For those of us who are fortunate enough to become an executive at a larger company, the way we receive compensation will change. While cash compensation increases slightly, the biggest change is in the benefits package known as “executive compensation.” These benefits are typically structured to promote performance and longevity and have significant payouts over time. Once you receive these benefits, it is important to structure them appropriately to meet the timeline of your goals and make sure they are planned for tax efficiency.
The first tier of executive pay is similar to most employee pay. There is a base of pay and some kind of bonus/profit-sharing pay included in this category. One thing to keep in mind is that because of the additional benefits that come with executive pay, it is important to be deferring the maximum into your company 401(k) because you are usually in a higher tax bracket once you become an executive. We also recommend not investing in any of your company stock in your 401(k). Most of your executive compensation will be backed by the company and represents more than enough exposure so it is best to go ahead and diversify what you can in your 401(k) to lower your risk profile.
One of the biggest changes to compensation is your long-term incentives. These incentives are usually in the form of shares in the company and can be awarded in a few different ways. By awarding shares, the hope is that your future is tied more directly to the success of the company thereby creating a greater incentive for you, the executive, to perform well.
While some companies directly reward their executives with shares, it is much more common to receive them as options, as performance shares, or some kind of blend of the two. Performance shares are fairly straightforward. To start the year you are given performance goals and are awarded a preset amount of shares if those goals are met. These shares are usually vested over a certain amount of years.
Stock options are slightly more complex. Stock options are a vehicle that gives the owner the “option” to purchase the shares of a company at a preset price sometime in the future. An example would be that you are awarded options of XYZ Company with a strike price of $20. Three years from now XYZ Company is now trading at $40 a share but because of your options, you get to purchase the shares at only $20. There is also an expiration date to these options that is important to keep track of.
The taxation of long-term incentives is important to monitor and is usually very lumpy depending on when the shares/options are awarded and what the company stock is doing. If awarded when your company stock is low, the income generated when the shares are sold can be incredibly high, sometimes even higher than your base pay. It is important to take advantage of income deferral vehicles to avoid paying taxes in the highest brackets during these years.
Executive compensation usually comes with many other significant benefits including things like meal plans, company cars, and for the elite few, the company jet. Executive pensions are also a significant benefit for some companies. One benefit that is important to take advantage of is the ability to defer compensation. For many executives, it becomes possible to have parts of their compensation deferred until retirement which can have major tax saving implications. Especially in years in which significant stock options come due, you can save an extraordinary amount of taxes by deferring salary.
Every company has its own variation of executive compensation and it is important to understand what your plan offers to make sure you take every advantage of it. Tax planning plays a crucial role here and it is usually best to coordinate with your CPA and financial advisor to make sure you are doing everything you can to be efficient with these extra benefits. If you'd like to understand more about the best way to maximize your executive compensation, feel free to send us an email or give us a call today.