1. ©2013, College for Financial Planning, all rights reserved. Module 8 Deferred Compensation & Stock Plans CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Retirement Planning & Employee Benefits

2. Learning Objectives 8–1 Identify characteristics of a nonqualified deferred compensation plan. 8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan. 8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan. 8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election. 8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans. 8-2

3. Questions to Get Us Warmed Up 8-3

4. Learning Objectives 8–1 Identify characteristics of a nonqualified deferred compensation plan. 8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan. 8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan. 8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election. 8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans. 8-4

5. Definition of Nonqualified Deferred Compensation “A nonqualified deferred compensation plan means any plan that provides for the deferral of compensation.”  American Jobs Creation Act of 2004 8-5

6. Nonqualified Deferred Compensation Overview 409A—Increased restrictions on deferred compensation Nonqualified plans are ideal for business owners and key employees who want to provide benefits for themselves in excess of qualified plan limitations. The historically low personal income tax brackets make nonqualified deferred compensation less attractive than previously. The prospect of rising taxes in the future also makes nonqualified deferred compensation less attractive. 8-6

7. Nonqualified vs. Qualified Plans 8-7 CharacteristicQualified PlanNonqualified Plan Internal Revenue Code Requirements DiscriminationPlan may not discriminatePlan may discriminate ERISA RequirementsAll plans must satisfy ERISA and IRC requirements Certain plans are partially exempt from ERISA Tax Treatment Employer deductionAvailable in year of plan contribution Available in year of employee taxation Employee deferralTax deferred until plan distribution; rollovers allowed Tax deferred only if unfunded or funds are at risk; no rollovers Fund earningsEarnings accrue tax deferred until distribution Earnings usually are currently taxable to employer DistributionsTaxed at ordinary rates; averaging may be available on lump sums Taxed at ordinary rates; averaging not available on lump sums

8. Types of Nonqualified Deferred Compensation Pure deferred compensation (employee funded) Supplemental plans (employer funded) o Excess benefit plan o Supplemental Executive Retirement Plan (SERP) o Death Benefit Only plan (DBO)— provides a survivor benefit 8-8

9. Excess Benefit Plans An excess benefit plan is linked indirectly to the qualified plan or plans in place and provides for benefits in excess of the amount to which the employee would otherwise be entitled under the qualified plan. The payment is typically made when the employee retires and is usually paid out the same way that benefits are paid under a qualified retirement plan. The plan may be funded, informally funded, or unfunded. 8-9

10. Supplemental Executive Retirement Plans (SERPs) A SERP (or top hat plan) is an unfunded plan providing benefits for select employees (generally only high-level executives) in excess of those provided by the employer’s qualified retirement plan. o Benefits are usually based on elements of compensation not otherwise provided under the qualified plan (such as a benefit formula with a higher multiple of earnings or ignoring altogether Social Security integration levels). SERPs can be used for a broader range of purposes than excess benefit plans. Unfunded SERPs are exempt from all but the reporting and disclosure requirements of ERISA. 8-10

11. Learning Objectives 8–1 Identify characteristics of a nonqualified deferred compensation plan. 8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan. 8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan. 8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election. 8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans. 8-11

12. Nonqualified Deferred Compensation Tax Implications To employer Deduction when taxed to employee Earnings taxed to employer To employee Taxed when benefit constructively received Subject to FICA taxes when constructively received 8-12

13. ERISA Requirements for Nonqualified Deferred Compensation Plans 8-13 ERISA Reporting and Disclosure Participation, Vesting, and Funding Fiduciary Responsibility Plan Termination Insurance Unfunded Plan or Trust Must complyExempt if top-hat plan; must comply if plan includes rank and file Exempt if top- hat plan; must comply if it includes rank and file Funded Plan or Trust Must comply Government, Church, Unfunded Excess Benefit Plans Exempt

14. Nonqualified Deferred Comp Funding Unfunded Promise to pay Agreement executed prior to service performance Available to company creditors Funded Not available to employer’s creditors Currently taxable to employee unless substantial risk of forfeiture Informally Funded Employer “informally” dedicates assets to through accounting device or segregating assets to a trust Rabbi Trust an example 8-14

15. Rabbi Trust A rabbi trust is an employer- sponsored irrevocable grantor trust Trust has two beneficiaries: o the employee and o creditors of the company Trust earnings are currently taxable to the employer 8-15

16. Secular Trust Irrevocable fully funded trust established for an employee Employee is vested in contributions, so current taxation to employee results Assets are not subject to the claims of an employer’s creditors 8-16

17. Requirements for Deferral of Taxation IRS Regulations stipulate three principles that must be followed for deferred compensation: 1. The agreement to defer compensation must be made before the dollars are earned 2. The agreement must represent only an unsecured promise 3. The agreement cannot be funded (i.e., any funds used to provide the benefit must be held by the employer as a general asset available to creditors) 8-17

18. Substantial Risk of Forfeiture Employee’s right to payments must be contingent upon future performance of substantial services (death or disability are not considered substantial services) Plan must provide for loss of rights to payments if substantial services are not performed OR if employment terminates for reasons other than death or disability Generally only relevant in funded plans 8-18

19. Constructive Receipt The constructive receipt issue isn’t whether the taxpayer has actually received the income, but whether he/she has access to it To avoid constructive receipt, agreements usually contain specific provisions establishing substantial risk of forfeiture (funded plans), or availability of funds to company’s general creditors (unfunded plans) 8-19

20. Economic Benefit Economic benefit relates to the receipt of non-cash property that can be valued in cash When the employee’s benefit is treated as the equivalent to the receipt of cash, current income taxation will result In unfunded and unsecured plan, mere promise to pay does not confer economic benefit 8-20

21. Learning Objectives 8–1 Identify characteristics of a nonqualified deferred compensation plan. 8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan. 8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan. 8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election. 8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans. 8-21

22. “Stock” Plans Restricted stock ISOs ESPPs NSOs SARs Phantom stock Performance unit or share plans Junior stock 8-22

23. Restricted Stock Plans Shares of stock are granted to the employee at no cost or at a bargain price, subject to restrictions There is no taxable transaction when shares are granted (unless 83(b) election) They are taxed as compensation when constructively received Capital gain holding period begins when restrictions are lifted (or when taxed under 83(b) election) 8-23

24. Employee Stock Options: The Option Agreement The option agreement specifies: the number of shares of stock that can be purchased, the price of the stock, the date when the options will expire, and terms under which the options can be used The terms under which the options can be exercised include: the dates when the options can be exercised, specific requirements that must be met before the options can be exercised, and whether the option holder must be employed by the company when the options are exercised 8-24

25. Learning Objectives 8–1 Identify characteristics of a nonqualified deferred compensation plan. 8–2 Identify concepts relating to taxation of a nonqualified deferred compensation plan. 8–3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan. 8–4 Identify characteristics of a restricted stock plan and analyze a Section 83(b) election. 8–5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8–6 Identify characteristics of nonqualified stock options (NSOs) and other types if incentive stock plans. 8-25

26. Incentive Stock Options (ISO) Requirements Can only be offered to employees Must be issued under a written plan approved by the stockholders of the corporation The option term and exercise period cannot exceed 10 years The option price must equal or exceed the FMV of the stock at the time of the grant 1 The options must expire no later than three months after employment is terminated The option can only be exercised by the option holder and cannot be transferred, except at the death of the option holder No more than $100,000 can be exercised in one year 1 If the employee owns more than 10% of the voting stock of the company, the option price must be at least 110% of the FMV. 8-26

27. Tax Treatment of Incentive Stock Options No income tax is owed when the ISOs: o are granted and o are exercised The difference between grant and exercise price is AMT income in year of exercise (if stock is disposed of in same year as exercise, no AMT income) Income tax is owed when the stock purchased with the ISOs is sold How the gain will be taxed depends on whether the disposition is a “qualifying disposition” or a “disqualifying disposition” 8-27

28. $10 $15 $25 Price Understanding Stock Option Terms Time Disposition dateGrant dateExercise date Exercise price FMV at exercise Disposition price

29. Price Holding Periods and Taxation of ISOs 8-29 Time Disposition dateGrant dateExercise date $10 $15 $25 Exercise price FMV at exercise Disposition price 2 years from grant 1 year from exercise

30. Price Taxation of ISO Disqualifying Disposition 8-30 Time Disposition dateGrant dateExercise date $10 $15 $25 Exercise price FMV at exercise Disposition price Holding period requirement not met Held less than 1 year – entire gain taxed as ordinary income $5 $10 The tax treatment of a disqualifying disposition is the same as for an NQSO (except for FICA and withholding rules). Disqualifying dispositions generally do not have AMT ramifications.

31. Employee Stock Purchase Plans (ESPPs) $25,000 annual maximum Shares can be sold at up to a 15% discount Same holding period requirement as ISOs for capital gains treatment 8-31

32. Nonqualified Stock Options (NQSOs) Options can be given to both employees and non-employees Exercise price must equal or exceed FMV of stock at time of grant The company can set the requirements for exercising the options The company can determine the conditions under which the options are forfeited No holding period rules apply 8-32

33. Tax Treatment of NQSOs The options are not taxed when granted unless they have an ascertainable value Taxed as compensation (W-2 income) upon exercise of the option (bargain element) The employer receives a deduction for the amount taxed to the option holder Any change in value between the FMV at exercise and the disposition price is taxed as a long-or short-term capital gain or loss 8-33

34. Price Taxation of Nonqualified Stock Options 8-34 Time Disposition dateGrant dateExercise date Exercise price FMV at exercise Disposition price Compensation Capital gains $5 $10 $25 $10 $15

35. Stock Option Comparison (1) 8-35 The plan must:ISONQSO Be a written documentYes Declare the number of shares subject to grantYesNo Declare employees or classes eligibleYesNo Obtain shareholder approval 12 months before or after adoptionYesNo

36. Stock Option Comparison (2) 8-36 The options must:ISONQSO Be granted within 10 years of approval or adoption of planYesNo Be exercisable no later than 10 years after the grant (5 years for >10% owner)YesNo Be exercisable at no less than FMV on date of grant (110% for >10% owner)YesNo Be nontransferableYesNo Be limited to no more than $100,000 a year in FMV of shares per yearYesNo

37. Stock Option Comparison (3) 8-37 Recipient must meet holding period of:ISONQSO From date of grant2 yearsNone From date of exercise1 yearNone Be an employee on date of grantYesNo Exercise options within timeframe 3 months following termination No

38. Employee Stock Options Gives the employee the right to purchase shares of stock in the employer’s company for a set price during a specified time period Employee stock options are not free company stock The recipient isn’t required to use them They have no risk in and of themselves They have value only when used 8-38

39. Other Stock Plans Stock appreciation rights (SARS) Phantom stock plans (employee cannot choose exercise date) Performance unit or share plans Junior stock plans 8-39

40. Parachute Plans Golden Parachutes (typically for executives) o Payment has an aggregate present value of not more than three times the individual’s base amount (safe harbor) o Excess payments are not deductible to employer and subject to 20% excise tax Tin parachutes (typically for middle-management) o Similar to golden parachutes, but on a much smaller scale 8-40

41. Multiple Choice Question 1 Rex works for Titan Industries, which is currently trading at $12 per share. The company awards him incentive stock options (ISOs) for 2,000 shares with an exercise price of $12. Rex exercises (but does not sell) the options three years later when the stock is trading at $45 per share. Which of the following statements is correct? a.Upon exercise, Rex will owe taxes (W-2 income) on $24,000 (2,000 shares x $12 exercise price). b.Upon exercise, Rex will owe taxes (W-2 income) on $66,000 ($33 difference on 2,000 shares—difference between the $45 current price and $12 grant price). c.Upon exercise, Rex will be subject to AMT taxes of $45 per share. d.Upon exercise, Rex will not owe any regular income taxes. 8-41

42. Multiple Choice Question 2 Rex was also granted some nonqualified stock options (NSOs), with an exercise price of $15 per share (issued when the company stock was trading at $15 per share). His grant was for 4,000 shares, which he exercises (but does not sell) two years later when the stock is trading at $50 per share. Which of the following statements is correct? a.Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $200,000 (4,000 shares x $50 per share). b.Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $140,000 ($35 difference on 4,000 shares – difference between the $50 current price and the $15 grant price). c.Upon exercise, Rex will be subject to AMT taxes on $140,000. d.Upon exercise, Rex will not owe any regular income taxes. 8-42

43. Multiple Choice Data Jim Dandy, the CEO of Dandy Industries, was awarded the following stock options from his company: During the current year, 2013, Jim has the following transactions with the stock options: During the current year, Jim has the following transactions with the stock options: 8-43 Stock OptionGrant DateTypeGrant Price# of shares AA2006, Mar 1NSO$155,000 BB2007, Feb 1ISO$201,000 CC2008, Oct 1ISO$301,000 DD2009, Aug 1NSO$35,5000 Stock OptionDateAction Number of Shares Mkt Price on Action Date AA2013, Jan 1Exercise3,000$77 BB2013, Feb 1Exercise1,000$78 BB2013, Feb 1Sold1,000$78 CC2013, Mar 1Exercise1,000$80 DD2013, Apr 1Exercise2,000$82 DD2013, Oct 1Sold2,000$85

44. Multiple Choice Question 3 Which of the following is correct for options AA for 2013? a.Jim has W-2 income, subject to payroll taxes, of $186,000. b.Jim has a short-term capital gain of $186,000. c.Jim has a long-term capital gain of $186,000. d.Jim has no tax liability since the shares were exercised but not sold. 8-44

45. Multiple Choice Question 4 Which of the following is correct for options BB for 2013? a.Jim has a short-term capital gain of $58,000. b.Jim has a long-term capital gain of $58,000. c.Jim’s sale is a disqualifying disposition, and he has W-2 income of $58,000. d.Jim has AMT income in the amount of $58,000. 8-45

46. Multiple Choice Question 5 Which of the following is correct for options CC for 2013? a.Jim has no tax liability since the shares were exercised but not sold. b.Jim has a $50,000 long-term capital gain since the shares have been held more than two years since the grant date. c.Jim’s exercise is a disqualifying disposition, and he has W-2 income of $50,000. d.Jim’s exercise will result in AMT income of $50,000. 8-46

47. Multiple Choice Question 6 Which of the following is correct for options DD for 2013? a.Upon exercise, Jim will have W-2 income of $94,000. b.Upon exercise, Jim will have W-2 income, with payroll taxes of $94,000. c.Upon exercise, Jim will not owe any taxes since the shares have not been sold yet. d.Upon exercise, Jim will have AMT income of $94,000, but no regular income taxation. 8-47

48. Multiple Choice Question 7 Which of the following is correct for options DD for 2013? a.Upon sale of the stock, Jim will have W-2 income, with payroll taxes, of $100,000. b.Upon sale of the stock, Jim will have W-2 income of $6,000. c.Upon sale of the stock, Jim will have a short- term capital gain of $6,000. d.Upon sale of the stock, Jim will have AMT income of $100,000. 8-48

49. Multiple Choice Question 8 Which of the following statements is true? I.Upon exercise, W-2 income is reported, and payroll taxes due, for NSOs. II.Upon exercise, W-2 income is reported for ISOs. III.Upon exercise, AMT taxable income will be created if the ISO is not sold by the end of the year. IV.If an ISO is sold in the same year as exercised, there will not be any AMT income reported. a.I and III only b.II and III only c.I, III, and IV only d.II, III, and IV only 8-49

50. Multiple Choice Question 9 Which of the following does not describe an instance when an employer is generally allowed to take a deduction for its contribution to a nonqualified deferred compensation arrangement? a.When the employee becomes vested. b.When the contribution is actually made to the plan. c.When the employee has constructive receipt. 8-50

51. Multiple Choice Question 10 Manning Manufacturing wants to implement a nonqualified deferred compensation plan that will enable the company to set aside the same 10% they are contributing into the profit sharing plan for amounts executives earn above the $250,000 Section 415 limit. You would recommend a(n) a.SERP. b.death benefit only plan. c.rabbi trust. d.excess benefit plan. 8-51

52. ©2013, College for Financial Planning, all rights reserved. Module 8 End of Slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Retirement Planning & Employee Benefits