Eubie Blake, a famous ragtime jazz pianist who lived to be almost 100, coined the phrase, “If I’d known I was going to live this long, I’d have taken better care of myself.” A similar saying may apply to today’s technology executives who spend a great deal of time creating value for their employer, shareholders, and employees, but spend little time taking care of themselves from a financial- and tax-planning perspective.
For those technology executives who derive a significant amount of income from stock-based compensation, a variety of planning opportunities are available—such as estate planning, change in residency, and charitable giving. Regardless of which avenues are pursued, early planning is instrumental in helping executives get the most value from their options.
Stock options are the most common form of executive compensation—especially if an employer is a prepublic company.
For income tax purposes, there are two types of options:
- Incentive stock options (ISOs)
- Nonqualified stock options (NSOs)
The most important difference between the two options is their taxability upon exercise. For an ISO, the difference between the stock’s fair market value (FMV) and its exercise price—commonly referred to as the spread—is taxable under the alternative minimum tax (AMT) system. For NSOs, the spread is taxed as regular compensation.
In both cases, the tax impact of exercising an option is lessened when the FMV is low because this results in a smaller spread.
Options are almost always subject to vesting, which means an executive needs to remain employed over a set period of time to own his or her options. Because of this, exercising an option doesn’t trigger the underlying spread until vesting takes place. This can be problematic when an executive attempts to take advantage of a low stock valuation.
However, Internal Revenue Code (IRC) Section 83, which governs the taxability of property received in exchange for services, provides an election that allows taxpayers to recognize income from the exercise of unvested options at the time of exercise. More importantly, this election—commonly referred to as an 83(b) election—uses the FMV on the exercise date to determine spread.
Why It Matters
If stock options are held until an exit event, exercised, and then sold—commonly referred to as a same-day sale—the gain from the sale is deemed W-2 compensation, which is taxed at ordinary rates. For 2018, the highest rate is 37%.
Alternatively, exercising an option earlier starts the holding period at that time, which means the ultimate gain recognized may qualify as a long-term capital gain. These types of gains are currently taxed at 20%. Shares may also qualify as qualified small business stock, which could further reduce or eliminate federal tax upon sale.
An exercise-and-hold strategy can be very effective for executives at early-stage companies with relatively low valuations. The rules in this area are complicated, however, so always consult a tax advisor before exercising options.
The United States is one of the few countries in the world that imposes a federal estate tax, also known as the death tax. Several states also have similar rules—Washington, for example.
Tax reform, commonly known as the Tax Cuts and Jobs Act, increased the lifetime estate and gift tax exemption to an inflation-adjusted amount of $11.18 million per person or $22.35 million for married couples. This amount can be used either during a taxpayer’s lifetime via gifting or at his or her death.
Estate tax planning focuses on the process of moving assets out of an estate during a taxpayer’s lifetime using the smallest amount of the lifetime exemption as possible. There are a variety of methods for doing so. For example, if the valuations of certain stock are very low—which is typically the case with early-stage companies—a simple gift may be all that’s necessary. Note that unvested shares can’t be gifted, however, which may close the opportunity to move shares when valuations are attractive.
Transferring wealth out of an estate can be done via straightforward or complex means. The gifting ideas outlined below aren’t meant to be inclusive, but rather to represent some of the more popular strategies.
Annual Exclusion Gifting
In 2018, the annual gift exclusion amount is $15,000, meaning taxpayers can gift up to $15,000 of value in cash and stocks before reducing the lifetime-exemption amount. Married couples making a gift together from community property can gift $30,000 to any individual without triggering a gift-tax reporting requirement. Below this threshold, there’s also no reduction in the federal estate and gift lifetime-exemption amount, currently set at $11.18 million per person.
Gifts can be made to more than one person by filing IRS Form 709, Gift Tax Return, but the lifetime-exemption amount will be reduced dollar for dollar. It’s important to note that gifting to trusts may necessitate a gift tax filing regardless of the transferred amounts.
Directly Paying College Tuition or Medical Bills
There are two exceptions to the annual gifting limit:
- Paying medical expenses directly to the provider
- Paying college tuition directly to the provider
In these cases, the $15,000 limit doesn’t apply, and the amount is treated as an excludable transfer and not a taxable gift.
Grantor Retained Annuity Trust (GRAT)
A GRAT is a gifting vehicle used for assets that have the opportunity to highly appreciate. It’s a type of irrevocable trust that allows a grantor to potentially pass a significant amount of wealth to beneficiaries without using a material amount, or in some cases any, of his or her lifetime estate and gift tax exemption.
GRATs are established for a specific number of years. When creating a GRAT, a grantor contributes assets to the trust but retains a right to receive the original value of those assets as well as a government-stated interest rate over the term of the GRAT. Any appreciation above the government-stated interest rate then passes from the grantor’s estate to the specified beneficiary free of gift tax.
Intentionally Defective Grantor Trust (IDGT)
An IDGT is a more complicated strategy that allows a grantor to transfer assets out of his or her estate for estate-tax purposes but not for income-tax purposes.
This means the grantor pays all of the income taxes on income produced by assets transferred to the IDGT, which allows those assets to grow tax free for the chosen beneficiary. The grantor further reduces his or her estate by paying income tax on the income generated by the IDGT. When the IDGT terminates or distributes, the beneficiaries receive assets that have been able to grow with no income-tax reductions.
Part of what makes an IDGT strategy complicated is the way in which the grantor funds the trust. A common approach is selling an appreciating asset to the IDGT in exchange for a promissory note. As long as the asset in the trust appreciates faster than the interest on the note, value is transferred out of the grantor’s estate free of gift tax.
Estate planning and the associated tax ramifications can be very complex. Before implementing any estate- or gift-planning strategy, discuss those plans with a qualified estate attorney or accountant.
Many executives who are about to experience a significant exit event consider changing residency to a state with lower taxes—especially given tax reform’s effective elimination of the federal deduction for state income and property taxes. This elimination is an especially big deal in states such as California or New York where both taxes are significant.
In California, the Franchise Tax Board (FTB) aggressively pursues taxpayers who’ve purportedly moved out of state. A common scenario involves an individual who doesn’t want to be subject to California’s tax system, but doesn’t want to actually move.
Accordingly, that taxpayer moves to a state without an income tax that happens to be next to California, such as Nevada. The individual then continues to maintain property in California, likely works a bit in the state, and visits on a regular basis. It’s worth noting this fact pattern almost always fails upon audit.
The law in this area is somewhat vague, and there’s no safe harbor to follow. Although the FTB Publication 1031 outlines the rules, including a long list of factors they consider, none of them are determinative on their own. A general recommendation is to do the following:
- Move out of the state
- Stay out of the state as much as possible
- Dispose of all major personal assets located in the state
How income is sourced to a state can also have a large impact on an executive’s decision to change residency. California, for example, sources investment-type income—interest, dividends, and capital gains, for example—to the state of residency, which is often beneficial for taxpayers.
Compensation-related income, on the other hand, is sourced based on where income is earned. A typical situation involves an individual who holds highly appreciated stock options and moves out of state to avoid California income tax.
Any same-day-sale gains from the exercise of an executive’s options generate ordinary income that’s reported as compensation. This means if the employee were granted the options while in California and either worked or resided in the state during the vesting period, the FTB deems at least a portion of the income that comes from those options as California sourced. This in turn results in the taxpayer owing California income tax on those options.
When It Works
Given these facts, there can be significant planning and savings opportunities for executives who really will be changing residency and are contemplating an options exercise or stock sale, including stock in a closely held business.
For example, an executive who acquired significant long-term shares via an early exercise of an option as a California resident wants to start diversifying. By relocating to Washington—an example of an income-tax-free state—the executive can avoid all California income tax on the long-term capital gains, providing a potential savings of 13.3%.
The tax benefits of donating cash or property to charities are familiar to everyone, although the rules regarding the amount and deduction vary depending on the type of property donated.
Cash is fully deductible but limited to 60% of the taxpayer’s adjusted gross income. Different rules apply when donating stock:
- Stock that’s been held for one year or less. The deduction is limited to the cost basis of the shares donated and has the same overall limitation as a cash donation.
- Stock that’s been held for more than one year. The deduction is equal to the FMV of the donated shares and the overall limitation is 30% of adjusted gross income and no taxable income to the individual making the donation.
Donor Advised Fund (DAF)
Executives who want to make a donation at the end of the year, but who don’t have time to deal with the details or aren’t sure which charities they want to support, may have the option to open a DAF and contribute long-term appreciated stock.
DAFs are easy to set up and allow individuals to make a donation to the DAF, receive the deduction in the current year, and then advise the fund on how to spend the money in the future. It’s important to note donations of nonpublicly traded shares with a value of over $5,000 require an independent appraisal to support the donation amount. Additionally, there are strict timeframes when an appraisal is required relative to the date of the donation.
Company Stock Donations
Timing is critical for executives trying to donate shares from a private or public company that’s presently or imminently involved in a sale transaction. The closer the donation is to the actual sale, the greater the risk the tax authorities will treat it as if the taxpayer sold the shares first and then contributed cash to the charity, triggering the capital gains tax.
We’re Here to Help
For more information on how to proactively plan for retirement, contact your Moss Adams professional.