Financial health check for executives

Some factors relating to timing of deferred compensation are beyond executives' control, as they are set by a compensation committee. However, in many cases, there are openings for executives to limit the tax burden imposed by deferred compensation in the form of vested restricted stock or options as well as deferred cash compensation. In particular, executives nearing retirement may be able to significantly improve their tax outcomes.

Two of the most important considerations are (1) state income tax and (2) timing or duration of payment distributions.

Both of these factors are even more important given issues created by The Taxpayer Relief Act of 2012 (the Act), which Congress presented as a means to lessen the tax burden for most taxpayers. For many wealthy taxpayers, the Act instead limits their ability to lower their taxes effectively through personal exemptions and itemized deductions.

Specifically, the Act makes this more difficult by adding triggers to classify a taxpayer as "wealthy." These triggers then (1) increase a wealthy household's tax rates on income, capital gains and investment income and (2) reduce or eliminate their personal exemptions and itemized deductions. The triggers are "tripped" by adjusted gross income on page 1/line 37 of the 1040 tax return, where deductions don't impact the numbers. Therefore, taxpayers now must consider how the timing and amount of any income they earn may trigger these higher tax rates.

In essence, the Act promotes proactive tax planning (controlling the timing of income when possible) by taxpayers who may feel the effects of the increases it imposes. The Act also has created a shift toward favoring state income tax planning over federal tax planning as a means to lower the overall tax bill.

STATE INCOME TAX CONSIDERATIONS

Relocation due to job opportunities-both nationally and internationally-are common in the oil and gas industry. Furthermore, many executives locate to a new state after retirement. Executives should consider state tax consequences relating to where income is earned both pre- and post-retirement.

Executives also may consider how residency impacts their separate state income tax liability.

As noted above, the Act highlights the importance of state income tax planning. For this purpose, deferral of income tax over time will help. However, executives can attain even greater benefits if certain benefits are payable over 10 or more years.

That is, benefits paid over 10 or more years are subject to tax in the state the taxpayer lives when paid instead of the state the taxpayer lived when earned. If any executive has earned benefits in a state that maintains an income tax and retires to a state with no income tax, this relocation alone may provide the executive with significant savings when collecting those benefits.

So, executives may want to compare the state income tax rate where they live to that of the state to which they may retire and then ask whether benefits may be paid over more than 10 years.

PLANNING IN ACTION

Executives earning deferred compensation (whether cash, restricted stock, or stock options) may be able to avoid bunching of income and, therefore, higher tax bills by properly aligning annual deferral decisions.

Two common examples highlight the benefits of planning:

Example 1

An executive became eligible for a deferred compensation program. At the time, he was 50 years old. His plan allowed him to defer his income 10 years out and then take payments over the following 14 years. In his first year, he simply made a deferral election that would provide him with a single payment of all income 10 years out.

Through financial and cash flow modeling, he could see the income tax spikes he would generate if he would continue working past age 60 while being paid this deferred income based on this election strategy. He was then presented a model that was designed to show the benefits of electing to defer future payments over more years. The modeling accounted for his projected retirement age and his receipt of the deferred income along with social security, pension and other retirement benefits. This allowed him to (1) make different deferred compensation choices each year, (2) smooth his overall income to lower tax levels throughout his retirement and (3) take advantage of paying lower state income taxes if he would retire (or remain) in a state with no income tax.

Example 2

Another executive had significant non-qualified stock options (NQSOs) and deferred compensation that he would earn post retirement. He remained extremely income tax sensitive because his benefits would continue to place him in the highest income tax brackets well past retirement.

He provided his advisor with a spreadsheet that detailed his sources of income and benefits along with a timeline of when he would receive them. Upon review of the spreadsheet, he was asked whether any of the benefits could be paid over more than 10 years in the form of (a) deferred compensation or (b) deferred vesting of stock options. He spoke with his HR department and confirmed that it was possible. He, therefore, could "smooth" his income tax liability over more years by taking second look deferrals of his stock options. This helped him recognize less income over more years (and bring him below the highest income tax bracket level).

In addition, he could consider moving from New York to Florida during retirement and no longer pay state income tax on his deferred compensation once he retires there. As noted above, deferred compensation is taxed in the state where earned when paid out over less than 10 years. However, it is taxed in the state where received when paid out over more than 10 years.

Performance-based compensation, often with vesting and/or exercise periods of multiple years, is almost universal at publicly traded oil and gas companies. As executives strive to lead their firms to robust growth during a challenging time, they need to also remain proactive about their personal financial planning to ensure they explore all appropriate measures to potentially lower their tax burdens through optimal timing of their elections and future state-of-residency factors.

ABOUT THE AUTHORS

The article was written by Terry LaBant, JD/Senior Wealth Strategist, and Sterling Sullivan, CFP/Senior Wealth Advisor for Calamos Wealth Management. LaBant specializes in tax law, counseling executives on compensation, and benefit planning matters. Sullivan was formerly an international investment banker and financial director within the oil and gas industry and currently advises affluent individuals, including executives and professional athletes.