Curt's Chalk Talk - Live! Non-qualified Plans

Imagine you're at work one day. The boss comes and he says, "Hey, I need to talk to you for a moment." So you go into the office and he starts talking about all these new incentive plans and compensation plans that he's going to offer you. You act like you're happy, you walk out of the room and you say, "What the heck was he talking about?"

Hi, I'm Curt Sheldon, and today I want to take a little bit of time to talk to you about what we call non-qualified compensation or non-qualified plans. So I'll just abbreviate that with non-qual or equity compensation. These are things you probably haven't heard about or worked with unless you're in a company that is heavy into tech or you've worked your way up into the higher echelons of the company and that's when you're going to see some of these different type of plans.

So today we're going to talk about non-qualified or equity compensation plans. So before I get into some of the individual ones, let's talk about what they all have in common. They have what's called a substantial risk of forfeiture, and what that means is there's a chance you might not get this money, and because of that, the money is not taxed when you receive it. Or probably more correctly I should say the compensation is not taxed when you receive it because you have this substantial risk of forfeiture, which gives us a similar treatment to a 401(k) or an IRA. But since these plans are not qualified, they don't have to be offered to all the employees. They can discriminate, which if you've heard me talk at an ETAB, I talk about non-discrimination rules and qualified plans. In a non-qualified plan, discrimination is just fine.

So we'll go ahead and we're going to take a look at some of those different plans that you have available out there. Remember, in all cases we're going to talk about substantial risk of forfeiture. So let's talk about the one that is probably closest to what you've seen before and that's called deferred compensation or I'm going to abbreviate that as deferred comp. So deferred compensation plan works a lot like a 401(k). You're going to talk to your boss and say, "Hey boss, instead of giving me my full salary, I want you to defer some of it and pay it to me later." So in that case with a 401(k), since it goes into a trust on your behalf, you don't pay taxes on it now, if it's a pre-taxed 401(k). Because it's going into a trust account, you can't get to it unless there's certain rules and when you take the money out, you're going to be taxed on it. Or if you take it out too early, you're going to pay penalties as well.

The difference with a deferred compensation plan is it basically just becomes an entry on the books of the company in its very most basic form. It becomes a liability of the company that they have to pay at some point in the future. And if the company goes bankrupt, that is a liability just like any other liability of the company. And if you have a deferred compensation plan, you will go into line with the other creditors and you'll hopefully get some or all of that deferred compensation back. There's no guarantee that you will. That's where the substantial risk of forfeiture comes into effect. If the company goes out of business, you may lose some or all of that deferred compensation. So you need to realize that and take that into account when you're looking at a deferred compensation plan.

Now most companies that offer them are large and this will probably not be an issue, but all we have to do is think about Enron and companies do go out of business. Now, a couple nuances when it comes to deferred compensation. First thing has to do with social security and Medicare. It's going to be subject to social security and Medicare tax when you take it out. But in most cases, if you're being offered deferred compensation, you're probably already over the social security wage base and you're not paying social security anyways, but you will pay Medicare taxes.

Now, in some companies, they will actually fund the deferred compensation where they'll buy maybe bonds to pay for this deferred compensation, which by the way, you will have earnings in a deferred compensation plan just like a 401(k), but it's normally determined by your employer. I.E, you don't get to pick what you invest in. So you'll get some earnings. Again, those will be a liability on the books. They may offset the liability with assets. In other words, they'll actually set aside funds to cover it and credit those funds with interest, but they're not required to.

And one thing to keep an eye out for is some deferred compensation plans have what are called or set up what's called a rabbi trust. And again, it secures your position a little bit more as an employee. And what a rabbi trust is basically used for is it still is subject to the creditors of the corporation, but if the corporation is bought out by someone else or it doesn't have to be the corporation. If the company is bought out by someone else, the rabbi trust sets up a wall, so to speak, to help fund the deferred compensation liability.

So again, to summarize on a deferred comp, it's a lot like a 401(k) in that you defer some of your wages to be paid to you in the future. When they are paid to you, you'll pay taxes on them, including Medicare and Social Security if they apply. The reason you don't pay for them now is because of that substantial risk of forfeiture and the fact that you could at some point in the future not get that money. Again, generally they pay and when you leave the company is generally when you get paid and it's usually a period of around 10 years where that gets paid out. So this can be a great way to reduce your tax burden while you're working and in the high tax bracket, much like a 401(k), and then when you're retired and at least theoretically in a lower tax bracket, you take the money out of the deferred comp plan and pay taxes on it at that point.

So again, that's the most basic one in the simplest, which it really isn't all that simple at all. Let's take a look at the next level up, I would say, of complexity, and that is called a restricted stock unit. It's usually identified as an acronym of RSU and it has a cousin that is just straight restricted stock. They're both for almost all purposes treated the same with one major exception.

So let's talk about how these work in general. So in general, your employer will; grant is the term we use; grant you a block of stock in the company or the rights to a block of stock in the company. And that's the difference between a restricted stock unit and restricted stock. A restricted stock unit, you have rights to stock in the future. Restricted stock, there's actually shares that they set aside on your behalf. So you are granted the rights to the stock in the future or the stock itself, but you can't have it unless you stay with the company X amount of time. So there's your substantial risk of forfeiture. If you don't stay with the company, let's say it's three years or five years, if you don't stay with the company for those three years or five years, you don't get the stock and therefore you, generally speaking, don't pay taxes on it.

Now, when the stock becomes yours, it is considered ordinary income. It's essentially wages and it'll be reported on your W-2 as wages. So it can be a big surprise when you think, "Well, I make a hundred thousand dollars a year and I got this grant that I haven't sold yet, but I've got this stock." Well, the value of that when it vests; and vesting is the term we use in this case; when it vests will be entered as ordinary income or wages, and it'll be on your W-4. Normally speaking, there'll be a ... Correction, your W-2. On the W-2 there'll be some notes that tax preparers look at to determine where that came from.

When it vests it's subject to taxation and social security and Medicare. Again, in most cases you'll already be over the social security wage base, but you'll pay Medicare tax. Now, when you sell the stock, you'll be subject to capital gains and that tax will be long-term or short-term depending on how long you own that stock.

Now this can get a little bit tricky, and if you don't have a tax preparer that's on the ball, you could end up with a real issue here. So when the stock vests, it goes to a broker and they will look at it or will track it for you, and when you sell it, they'll give you a 1099. But more often than not, that 1099 will show zero as the basis because you didn't technically buy it from that broker and if it sells for a $100, they're going to show a $100 worth of gains, even though you may have included $80 of that fair market value on the date it vested in your income as wages when it did vest.

There should be a supplemental form that goes with the 1099, but more often than not, if you don't know to look for it and if you just hand it to a tax preparer that maybe doesn't deal with these on a routine basis, they're going to take the 1099, they're going to enter it and you're going to pay more taxes than you need to.

So when you do sell restricted stock or restricted stock units, make sure you look for that supplement. Supplemental form that shows that, oh, by the way, when it vested, it had a fair market value of $80 and that was included in your income. So you only have $20 worth of capital gains, not $100. So that's really important.

Now, let's talk about the major difference between an RSU and restricted stock, and that has to do with how you can treat it before taxation. So when you receive restricted stock, you can take what's called an 83(b) election and that 83(b) election changes how that restricted stock ... Again, restricted stock only. Not restricted stock units. How it is taxed in the future. So basically with an 83(b) election, remember under the normal circumstances we get the grant, you don't pay any taxes because you have a substantial risk of forfeiture. With an 83(b) election you say, "I choose to pay tax on the difference between the fair market value and what I paid for this stock on the date of the grant."

So in a lot of cases with restricted stock, you don't pay anything for it. So let's say the stock is at $10 a share and you get 10 shares, you're going to declare a $100 as income at that point, and then any growth between then and the time it vests is treated as capital gains instead of ordinary income. So if you don't elect the 83 election or if you don't take the 83 election, any growth that occurs from the grant date to the vesting date is going to be taxed as ordinary income. But you don't pay any taxes at all during that time period. By electing to pay tax on the fair market value when it's granted you change ordinary income into capital gains income, which at least under current law is taxed at a better rate than ordinary income.

You need to make this election within 30 days of the grant. You need to inform the IRS in writing that you are doing that, and you also need to inform your employer that you are doing that. Most employers have a form that you can fill out to do that, and you just send it off to the IRS and a copy to the employer.

There's not a lot of absolutes in financial planning, but this one's generally speaking a pretty good deal. I suppose if the stock goes down in value, that would be the downside of paying the taxes because now you don't have the capital. You've paid tax and when you sell it's worth less than what you paid for it. So that you paid ordinary income on more than what it's worth. So that may be a downside, but in most cases, you're going to want to take the 83(b) election if it's available, and again, it's available only with restricted stock, not restricted stock units.

Now the last one I want to take a second to talk about is incentive stock options, and this is how it's normally abbreviated. ISO. So an incentive stock option is a lot like a regular option, and what an option does is it gives you the option, if you will, to buy a stock at some point in the future at a price set today. So in an incentive stock option, you receive options from your employer. They normally have what's called the strike price, which is the price that you can buy the stock at is set at the fair market value on the date of the grant, and you need to stay with the company for three or four or five years to be able to exercise those stock options. There's, again, substantial risk of forfeiture. If you don't stay with the company for X number of years, then you won't get the stock or you won't get to exercise the option.

When the options do vest, the fair market value is included in income, but that's it. Then when you exercise the options, if you exercise them properly, the difference between the strike price, what you bought the stock for, and what you actually sell it for is considered capital gains. And basically you need to have held the stock for one year from the time you bought or invested and you purchase the shares transferred, or it has to be two years after the date of the grant of the ISO, whichever one is longer, to be able to get long-term capital gains treatment on the proceeds from selling the stock.

Now, one real weird thing about ISOs is that the difference between the strike price and the fair market value on the date that it vests, as I mentioned, is not included in income for ordinary income taxes, but for the alternative minimum tax, that difference is actually included in income.

Now, that's pretty weird if you think about it. You're paying taxes on income that you haven't received yet, but that only applies if you're subject to the AMT; the alternative minimum tax. That is a relatively small number right now under the Tax Cuts and Jobs Act. However, if the tax Cuts and Jobs Act does sunset as it's set to do at the end of 2025, more and more people will be subject to the alternative minimum tax, and this could become more of an issue if you do get incentive stock options.

So those are three of the major non-qualified or equity compensation plans out there. There are others. There are things called non-qualified stock options, which are very similar to ISOs from your standpoint. There's some difference on how they're set up. There are things called phantom stock where you basically get the benefit of having the stock ownership, but you don't actually own part of the company.

You basically get the returns that the stock provides without owning the stock. That's used when the owners don't want to decrease their equity in the company or dilute their equity. So there's other things out there that you may see. These I think are the three big ones. All of them are somewhat complicated when it comes to your taxation. Again, they all have the same thing in common, and that is the substantial risk of forfeiture.

Now that's going to wrap it up on those. I did have one question that came up and it's not necessarily directly applicable to today's, so in case you are not interested in the question, if you do have any questions about what we talked about, feel free to contact me at curt@clsheldon.com or check out our blog where we write about these things as well; clsheldon.com/blog.

All right, so the question I got had to do with the two out of five rule. I was asked to explain that for military members. And let's talk, and this has to do with real estate and the primary residence exclusion. So the general rule is if you live in a house for two out of five years, you can exclude up to $250,000 of capital gains if you're single or $500,000 worth of capital gains if you're married.

Now, there's a special rule that applies to this for the military, and that's what the question is about. The military or the rule for the military or more correctly the law, because it is written into law, says that if you move from your house due to military orders assigning you 50 miles away or more, or requiring that you move into government quarters, you can ... And this is not the word the law uses, but I think it's the best way to explain it. You can suspend the clock for up to 10 years. So let's give an example. So you're stationed at base X and you live there for two years and you get PCS orders and it's more than 50 miles away. You move away, you turn the house into a rental.

At that point, the clock stops and no time elapses. We fast-forward 10 years. The clock starts again. And now to meet that two out of five, you have three more years to sell the property and exclude the growth from what you paid for it to what you sold it for, from taxation. If you took depreciation, which you should have if it was a rental, then that depreciation is not excluded. You do need to pay depreciation recapture regardless of whether you meet the two out of five rule or not, whether it's the general rule or the military exception.

Now, a couple of things on this that are not clear in the law, and I'll give you my opinion on them. One is what happens when you retire from the military. At that point, I take the position; and again, it is an opinion. The law is not clear. That once you retire from the military, you're no longer absent from your residence due to military orders so the clock would start again, whether it's been 10 years or not. Same rule, I would take a similar interpretation, if the military PCSs you back to base X. Now you're no longer absent due to military orders and the clock would start again, whether it's been 10 years or not.

One other thing to mention on this. I saw this in a Facebook group where someone mentioned that they knew people who had a lot of real estate and they were basically moving around the country. They were retired from the military and they were moving into each house just to live in it for two years to get the primary residence exclusion. Great idea, except it doesn't work. If you move back into a property except under the rules where we just talked about where primarily, if you move back in within 10 years due to military orders, this does not apply. But for pretty much everything else, if you move back into a house after you've rented it, you trigger what's called non-qualified use and that time period of non-qualified use is basically while it was rented.

And you'll have to prorate the growth of the property over those years. So let's say you lived in it for two, you were out for six, and then back in for two. And we'll ignore the military exclusion in this case. So you've lived in it for 10 years. Six of those would be non-qualified use. So whatever your gain is over the price of what you paid for the property, basically 60% of that gain would not be excluded from income or said another way, only 40% of the gain would be excluded from income.

So that's something to keep in mind. Hopefully that explains for the person who asked the question how the two out five rule works for military members. And again, the non-qualified use is something that a lot of people aren't aware of, and you can, as you saw, mess things up if you move back in.

So that'll wrap it up for today. I don't see any other questions. We are looking to do more of these in the future. We'll keep you posted as we schedule them. If you have any topics that you'd like us to go over, please let me know and we will do that. Again. If you have any questions from today, feel free to contact me at curt@clsheldon.com. You can also contact the company at info@clsheldon.com.

Have a good day.