How the Taxation of Executive Compensation Works

Executive compensation includes the financial rewards for a company’s highest-level managers. The taxation of these rewards is complex, with rules that alter the net value of a pay package. How an executive is paid determines when taxes are due and at what rates, as different components like salary and equity grants are subject to distinct tax treatments. These differences can impact an executive’s financial planning and the ultimate value derived from their service.

Taxing Cash Compensation

The most direct forms of executive pay are base salary and cash bonuses, which are taxed as ordinary income in the year they are received. This income is subject to federal, state, and local income taxes at standard progressive rates. This compensation is also subject to payroll taxes, including Social Security tax up to the annual limit and Medicare tax. High-earning executives also pay an Additional Medicare Tax of 0.9% on wages over a certain threshold.

Income is taxed when it is actually or constructively received. Constructive receipt occurs when money is made available without substantial restrictions, meaning a bonus available in December is taxable in that year, even if collected in January.

While salary has standard withholding, supplemental wages like bonuses may be handled differently. Bonuses under $1 million are often subject to a flat 22% federal withholding rate, while amounts over $1 million are withheld at 37%. This flat withholding may not be sufficient to cover the executive’s total tax liability, potentially requiring them to make quarterly estimated tax payments to avoid underpayment penalties.

Navigating Equity Compensation Taxes

Nonqualified Stock Options

An executive receives no taxable income when Nonqualified Stock Options (NSOs) are granted. The taxable event occurs at exercise, when the executive purchases stock at a predetermined strike price. The difference between the stock’s fair market value (FMV) and the strike price, known as the bargain element, is taxed as ordinary income and subject to payroll taxes. This amount is reported on the executive’s Form W-2.

The executive’s tax basis in the acquired shares is the FMV on the exercise date. When the stock is later sold, any appreciation above this basis is a capital gain. If the stock is sold one year or less after exercise, the profit is a short-term capital gain taxed at ordinary income rates; if held for more than one year, it is a long-term capital gain with more favorable tax rates.

Incentive Stock Options

Incentive Stock Options (ISOs) receive different tax treatment. For regular tax purposes, no income is recognized at grant or exercise, allowing an executive to purchase stock without an immediate ordinary income tax event. However, the bargain element at exercise is considered an income item for the Alternative Minimum Tax (AMT), which can trigger a significant AMT liability in the year of exercise.

To receive the most favorable tax treatment upon sale, the shares must be held for at least two years from the grant date and more than one year from the exercise date. If these holding periods are met, the entire gain between the final sale price and the original strike price is taxed as a long-term capital gain. If the holding periods are not met, it is a disqualifying disposition, where the bargain element at exercise is taxed as ordinary income and any additional gain is treated as a capital gain.

Restricted Stock Units

Restricted Stock Units (RSUs) are a promise to deliver company shares at a future date, provided certain conditions are met. No tax is due when RSUs are granted. The taxable event occurs when the RSUs vest and shares are delivered.

At vesting, the full fair market value of the shares is recognized as ordinary income and is subject to income and payroll taxes. Companies typically withhold a portion of the vested shares to cover the tax liability, delivering the net shares to the executive. The executive’s tax basis equals the FMV on the vesting date, and any subsequent change in value is a capital gain or loss upon sale.

Restricted Stock Awards

Restricted Stock Awards (RSAs) involve transferring company stock to an executive at grant, but the shares are subject to a risk of forfeiture until they vest. The default tax rule is that the value of the shares is taxed as ordinary income as they vest, based on the FMV on each vesting date.

A unique feature for RSAs is an election under Internal Revenue Code Section 83(b). This allows an executive to be taxed on the entire value of the stock at the time of grant, rather than as it vests. The election must be filed with the IRS within 30 days of the grant date and is irrevocable.

An 83(b) election is advantageous if the stock’s value is low at grant but expected to appreciate. By paying ordinary income tax upfront, all future appreciation becomes potential capital gain. The risk is that if the executive forfeits the shares, the tax paid at grant is not recoverable.

Understanding Nonqualified Deferred Compensation

Nonqualified deferred compensation (NQDC) plans allow executives to postpone receiving income to a future year, often deferring taxes until retirement. These plans can be offered selectively to management or highly compensated employees and do not have the same contribution limits as qualified plans like 401(k)s.

The taxation of NQDC plans is governed by Internal Revenue Code Section 409A, which dictates that an election to defer compensation must be made in the year before the compensation is earned. The plan must also specify the timing and form of payment, which can only be triggered by certain events. Permissible distribution triggers are limited to:

• Separation from service
• Disability
• Death
• A specified time or fixed schedule
• A change in control of the company
• An unforeseeable emergency

Once a payment schedule is set, it is difficult to change. A subsequent delay must be elected at least 12 months before the scheduled payment and must postpone it for at least five more years. Failure to comply with these rules results in severe tax consequences. All compensation deferred under the plan becomes immediately taxable as ordinary income, and the executive faces a 20% penalty tax on that amount, plus interest penalties.

Special Corporate Deduction and Excise Tax Rules

Section 162(m) Deduction Limit

Internal Revenue Code Section 162(m) limits the tax deduction a publicly held corporation can take for compensation paid to its top executives. The rule caps the annual deduction for each “covered employee” at $1 million. A covered employee includes the CEO, CFO, and the next three most highly compensated officers. Under the “once covered, always covered” provision, the $1 million deduction limit applies to all compensation paid to that individual by the company in all future years, even after they leave the company.

Section 280G Golden Parachute Payments

Internal Revenue Code Section 280G addresses “golden parachute” payments, which are payments to executives contingent on a change in company ownership or control. If these are deemed “excess parachute payments,” two penalties apply: the executive pays a 20% excise tax on the excess amount, and the company is denied a tax deduction for that same portion.

A payment becomes “excess” if its total value equals or exceeds three times the executive’s “base amount,” which is their average annual compensation over the five years before the change in control. If this threshold is met, the penalties apply to the portion of the payments that exceeds one times the base amount, not just the amount over the three-times trigger.