403(b) annuities 457(b) plans 408(k) simplified employee pensions and 408(p) simple retirement accounts Bona fide vacation, sick leave, compensatory time, disability, and death benefits Annual bonuses payable within 2½ months after close of the relevant determination period Statutory stock options (ISOs and ESPPs) Stock options granted at FMV with no deferral feature All Rights Reserved 10

Elective plan Overview Types of Plans A type of NQDC that is initiated by the employee who is electing to defer compensation that would otherwise be earned and received within the near future. Non-elective plan A type of plan (a.k.a. golden handcuffs ) structured as a fringe benefit which is initiated by the employer. In most circumstances, this does not result in a reduction in the employee s current compensation. All Rights Reserved 11

Funded plan Overview Types of Plans A type of NQDC arrangement whereby the employer places assets aside for benefit of the employee through the use of trusts, escrow accounts, annuities and/or life insurance contracts. A typical example of this type of plan is a rabbi trust, whereby the employer creates and funds a trust for the benefit of the employee. However, the assets in the trust continue to be owned by the employer and are subject to the claims of the employer s creditors (but not accessible to the employer). All Rights Reserved 12

Unfunded plan Overview Types of Plans A type of NQDC arrangement whereby the employee agrees to perform future services for the employer in exchange for employer s unsecured promise to pay future compensation. Unlike a funded plan, the assets used to pay obligations arising from this type of agreement must come from the employer s general funds and are subject to the sponsor s creditors. At no time are any assets specifically set aside for the employee or available for assignment. Generally not advisable All Rights Reserved 13

Account balance plan Overview Types of Plans A type of NQDC arrangement in which the employee s benefit consists solely of a principal amount credited the participant and any income attributable to the principal. A typical example of this is a situation where an employee defers a portion of his/her salary and the plan credits a specified amount of income to that deferral each year. Non-account balance plan Is any type of plan not considered to be an account balance plan. Typically, the benefit is indeterminable until the occurrence of a certain event (retirement, death, disability, etc.) All Rights Reserved 14

Employee Income Taxation of NQDC General Taxation Rule Taxed when the compensation (cash or other property) is received, not when deferred. Employer Entitled to an income tax deduction in the tax year that ends in the year in which the employee recognizes the income. All Rights Reserved 16

Income Taxation of NQDC General Taxation Rule Example On February 1, 2007, ABC Corp., whose tax year ends July 30th, establishes a NQDC plan for its president, Mr. Smith (whose tax year ends December 31st). On January 15, 2009, Mr. Smith receives a payment under the NQDC plan and recognizes taxable income on his 2009 income tax return. Because the end of Mr. Smith s tax year occurs after July 30th, ABC Corp. is entitled to an income tax deduction for its tax year ended July 30, 2010. All Rights Reserved 17

Income Taxation of NQDC Constructive Receipt Constructive receipt is a general income tax principle that holds that income is taxable in a year in which it is credited, set apart, or otherwise made available to the recipient without restriction. Thus, in order to avoid immediate taxation, the NQDC deferral agreement should be entered into before the employee performs the related services. If the employee defers receipt of the compensation after the services have been performed, the IRS will take the position that the income has been constructively received, causing the income to be taxed immediately. However, to the extent that there are substantial restrictions or limitations on the employee s right, constructive receipt will generally not occur. All Rights Reserved 19

Income Taxation of NQDC Constructive Receipt Example Jones Inc. enters into a deferred compensation agreement with Ms. Johnson (an executive of Jones Inc.) whereby Jones Inc. agrees to pay (for services yet to be performed) $25,000 to Ms. Johnson upon her retirement. Assuming that the NDQC plan meets the qualifications of IRC 409A, constructive receipt will not occur until the compensation is due and payable at Ms. Johnson s retirement. All Rights Reserved 20

Income Taxation of NQDC Economic Benefit Economic benefit is a general income tax principle that holds that income is taxable in a year in which the employee acquires a nonforfeitable right to the assets of an employer and that right supersedes the rights of the employer s general creditors. All Rights Reserved 21

Income Taxation of NQDC Economic Benefit Example XYZ Corp. enters into a deferred compensation agreement with Mr. Paul (the CEO of XYZ Corp.) whereby he is to receive $50,000 per year for ten years, commencing in the year following the year of his retirement. At the time of the original agreement, XYZ Corp. funds an irrevocable trust with an amount needed to fund the future deferred compensation to paid to Mr. Paul. The trust agreement includes a provision stating that the trust assets are accessible to XYZ Corp. s creditors, but not to XYZ Corp. (i.e. rabbi trust ). Assuming that the NQDC agreement meets the requirements of IRC 409A, Mr. Paul will not recognize income at the time of funding in that he has not received an economic benefit. All Rights Reserved 22

Income Taxation of NQDC Substantial Risk of Forfeiture Substantial risk of forfeiture is a general income tax principle that holds that income will not be taxable to the employee to the extent that the entitlement to the deferred compensation is: (a) conditioned upon substantial future services or (b) the occurrence of a condition related to a purpose of the compensation, and the possibility of forfeiture is substantial. In the case of (b) above, the compensation must relate to the employee s performance for the employer or the employer s business activities and/or organizational goals (e.g. attainment of a certain level of earnings or equity value). All Rights Reserved 23

Income Taxation of NQDC Substantial Risk of Forfeiture An amount is not subject to a substantial risk of forfeiture merely because the right to the amount is conditioned, either directly or indirectly, upon the refraining performance of services (e.g. non-compete agreement). An amount is also not subject to a substantial risk of forfeiture beyond the date or time at which the employee could otherwise elected to receive the deferred compensation. However, this rule does not apply if the present value of the amount subject to a substantial risk of forfeiture is materially greater than the present value of the amount the employee could have elected to receive. All Rights Reserved 24

Income Taxation of NQDC Substantial Risk of Forfeiture Example On November 30, 2007, Ms. Jackson enters into a deferred compensation agreement with Greenacre Inc. whereby Ms. Jackson will defer 10% of her future salary. The agreement stipulates that Ms. Jackson is entitled to her deferred salary, provided that she is still employed with Greenacre Inc. as of December 31, 2010. Based the above facts, there is a substantial risk of forfeiture because Ms. Jackson s entitlement is contingent upon the performance of substantial future services. Thus, no income is taxable at the time the agreement was entered into. All Rights Reserved 25

Income Taxation of NQDC Consequences of an Improper Deferral All plan deferrals are included in gross income as soon as they are no longer subject to a substantial risk of forfeiture Deferrals subject to 20% additional tax, plus interest equal to the IRS underpayment rate plus 1% Form defects may affect all plan participants Operational defects affect only those that benefit All Rights Reserved 26

Income Taxation of NQDC Permitted Distributions Employee s separation from service Death Disability Specified time or fixed schedule established at deferral Occurrence of an event is not considered specific time (e.g., child enters college) Change in control Unforeseeable emergency All Rights Reserved 28

Income Taxation of NQDC Timing of Election Initial Deferral Election must be made in preceding tax year Election is prior to services being performed Exception: 30 days after date of initial eligibility Performance-based compensation Election must be made 6 months before service period ends Service period must be at least 12 months Distribution timing and form specified at deferral All Rights Reserved 29

Income Taxation of NQDC Timing of Election Subsequent Deferrals Election cannot take effect for 12 months Five-year additional deferral period Exception for distributions due to death, disability, or unforeseeable emergency Election cannot be made less than 12 months prior to first scheduled payment All Rights Reserved 30

General rule Income Taxation of NQDC No Acceleration of Benefits No haircuts No annuities changed to a lump-sum payment Exceptions Domestic relations order other than participant Federal conflict-of-interest requirements Withholding on section 457(f) plan vesting Withholding FICA taxes (and related income tax) De minimis ($10,000) and lump-sum distributions All Rights Reserved 31

Offshore trusts Income Taxation of NQDC Funding Restrictions Assets in offshore rabbi trust are taxable immediately Exception for assets in foreign jurisdiction if substantially all services were performed in such jurisdiction Financial health triggers All Rights Reserved 32

Income Taxation of NQDC IRC 409A Effective Date Effective for amounts deferred in tax years after 2004 An amount is considered deferred before 2005 if: Service provider has legal binding right to payment and Amount is earned and vested before that date Grandfather rule Effective if plan materially modified after 10/03/04 Effective date for earnings the same as the deferrals All Rights Reserved 33

Income Taxation of NQDC Additional Issues How to measure benefit Total value from dollar one Increased value from date of grant Valuation issues at time of payout Must be well-defined Generally determined as the fair market value of the property at the time payments are to commence All Rights Reserved 34

Income Taxation of NQDC Special State Income Issue Under P.L. 104-95, federal tax law restricts a state s ability to tax distributions from NQDC arrangements if the distributions are paid out over a period of at least ten years or the life expectancy of the beneficiary. In other words, if NQDC is deferred by an employee while a resident in a state that has an income tax (e.g. Minnesota) and then subsequently moves to another state that does not have an income tax (e.g. Florida) prior to the commencement of the benefits, none of the benefits can be taxed by the prior state (i.e. Minnesota), provided that the benefits are paid our over a minimum of a ten-year period (or the life expectancy of the beneficiary). All Rights Reserved 35

FICA Taxation of NQDC General Taxation Rule Under IRC 3121(v)(2), FICA tax on NQDC is calculated on the amount deferred and is dependent on whether the plan is an account balance plan or a non-account balance plan. NOTE: Final regulations are expected to be released soon on the FICA taxation of NQDC. All Rights Reserved 37

FICA Taxation of NQDC Taxation of Account Balance Plans In an account balance plan, FICA taxes are assessed on the principal that is credited to the employee s account. However, if a deferral under an account balance plan is not immediately taken into account for FICA tax purposes, the amount deferred (at a later date when it is required to be taken into account) will include not only the original principal, but also any income attributable to the principal. All Rights Reserved 38

FICA Taxation of NQDC Taxation of Account Balance Plans Example In 2007, Ms. Allen enters into a deferred compensation agreement with Orange Corp. whereby Ms. Allen will defer 10% of her future salary (beginning in 2008). In this case, Ms. Allen and Orange Corp. have established a account balance plan. Given the above and assuming that Ms. Allen defers $25,000 of her salary in 2008, both Ms. Allen and Orange Corp. will be subject to FICA taxes, during the 2008 tax year, on the $25,000 compensation deferred. All Rights Reserved 39

FICA Taxation of NQDC Taxation of Non-Account Balance Plans In a non-account balance plan, the benefit credited to the employee is usually not determinable at the time the NQDC agreement is entered into. As a result, the amount deferred will not be taken into account for FICA tax purposes until the employee s resolution date. For purposes of FICA taxation, the resolution date is the first date in which the amount deferred by the employee is reasonably ascertainable (i.e. the date in which the amount, form and commencement date are known). Once at the resolution date, the amount that is taxable for FICA tax purposes will be the actuarial present value of the future payments. All Rights Reserved 40

FICA Taxation of NQDC Taxation of Non-Account Balance Plans Example In 2007, Mr. Brown enters into a deferred compensation agreement with LMN Inc. whereby Mr. Brown s compensation amount will be based on a fixed percentage of an average of his salary for the five years immediately preceding his retirement. Subsequent to commencement (one year after retirement), Mr. Brown s benefit will be indexed for a cost-ofliving adjustment. Accordingly, this type of plan is a nonaccount balance plan. Based on the above facts, none of Mr. Brown s deferred compensation will be includable for FICA tax purposes until the amount of the benefit is reasonable ascertainable (i.e. after the benefits commence). All Rights Reserved 41

Compensatory Stock Options Non-Qualified Stock Options (NQSOs) Any stock option that does not qualify for special tax treatment under IRC 422 May be transferable No specific holding period requirements Employer receives an income tax deduction for the difference between the strike price and the fair market value of the securities on the date of exercise All Rights Reserved 44

Compensatory Stock Options Non-Qualified Stock Options (NQSOs) Cashless Exercise The exchange of previously acquired stock (not subject to any holding period requirement) for the funding price of new shares is a tax-free exchange. The basis and holding period of the old stock are carried over (i.e. tacked ) to the same number of shares acquired in the exchange. The basis in the excess shares is equal to the income recognized on the transaction (the fair market value), and the holding period begins with the date of exercise. All Rights Reserved 45

Compensatory Stock Options Non-Qualified Stock Options (NQSOs) Tax Consequences Ordinary income is recognized on the difference between the strike price and the fair market value of the stock on the exercise date. FICA and Medicare are applicable to the ordinary income. The subsequent appreciation will be subject to capital gain. The holding period will determine whether the gain will be long-term or short-term. The holding period for purposes of determining the correct capital gain rate begins with the exercise date. The basis of the stock is the exercise price plus the amount of income recognized upon the exercise of the option. All Rights Reserved 46

Compensatory Stock Options Non-Qualified Stock Options (NQSOs) Tax Consequences $100 FMV at sale FMV at exercise Short or longterm capital gain $0 Compensation income Strike price All Rights Reserved 47

Compensatory Stock Options Incentive Stock Options (ISOs) Requirements The stock option plan is in writing The plan specifies the number of shares that can be purchased under the plan, as well as the eligible employees The FMV of the stock with respect to which the options are exercisable for the first time does not exceed $100,000 during any calendar year The options must be exercised within ten years after they are granted The options are exercisable only by the employee during his or her life The options are transferable only upon the death of the employee All Rights Reserved 48

Compensatory Stock Options Incentive Stock Options (ISOs) Requirements The employee must be employed by the issuing corporation at all times from the option grant date until three months after the date of exercise The stock acquired under the option must be held for at least two years after the time it is granted and one year after the time it is exercised If an option is granted to a 10% or greater shareholder, the exercise price must be at least 110% of the FMV of the stock subject to the option The employer s shareholders must approve the plan within twelve months before or after the employer s board of directors adopts the plan The option is granted within ten years of the plan s adoption by the board of directors or, if earlier, the date it is approved by the shareholders All Rights Reserved 49

Compensatory Stock Options Incentive Stock Options (ISOs) Cashless Exercise Stock acquired from a means other than a previous ISO or stock acquired from a previous ISO that is held for the required period of time can be used for a stock swap. The exercise of an ISO with a stock swap will not trigger ordinary income (but could trigger AMT). The basis and holding period for the shares surrendered tack to the same number of share acquired in the swap. However, the holding period of the old shares does not tack for purposes of the special holding requirements of the ISO stock. All Rights Reserved 50

Compensatory Stock Options Incentive Stock Options (ISOs) Disqualifying Disposition If the stock acquired by the exercise of an ISO is disposed of before one year has lapsed from the exercise date or two years from the issue date, the sale will be subject to the following recapture rules: Ordinary income is recognized on the difference between the exercise price and the fair market value at the time of exercise. FICA and Medicare withholding will not apply In addition there will be short or long term capital gain on the difference between the fair market value at the time of exercise and the selling price. All Rights Reserved 51

Compensatory Stock Options Incentive Stock Options (ISOs) Tax Consequences $100 FMV at sale FMV at exercise AMT adjustment AMT capital gain Regular capital gain (short or long-term) $0 Strike price All Rights Reserved 52

Compensatory Stock Options Exercise Considerations Opinion of experts Historical returns Fundamental analysis--look at data about company, ratios, statistics, etc. Security market line Importance of expert investment counsel to your client Important for setting inputs for option exercise model All Rights Reserved 53

Compensatory Stock Options Early Exercise Considerations Forfeit time value of option Differential tax consequences favor early exercises) Dividends on underlying stock Cash flow situation Price change expectations for underlying stock Need for diversification--concentrated portfolio Better investment is available--exercise, sell and reinvest Possible future change in tax rates Employer stock ownership requirements All Rights Reserved 54

Financial Planning Issues Risk Factors Financial stability of employer Investments within the deferred compensation plan Executive s financial exposure Executive s financial condition aside from deferred compensation Federal and state tax issues Executive s estate planning goals and objectives All Rights Reserved 56

Financial Planning Issues Investments Within Plan Determining the proper mix of investments within the plan May be prudent to structure investment mix similar to that in a traditional IRA If executive receives company stock, diversification again is central All Rights Reserved 57

Financial Planning Issues Executive s Exposure to Company Stock Example Company A is valued at $100. Company A's stock grows 6% for 5 years followed by 10% growth for 15 years. Compare these results to S & P 500 return (10%) for the 20 year period. 650 600 550 500 450 400 350 300 250 200 150 100 50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 6% (5 years) 10% (15years) S&P 500 All Rights Reserved 59