Executive Compensation Plans

Executive compensation arrangements extend beyond traditional salary and bonuses to include retirement supplements, equity-based compensation, and change-in-control protections. For CFP exam purposes, understanding the tax treatment, holding requirements, and strategic considerations of each arrangement is essential.

Supplemental Executive Retirement Plans (SERPs)

A SERP is a nonqualified deferred compensation arrangement that supplements qualified plan benefits for key executives:

Purpose

• Provides retirement benefits above 401(a)(17) covered compensation limits
• Restores benefits lost due to qualified plan limits
• Rewards long-term executive retention

Common SERP Structures

SERP Funding

SERPs are typically unfunded (mere promises) or informally funded through:

• Rabbi trusts (most common)
• Company-owned life insurance (COLI) policies
• Employer general assets

Tax Treatment: No employer deduction until benefits are paid; executive is taxed when benefits are received.

Stock Options: ISOs vs. NQSOs

Stock options give employees the right to purchase company stock at a fixed price (exercise price or strike price) for a specified period.

Incentive Stock Options (ISOs)

ISOs are statutory options with favorable tax treatment but strict requirements:

ISO Taxation Timeline

Qualifying Disposition: Stock must be held more than 2 years from grant date AND more than 1 year from exercise date. The entire gain (sale price minus exercise price) is taxed as long-term capital gain.

The $100,000 Annual Limit

The $100,000 ISO limit restricts the aggregate fair market value of stock (determined at grant date) for which ISOs may become exercisable for the first time in any calendar year:

• Measured by FMV at grant date, not at exercise
• Excess options automatically convert to NQSOs
• Based on when options first become exercisable (vest), not when exercised

Example: If an executive is granted 100,000 ISOs at $2 per share that vest over 4 years (25% annually), only $50,000 worth can be ISOs in any year (25,000 shares x $2 = $50,000, under the limit). If the grant price were $5, only $100,000 / $5 = 20,000 shares could qualify as ISOs per year.

Disqualifying Disposition

A disqualifying disposition occurs when ISO shares are sold before meeting the holding period requirements:

• Ordinary income (W-2) = FMV at exercise minus exercise price
• Capital gain/loss = Sale price minus FMV at exercise
• Employer receives deduction equal to employee's ordinary income

Cashless Exercise

Cashless exercise involves borrowing to exercise options, immediately selling shares, and repaying the loan:

• Always creates a disqualifying disposition (no holding period)
• Ordinary income on spread at exercise
• Employer receives deduction
• Common practice due to no out-of-pocket cost

Non-Qualified Stock Options (NQSOs)

NQSOs have no special tax treatment but offer flexibility:

NQSO Taxation

Employer deduction: Equal to employee's W-2 income at exercise.

ISO vs. NQSO Comparison

Restricted Stock and RSUs

Restricted Stock Awards (RSAs)

Restricted stock is actual stock transferred to an employee, subject to vesting restrictions:

• Employee owns shares immediately but cannot sell until vested
• Subject to substantial risk of forfeiture until vesting
• Dividends may be paid (currently taxable)
• Voting rights typically granted

Section 83(b) Election

The Section 83(b) election allows employees to:

• Pay ordinary income tax at grant (on current FMV minus any amount paid)
• Start capital gains holding period at grant
• Convert future appreciation to capital gain rather than ordinary income

Strategic Consideration: The 83(b) election is beneficial when:

• Current FMV is low (minimal current tax)
• Significant appreciation is expected
• Employee is confident they will vest

Critical Rule: Section 83(b) elections are NOT available for RSUs because no property is transferred until vesting.

Restricted Stock Units (RSUs)

RSUs are promises to deliver shares upon vesting—not actual stock ownership:

RSUs vs. Restricted Stock:

Stock Appreciation Rights (SARs)

SARs provide the right to receive cash (or stock) equal to the appreciation in stock value:

• No actual stock purchase required
• "Cashless" by design
• Taxed as W-2 income when exercised
• Employer receives deduction equal to payment

SARs vs. Stock Options: SARs are economically similar to cashless exercise of options but simpler—no stock purchase, no holding period considerations.

Employee Stock Purchase Plans (ESPPs)

ESPPs allow employees to purchase company stock at a discounted price:

Qualified ESPP Requirements

ESPP Lookback Feature

Many ESPPs include a lookback provision:

• Purchase price = 85% of lower of FMV at offering start or purchase date
• Can result in effective discounts greater than 15%

Example: If stock is $20 at offering start and $30 at purchase, the purchase price is 85% x $20 = $17. The effective discount is ($30 - $17) / $30 = 43%.

ESPP Taxation

Qualifying disposition: Only the discount (up to 15%) is ordinary income; remaining appreciation is LTCG.

Disqualifying disposition: The spread at purchase (FMV - purchase price) is W-2 income; gain/loss from purchase date FMV is capital.

Golden Parachutes (Section 280G)

Golden parachute payments are compensation contingent on a change in corporate control:

Section 280G Rules

Example: Executive's base amount is $500,000 (5-year average). Change-in-control payments total $1.8 million.

• Threshold: 3 x $500,000 = $1,500,000
• Since $1.8M > $1.5M, Section 280G applies
• Excess parachute payment: $1,800,000 - $500,000 = $1,300,000
• Executive owes 20% excise tax: $260,000
• Employer loses deduction for $1,300,000

280G Exemptions

• S corporations
• Partnerships and LLCs (unless owning a subsidiary corporation)
• Tax-exempt organizations
• Shareholder-approved payments (with specific voting requirements)

457 Plans for Nonprofits

457(b) Plans

Governmental 457(b) and Non-governmental 457(b) plans differ significantly:

Unique advantage: 457(b) contributions do not count against 401(k)/403(b) limits, allowing executives to "double up" on retirement savings.

457(f) Plans

457(f) plans are ineligible deferred compensation plans for nonprofit executives:

• No contribution limits
• Must have substantial risk of forfeiture
• Taxable when vested (or no longer at risk)
• Subject to Section 409A rules
• No catch-up provisions

Use case: Providing deferred compensation to hospital executives, university presidents, and other nonprofit leaders without dollar limits.

On the CFP Exam

Expect questions testing:

• ISO vs. NQSO taxation at grant, exercise, and sale
• $100,000 ISO annual limit calculation
• Qualifying vs. disqualifying disposition consequences
• Section 83(b) election timing, availability, and strategy
• RSU taxation (no 83(b) available)
• ESPP $25,000 limit and 15% maximum discount
• Golden parachute 3x threshold and excise tax
• 457(b) governmental vs. non-governmental differences