It’s that time of the year again.
By midnight on Monday, all 2001 income tax returns — or extensions to file said returns — should be in the hands of the IRS or the U.S. postal service. While the witching hour is only days away, tax experts say it’s not too late for chief financial officers, and other senior level executives, to make some shrewd moves.
Brent Lipschultz, senior manager, personal financial planning, in KPMG LLP’s New York office, offers five tax strategies for senior-level executives:
If you have large losses in your stock portfolio for 2001, consider making the one-time deemed capital gains election to offset these losses without actually selling stock (Note: This option applies to stock purchases or other assets acquired in 2001). Benefits are two-fold. First, the special election steps-up the cost-basis for the securities. Moreover, if the securities are held for five years, the election will result in a 2 percent reduction in the normal capital gains tax (18 percent instead of 20 percent).
The Internal Revenue Service treats the elected securities as if they were sold at the stock’s closing market price on January 2, 2001 for “readily tradable stock” and as if they were then reacquired on the same day (Jan. 2) for the same amount or that day’s market price. Although individuals must pay tax on any gain from this deemed sale in 2001, the shares will then have a new holding period. Hence, any future gain is eligible for the 18 percent tax rate in 2006.
“You’re stepping up the stock to whatever is the fair market value on January 2 using gain recognition to offset the losses in your portfolio for 2001,” Lipschultz explains. He does caution, however, that a filer does need to make sure he/she still owns the securities as of January 2, 2002, a year after the deemed sale.
For more information on this special election, visit the IRS Web site, click here.
Executives may want to consider transferring stock options (Note: only non-qualified qualify) to family members — if their company plan allows for such a transfer. Any combination of estate planning vehicles can be put to use for the purpose: family trusts, family limited partnerships, and grantor retained annuity trusts.
“You’re hoping that appreciation of the underlying stock increases so the value would pass to the family members,” Lipschultz says. “I like this move because when the trustee exercises the stock options, it’s not the trustee that pays the tax, [rather] it’s the grantor or the employee whose options it was.” With a stock option transfer to a family member, he adds, “the employee is not deemed to make a gift and of the income tax that he paid on the exercise of the stock option by the trustee this results in additional estate tax savings.”
Consider having your employer establish a non-qualified deferred compensation plan for you to defer salary into the future when you may be in a lower tax bracket. One warning, though: the plan cannot be funded, meaning if the company goes bankrupt, the money is not protected. At Enron, Lipschultz says, employees suffered because of that. “People [at Enron] ended up losing money because they fell in the line with other creditors,” he explains. He also notes that the deferred compensation plans are very common among closely-held businesses.
For more information on deferred compensation, go to the IRS Web site, click here.
Reduce your exposure to the Alternative Minimum Tax (AMT) by considering the AMT implications on the exercise of incentive stock options. “Make sure that you examine your tax liability in the year that you exercise, so that they’re not in an AMT tax position,” Lipschultz says. “That requires doing a regular tax calculation and an AMT tax calculation. If the AMT is higher, then you’ll pay that.”
If an executive does have to pay the AMT, the cost may be hard to recoup, if the stock underlying the options goes down. “You really have to take a look at the true expectations of the stock to what your exposure is to the AMT,” he adds. “You have to be very strategic in exercising them.” His advice? Stagger the exercise dates. What may also help reduce the AMT exposure: Congress recently increased the exemption amount for a married individual for the next five years by $4,000 (to $49,000); and $2,000 (to $35,750) for singles.
For more information on the Alternative Minimum Tax, click here.
If your company issues restrictive stock or options, which if exercised will result in restricted stock, consider making an 83b election. That election allows you to minimize your exposure to ordinary income should the stock appreciate in value at a later date when restrictions lapse. This election has to be made 30 days after the stock is received, however.
Consider this scenario. A company gives its CFO 10 shares of stock exercisable at $1 per share. The CFO does not make the 83b election. If the stock share price then rises to $100 and the CFO sells, the executive pays ordinary income tax on the gain at a rate as high as 38.6 percent (the rate depends on the CFO’s income bracket). If the election is made, however, Lipschultz says the executive pays ordinary income tax at the $1 level and pays only a 20 percent capital gains income tax at the $99 level.
While it may be too late for most to take advantage of this strategy this year, it could save you some money down the line. For more information on tax treatment for restrictive stock options, click here.