Planning for Corporate Executive Compensation and Management of Concentrated Stock Positions Tim Kochis, JD, MBA, CFP® CEO. Kochis Global

Overview Stock Options Non-Qualified and Incentive Stock Options Restricted Stock IRC Section 83b Deferred Compensation Plans IRC Section 409A “Golden Parachutes” IRC Section 280G 2 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Stock Options/NQSOs The spread is taxable as ordinary income at exercise (wage income, so payroll taxes also apply). The employer gets a payroll deduction at time of exercise. 3 Tim Kochis, JD, MBA, CFP ®

Statutory Stock Options/ISOs “Incentive Stock Options” The spread is not taxable at exercise (i.e. deferred until sold), instead it is an adjustment for AMT purposes. 1.Holding period requirements: a.At least 1 year from the date of exercise and b.Two years from grant date 2.If holding period requirements met, sale is long-term capital gains. 3.The AMT adjustment increases the AMT basis of the stock. The stock has a different tax basis for regular tax and AMT purposes. 4.If AMT results from exercise of an ISO, an AMT credit may be available in future tax years. 4 Tim Kochis, JD, MBA, CFP ®

Statutory Stock Option/ISOs If the holding period requirements are not met, a “disqualifying disposition” occurs 1.The spread is taxed as ordinary wage income in the year of the disqualifying disposition. 2.The employer gets a compensation deduction. 5 Tim Kochis, JD, MBA, CFP ®

Restricted Stock Popular (but flawed) alternative to options. Responded to concerns regarding stock option abuses: – No leverage – Rewards without (or even despite) performance – Relatively inefficient for taxes and for investment planning. 6 Tim Kochis, JD, MBA, CFP ®

Restricted Stock: Benefits and Risks of the IRC Section 83(b) Election Avoiding §83b elections – Confidence in no forfeiture – Confidence in compensation for opportunity cost – Side purchase is usually better 7 Tim Kochis, JD, MBA, CFP ®

Restricted Stock: Benefits and Risks of the IRC Section 83(b) Election Side purchase is better… unless 8 No opportunity to purchase; or sufficiently higher future tax rate Rate Increase from 28% to 40% No Election No Election/Side Purchase Section 83 (b) Election Initial value$10,000 Additional PurchaseN/A2,800N/A Initial 28%N/A (2,800) 5 years’ earnings on $2,800 per year after taxes) 947N/A Cost of additional purchaseN/A(2,800)N/A Growth in value on initial shares in % per year 5,923 40% at lapse of restrictions(6,369) N/A Growth in value on additional 9.75% per year N/A1,658N/A Tax on long-term capital gain on sale of initial or additional 20 % N/a(331)(1,185) Best choice$10,501$10,881$11,938 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Historical Evolution  The “old days” of 90% tax rates and very steep graduation. “Lower rates in retirement” was a realistic expectation. Tax deferral enough; often no earnings within plan.  1970’s: 70% marginal rates, but 50% “max tax” on current compensation: o In service deferral periods arise o Impetus for earnings; initially only an interest rate measure  Equalized rates (before and after retirement) and much lower rates o Deferred compensation institutionalized by then o Return becomes paramount  20% LTCG rates make high absolute earnings rates/opportunities essential  Section 409(a) Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Benefits and Costs Benefits Costs_______ For Employer ROR Cost of Capital? … small, young … large, mature companies companies For Employee - Superior Investment - Tax Rate Risks Returns - Collection Risks 10 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Superior Investment Returns Deferred compensation turns a pre-tax return into an after-tax return No Deferral Deferral Compensation$10,000 $10,000 Current Tax (40%) (4,000) N/A Net Investable 6,000 10,000 At 6% After Tax for 5 years 8,029 N/A At 6% Pre Tax for 5 years 13,382 Tax at Receipt (40%) N/A (5,353) Net in 5 years $ 8,029 $ 8, Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Tax Rate Risks: Tolerable Future Tax Rates The longer the deferral and the stronger the return, the higher the tolerable future tax rate Pre-Tax ROR within Deferred Compensation Plan* Period of Deferral 6% 8%10% 2 years40%42%44% 5 years40%45%50% 10 years40%50%58% 20 years40%59%71% *Assuming 6% after-tax outside the plan 12 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Key Conclusions From Analysis of Tax Risks  Plans with only modest internal returns are not attractive  Short deferral periods are especially risky 13 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Collection Risks  Insolvency: Must be an unsecured (even if funded) general obligation of the employer  Recalcitrance: Especially after a change in control  The Role of Rabbi Trusts: Independent custody of funded resources 14 Tim Kochis, JD, MBA, CFP ®

Non-Qualified Deferred Compensation Some Impacts of Section 409(a)  All unmodified deferrals, as of 12/31/04, grandfathered  Options or SARS issued at a discount are deferred comp subject to §409(a) Must fix exercise date  Reduced flexibility for new deferrals Separation from service Specified date Change in control, unforeseeable emergency Must elect before close of preceding year Or 30 days after 1 st eligible or 6 months in advance of performance period end No acceleration … but further delay if >12 months in advance and at least 5 yr. delay from original election  20% Excise tax for violations 15 Tim Kochis, JD, MBA, CFP ®

“Golden Parachute” Constraints §280G  Requires both a “change in control” and an acceleration of value  Acceleration: – Severance payments – Early release of restrictions on restricted stock – Early vesting of options  Employer gets no deduction  Employee pays an additional 20% tax 16 Tim Kochis, JD, MBA, CFP ®

§280G Safe Harbors Payments related to actual performance of services Qualified plans For other amounts: 3 x average of prior 5 years But if amount equals or exceeds 3x, 20% tax applies to anything over 1x. – Thus, possible “early” exercise of NQSO’s 17 Tim Kochis, JD, MBA, CFP ®

Management of Concentrated Stock Positions 18 Tim Kochis, JD, MBA, CFP ®

19 Tim Kochis, JD, MBA, CFP ®

Overview of Managing Concentration Limit downside risk…or Opportunistic Concentration? Avoid knee-jerk response; client’s actual tolerance for risk and overall planning context Special problems −Taxes −“Lock-ups”, post IPO −SEC Constraints: 16b; 10b5 −Executive holding requirements and SARBOX −Psychological constraints 20 Tim Kochis, JD, MBA, CFP®

Psychological Barriers 21 Tim Kochis, JD, MBA, CFP ®

Concentration Management Techniques Start with the Simplest solution first Partial Solution/Combinations are OK… “walk before you run!” 22 Tim Kochis, JD, MBA, CFP ®

Concentration Management Techniques Sale –Long shares/options –Deferred Compensation Plans Gifts: Family…Charity Margined Diversification Tax Managed Index Accounts Exchange Funds Derivatives 23 Tim Kochis, JD, MBA, CFP ®

Sale 24 Worst case: Keep 70-75% of pre-tax value (assumes zero basis) Can be about the same as a “sales tax” (5% or so) with a basis of 75% (33.3% appreciation). Waiting for “Basis Step-Up” is a bad bet Tim Kochis, JD, MBA, CFP ®

Distinct Sales Strategies 25 Long shares: sell to protect against downside risk –After tax exposure to downside: say, 75cents/dollar; no leverage Hold Options to capture upside –Downside exposure, say, only 55cents/dollar; leverage, especially young, high priced options Tim Kochis, JD, MBA, CFP ®

26 Tim Kochis, JD, MBA, CFP ®

Cashless Option Exercises Allows option holder to exercise without incurring hard dollar costs or liquidating current investments Minimizes concentration risk because fewer net new shares are purchased 27Tim Kochis, JD, MBA, CFP ®

Coordination With Deferred Compensation Plans Indirect “Deferral” of Sales Proceeds –Defer Salary/Bonus: Spend option/restricted stock proceeds. Disciplined Diversification Through Advance Commitment –Can’t spend what isn’t there; must “spend” what’s available to sell. 28 Tim Kochis, JD, MBA, CFP ®

Sales Under 10b5-1 Plans 29 Authorized by SEC in 2000 to Overcome 10b5, “Inside Information” Problems Long Shares and/or Options Disciplined Diversification Through Advance Commitment Tim Kochis, JD, MBA, CFP ®

Managing Concentration… includes not buying more 30 Avoid IRC Section 83b Elections –Confidence in no forfeiture –Confidence in compensation for opportunity cost –Side purchase is usually better …unless no public market, or tax rate change > 6 percentage points Tim Kochis, JD, MBA, CFP ®

Gifts…To Family 31 Lower tax brackets Psychic distance Discount transfer tax costs (FLP’s; Defective Grantor Trusts) Tim Kochis, JD, MBA, CFP ®

Transferring NQSO’s 32 Opportunistic upside Discounted wealth transfer –Retained income tax liability –Discount for non-transferability –May need to ignore IRS guidance on timing and on valuation (Black-Scholes) Trade-off for sale of long shares Tim Kochis, JD, MBA, CFP ®

Gifts …to Charity 33 Net “cost” of gift can be as little as 30cents/dollar (at zero basis; higher basis raises cost since lesser LTCG) 30% AGI limitation; 5-yr Carryover Lowest basis shares first; don’t wait for “Basis Step-up”. Outright; CRT’s; CLT’s Tim Kochis, JD, MBA, CFP ®

NQSO’s to Charity 34 Black-Scholes to advantage: income tax deduction for “inflated” value Charity only receives actual spread: maybe too opportunistic Better?: Consume options and transfer other assets to charity Tim Kochis, JD, MBA, CFP ®

Managed Retention: Margined Diversification 35 Simplest means of managing retained concentration Enhanced liquidity Likely reduced risk (believe it or not!) Enhanced net returns (after-tax returns greater than after tax margin costs) Tim Kochis, JD, MBA, CFP ®

Tax Managed Index Proxy Accounts Low tracking error to desired index Harvest tax losses from diversified envelope to offset gains in concentrated core Substitutes high tax-exposed, diversified portfolio for high tax-exposed concentrated portfolio Tax on sale and/or transfer to charity may still be ultimate solution 36 Tim Kochis, JD, MBA, CFP ®

Exchange Funds 37 Postpones, not eliminates tax liability Limited diversification –Stocks within same asset classes/sectors –Required 20% illiquid assets Restricted liquidity: 7 years Relatively high costs ( %) Tim Kochis, JD, MBA, CFP ®

Options and Hedges: Selling Covered Calls 38 Low risk strategy Diversifiable premium Sets attractive, pre-committed target sale price Worst case: sell later at higher price Tim Kochis, JD, MBA, CFP ®

Protective Puts 39 Additional investment in already concentrated position Best Case: pay for privilege of selling later at reduced price Tim Kochis, JD, MBA, CFP ®

Combining Options in a Collar 40 “Costless” Collars: Call premium = Put cost “Put-spread” Collars: retain more downside risk to maintain more upside Tim Kochis, JD, MBA, CFP ®

Prepaid Forward Contracts 41 Upfront cash payment (80-90%) Settlement 1 to 3 years later Partial upside (20-30%) through partial share retention Tax postponed to settlement (but no lending of shares to counter-party) Use competition among Brokers/IBanks to protect client Tim Kochis, JD, MBA, CFP ®

Summary of Concentration Management 42 Tie to client’s objectives within comprehensive plan Opportunistic concentration could be OK Partial solutions/Combinations are OK…often essential Simplest solutions usually the best