Individual Income Tax Planning for Higher Tax Rates Robert S. Keebler, CPA, MST, AEP Baker Tilly Virchow Krause, LLP 2201 E. Enterprise Ave., Ste 100 Appleton, WI PRESENTED BY © Baker Tilly Virchow Krause, LLP All Rights Reserved

Tax Planning Opportunities Compensatory stock options Roth IRA Conversions © Baker Tilly Virchow Krause, LLP All Rights Reserved 2

Outline Compensatory stock options Financial & tax planning issues Hedging using collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 3

Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 4

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 Non-Qualified Stock Options (NQSOs) Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 5

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. Non-Qualified Stock Options (NQSOs) “Cashless Exercise” Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 6

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. Non-Qualified Stock Options (NQSOs) Tax Consequences Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 7

$100 $0 Strike price FMV at exercise FMV at sale Compensation income Short or long- term capital gain Non-Qualified Stock Options (NQSOs) Tax Consequences Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 8

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 Exercise Considerations Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 9

Forfeit time value of option Differential tax consequences favor early exercises) Dividends on underlying stock Cash flow situation Price change expectations for underlying stock Better investment is available--exercise, sell and reinvest Possible future change in tax rates Employer stock ownership requirements Early Exercise Considerations Compensatory Stock Options © Baker Tilly Virchow Krause, LLP All Rights Reserved 10

Financial & Tax Planning Issues © Baker Tilly Virchow Krause, LLP All Rights Reserved 11

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 Financial & Tax Planning Issues Risk Factors © Baker Tilly Virchow Krause, LLP All Rights Reserved 12

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 Investments Within Plan Financial & Tax Planning Issues © Baker Tilly Virchow Krause, LLP All Rights Reserved 13

Risk of stock stagnation Risk of falling stock value Executive’s Exposure to Company Stock Financial & Tax Planning Issues © Baker Tilly Virchow Krause, LLP All Rights Reserved 14

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 period. Executive’s Exposure to Company Stock - Example Financial & Tax Planning Issues © Baker Tilly Virchow Krause, LLP All Rights Reserved 15

Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 16

A “cashless” collar involves the simultaneous combination of a put option (an option to sell a stock at a predetermined price in the future) and a call option (an option to purchase a stock at a predetermined price in the future) on the same underlying stock The put option is purchased by the stockholder to provide downside protection - The put option eliminates any loss below put strike price The call option is sold by the stockholder to finance the cost of the put option - The call option eliminates any gain above call strike price Hedging Using Collars “Cashless” Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 17

Settlement Options Cash Physical settlement “Cashless” Collars Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 18

“Cashless” Collars Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 19

Advantages: Downside protection Retain ownership of stock (keep right to dividends and to vote stock) Downside put protection makes it easier to borrow against stock (monetization potential) (50% maximum) Retain some upside potential Defer capital gains--further deferral if cash settled “Cashless” Collars Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 20

Disadvantages: Lose upside potential above call strike price Must post underlying shares as collateral for call options sold Some tax risk--rules not clear until regulations are issued Unfavorable straddle rules may apply for tax purposes Dealer profit May be forced to make physical delivery of underlying stock and recognize gain “Cashless” Collars Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 21

If taxpayer has an appreciated financial position and Taxpayer enters into transaction that eliminates substantially all chance of future gain/loss, then Taxpayer is treated as making a constructive sale Constructive Sale Rules – IRC §1259 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 22

Applies if collar is too tight 20% total spread generally considered permissible Total spread can be on put, call, or some combination Constructive Sale Rules – IRC §1259 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 23

Taxpayer has offsetting positions (i.e. value of one position goes up while the value of the other position goes down) Loss cannot be recognized until all gain in offsetting positions is recognized Gain is short-term and recognized immediately NOTE: One of the positions will be the long position in the stock. The put and call are not off setting to each other--run in the same direction. Straddle Rules – IRC §1092 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 24

Excess of stock price over call price paid to counter party, resulting in an economic loss, is deferred until underlying stock is sold. Cash received for call option that lapses selling is recognized currently as short-term capital gain income Excess of put price over stock price recognized currently as short- term capital gain income Cash paid for put option that is not exercised is deferred until underlying stock is sold Straddle Rules – IRC §1092 Cash Settlement - Taxation Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 25

Stock Price$54.00 Put Strike Price49.00 Call Strike Price67.00 Cost of Put 6.00 Cost of Call6.00 Price $54 $6 Short-term capital gain on sale of call - recognized currently $6 Long-term capital loss on purchase of put - deferred until underlying stock is sold Straddle Rules – IRC §1092 Example #1 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 26

Stock Price$54.00 Put Strike Price49.00 Call Strike Price67.00 Cost of Put 6.00 Cost of Call6.00 Price Drops to $29 $20 received from counterparty ($49 put price - $29 current price), less $6 basis in put option, is recognized immediately as short-term capital gain The $6 received from call is a short-term capital gain Straddle Rules – IRC §1092 Example #2 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 27

Stock Price$54.00 Put Strike Price49.00 Call Strike Price67.00 Cost of Put 6.00 Cost of Call6.00 Price Rises to $87 $14 loss for having to pay counterparty for difference (i.e. $87 market price - $67 call price - $6 received for call option) may not be deducted until stock is sold The $6 paid for put is deferred as a long-term capital loss (until underlying stock is sold) Straddle Rules – IRC §1092 Example #3 Hedging Using Collars © Baker Tilly Virchow Krause, LLP All Rights Reserved 28

Conclusion © Baker Tilly Virchow Krause, LLP All Rights Reserved 29

Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party. Although effort was taken to ensure the accuracy of these materials, Robert S. Keebler and Baker Tilly Virchow Krause, LLP assume no responsibility or liability for an individual’s reliance on these materials. These materials are being provided for educational and informational purposes only and are in no way to be construed as accounting, financial, tax, legal or other advice. Individual readers must consult their own professional tax and legal advisors. © Baker Tilly Virchow Krause, LLP All Rights Reserved 30

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