As I sit down to write this article, I’m reading President Trump’s recently-released tax reform proposal. While still in the early stages, the proposal calls for fairly significant reductions to the corporate and individual income tax rates. How and when this proposed legislation becomes law will certainly impact tax planning for 2017 and 2018.
Tax planning for executive compensation for closely-held business owners offers many challenges. We strive to achieve the best tax result for the owner/executive while working to find a mutually beneficial result for the business. Executive compensation is comprised of four interrelated parts: cash compensation, equity compensation, retirement benefits, and fringe benefits. Tailoring the optimal mix is vitally important for closely-held businesses when attracting and retaining talent.
Cash compensation consists of salary and bonus. Simply timing the payment of an executive’s bonus can be a means of saving taxes. An accrual basis corporation can deduct an accrued bonus if paid within two and half months of year-end. This allows for a corporate deduction in year one and income recognition by the executive in year two. S Corporations, however, are precluded from deducting accrued bonuses to shareholder/employees until actually paid and included in the shareholder/employee’s income.
When considering an executive’s salary level, the question of reasonable compensation always comes into play. When is a salary too high and considered excessive, or too low in relation to the services provided? The Internal Revenue Code does not clearly define “reasonable compensation.” Thus, a facts and circumstances test should be applied to determine whether the compensation is reasonable. In C Corporations, large bonuses are often paid to minimize the corporate taxable income and maximize the lower corporate and individual income tax brackets. If the IRS were to determine the salary to be excessive in relation to the services provided, they would deny the salary deduction and treat the excess portion as a dividend. This, in effect, triggers the “double taxation” of corporate income by taxing the income a second time as a dividend and losing the corporate level deduction.
This issue occurs quite often with S Corporation shareholder/employees as well. In an effort to minimize payroll taxes, owners will take little or no salary and allow the corporate net income to pass through on their K-1s. In recent years, the IRS has taken an aggressive stance on this issue, challenging the validity
of low salaries and assessing the associated payroll tax liabilities. Careful consideration should be taken when determining salary levels. If overturned, the outcome could result in an adverse tax situation.
A Nonqualified Deferred Compensation Plan can be an effective tool in tax planning for executive compensation. A properly structured NQDC plan results in executive compensation being taxed when received rather than when earned. While a deferred compensation plan does not eliminate the payment of taxes, it does defer the obligation to a future period. That’s pretty significant, considering the proposed lower corporate and individual rates in the Trump tax plan. If paid out over a number of years, the deferral is even greater. The executive’s decision to defer a portion of their salary involves careful consideration. Will the reduced cash flow meet current lifestyle requirements? Will future tax rates be lower than current rates? Is my company financially secure and able to meet the future obligation of paying the benefits? Another important factor is the issue of constructive receipt under Internal Revenue Code Section 409A. Avoiding constructive receipt can be achieved by placing a restriction such as a forfeiture clause on the executive’s right to receive the compensation.
The use of Nonqualified Stock Options provides flexibility and tax deferral for executives, as NQSOs are much less restrictive statutorily than ISOs. Typically, there is no tax consequence when NQSOs are granted. When vested and exercised, the executive recognizes compensation income on the excess of the fair market value over the option cost. This income and associated payroll taxes withheld are reported on the executive’s W-2. The employer receives a compensation deduction for this income in the year the options are exercised. When the stock is eventually sold, the income will be a capital gain to the extent the sales price exceeds the sum of the income recognized and option price paid.
The payment of compensation through Restricted Stock is useful when the executive is seeking an equity position in the corporation. This is particularly effective as a means of keeping the key executive engaged when the current ownership team is not ready to relinquish control. A restricted stock plan provides a key strategy for transforming ordinary income into capital gain income, thus reducing the executive’s tax liability. The receipt of restricted stock for services performed is not a taxable event due to the restrictions placed upon its subsequent sale. Once the restriction period has lapsed, the executive is taxed as compensation on the stock’s fair market value less the amount, if any, paid for the stock. Similar to a NQSO, any future sale results in capital gain. Alternatively, the executive may elect under IRC Sec. 83(b) to include the value as compensation on the date the stock is awarded. The appreciation during the restriction period would then be taxed as capital gain instead of ordinary income. Careful consideration should be given when making this determination, however. If the executive does not meet the terms of the restriction, the stock could be forfeited. Additionally, if future appreciation does not result, then income was accelerated unnecessarily. When significant appreciation is expected during the vesting period, this appreciation can be deferred until the stock is eventually sold and then taxed as capital gain rather than ordinary income.
These are just a few of the more common ways of designing a tax-effective executive compensation plan. Our Tax Strategies group is available to assist with crafting an executive compensation plan tailored to fit your needs and the lifestyle of your executive team.
Jeffrey W. Clark can be reached at firstname.lastname@example.org or 215.441.4600.
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