600 Introduction600.1 Family businesses are always looking for nontaxable and tax-deferred compensation planning techniques to maximize the effectiveness of their compensation packages for shareholder-employees and key executives. 600.2 Fringe benefits (Chapter 4) and qualified retirement plans (Chapter 5) provide only minimal help in this effort because of limits on the size of employer contributions, nondiscrimination requirements, or both. This chapter focuses on nonqualified deferred compensation (cash and stock-based) and nonqualified retirement programs that are typically the most effective supplements to the salary and bonuses of a shareholder-employee or key executive.600.3 Deferred compensation is a cash payment made in one period for services performed in an earlier period. In a nonqualified deferred cash compensation plan (for simplicity, the term deferred compensation plan is used in this chapter), the employee defers the receipt of cash compensation to a future year. Deferred compensation plans can be effective planning tools for deferring tax on cash salary and credited earnings, to take advantage of lower tax rates in later years, or to achieve personal financial planning and retirement goals.600.4 Equity-oriented plans determine compensation by the value of the company's stock and may involve cash, actual stock, or stockoptions. Several types of plans exist for each category and the employee's tax treatment depends on the form of payment.
What Is a Stock Option?603.11 A stock option is a contractual right granted to an executive to purchase shares of the company's stock in accordance with a specified plan. The plan normally specifies how many options may be granted, the executives who may participate, the option price, the form of payment, the periods for exercising options and making payment, and other matters. The company's shareholders usually must vote to approve the option plan. The purchase price, sometimes called the strike price, is usually the stock's FMV on the day the executive is granted the option. The plan may, however, set the option price different from the market value. The plan may specify the strike price be paid in cash or with employer stock the executive already owns. 603.12 Stock options fit into two broad categories: a. Incentive Stock Options (ISOs). Qualified stock options, more commonly known as incentive stock options, must meet certain statutory requirements outlined in IRC Sec. 422. ISOs are covered in sections 606 and 608.b. Nonqualified Stock Options (NQSOs). These include those not meeting the requirements of an ISO, or an option stating it is an NQSO. See sections 607 and 608 for coverage of NQSOs.Stock Options as a Risk-free Equity Vehicle603.13 A stock option program allows the executive an opportunity to participate in equity growth of the company. The option fixes the purchase price that executives must pay to exercise the option and buy stock. The better the company performs, the more the options are worth because of the increase in the value of the underlying stock. 603.14 Stock options generally are granted to the executive at no cost. Therefore, the executive gets in with minimal or no up-front capital and without significant downside investment risk if the company stock declines in value before the executive exercises the option. If the price of company stock drops below the exercise price, the executive does not incur a loss. He or she simply chooses not to exercise the option.603.15 Since the purpose of the option is to allow the executive to share in the company's growth, option programs are built around the assumption that the company's stock will increase in value. However, the ability of the option holder to participate in the company's equity growth without any upfront capital risk is a significant benefit.
605 RestrictedStock Plans605.1 In a typical restrictedstock plan, an executive receives company stock subject to certain restrictions. Often, the stock is transferred at no cost to the executive. The shares are subject to forfeiture if the executive fails to fulfill the terms of the restrictedstock program. For example, a common restriction is that the executive will forfeit the shares if he terminates employment within a certain number of years. 605.2 When restrictedstock (i.e., subject to a forfeiture risk) is transferred to the executive for payment of services, the executive's income and the employer's deductions are not recognized until vesting occurs (i.e., the stock is no longer restricted), unless the executive makes an election to recognize the income at the date of receipt.605.3 Note: When unrestricted vested stock is transferred in payment for services, the executive recognizes ordinary (compensation) income equal to the stock's value less any amount paid for the stock on the transfer date [IRC Sec. 83(a)]. Here, little or no planning can be done to reduce or minimize taxes; however, with vested stock, the executive also avoids the risk of losing his stock investment. 605.4 Appendix 6H is a sample restrictedstock plan agreement that can be used to assist the client's legal counsel. Appendix 6I is a checklist for evaluating a restrictedstock program.
AMTTax Treatment of ISOs606.4 The tax benefits of an ISO are heavily weighted in the executive's favor. Generally, the executive recognizes no taxable income for regular tax purposes on either the grant or exercise of an ISO [IRC Sec. 421(a)(1)]. However, upon exercise, the executive does have a tax preference item for the alternative minimum tax (AMT). The preference is the difference between the stock'soption price and its market value at exercise [IRC Sec. 56(b)(3)]. The employer receives no deduction. 606.5 Upon exercise, the basis of the stock for regular tax purposes will be the exercise price. For AMT purposes, however, it will be the exercise price plus the positive alternative minimum taxable income (AMTI) adjustment item (i.e., the excess of the FMV at the time of exercise over the option price) recognized upon the exercise of the ISO. An offsetting negative AMT adjustment item occurs when the stock is sold. Therefore, if the executive disposes of the stock in the same year as the exercise, the two adjustments will offset. However, if the executive does not dispose of the stock in the same year as the exercise (e.g., because the stock price declines substantially after exercise) the executive may incur an unexpected AMT liability.