Compensation: Tax Considerations and Optimization Strategies

Whenever an employer transfers something of value to an employee as compensation for the employee's services, a potentially taxable payment has been made. But what constitutes compensation? We have all heard the terms salary, wages, and compensation and understand they describe the amount of money an employee receives for services rendered. While these terms are related to one another, it is important to understand the distinction between them. 

Salary refers to the annual amount paid to an exempted employee for services rendered. An exempted employee is a taxpayer who receives a fixed amount of money annually and meets the federal requirements to be exempted from the Fair Labor Standard Act (FLSA). Wages, on the other hand, are paid to a taxpayer on an hourly or piecework basis. 

Compensation includes both salary and/or wages in addition to any other financial benefit the taxpayer receives for services rendered such as bonuses, commissions, paid time off, and fringe benefits. Since financial benefits received by an employee may be taxable, compensation is the appropriate scope when considering withholding and payroll taxes.

How is Compensation Taxed?

As a general matter, all items of value that are provided to an employee by an employer are taxable unless an explicit exception exists. In addition to federal and/or state income taxes, taxable compensation is subject to “payroll taxes” such as the the Federal Insurance Contributions Act (FICA) Social Security tax, the FICA Medicare tax, federal and state unemployment taxes, and state disability insurance taxes. These payroll taxes differ in the rates applied and whether there is a threshold and/or cap.

While the IRS does not provide an extensive list of what items of compensation constitute taxable income for employees, they do provide a long list of items that are excluded. Financial benefits can be entirely excluded from withholding and payroll taxes, partially excluded, or fully taxable. The following are some examples of financial benefits that are generally excluded:

Advances. While advances made to an employee are generally taxable, if the terms of the arrangement provide that the employee is legally obligated to repay, the advance is nontaxable.

Expenses. If an employer provides an advance to cover reasonably expected business expenses that the employee will occur on the employer’s behalf or reimburses such expenses, neither are considered taxable compensation.

Gifts. Generally, most gifts that an employer provides to an employee are presumed to be compensatory in nature. Although, there is an exception for the holiday season. Items such as Christmas gifts are not considered taxable compensation if the gifts have nominal value.

However, this exception does not apply to gifts of cash, just those of property.

Accident and Health Benefits. With a few exceptions, contributions made by an employer to an accident or health plan for an employee are excluded.One fringe benefit that is partially excluded is an achievement award. If an employee receives an award of tangible personal property (i.e., not a gift card or cash) for their performance pursuant to an established program or plan, such gift is excluded up to $400 for non-qualified plan awards and $1,600 for qualified plan award. For an extensive and detailed overview of the tax treatment of other financial benefits received by employees, check this out.

What About Equity Compensation?

Another common financial benefit is equity compensation. Equity compensation is non-monetary pay that is offered to employees in the form of stock options, restricted stock, and employee stock purchase plans. While such options are offered to various types of employees, executives are more likely to receive equity compensation than regular money compensation. Due to the vesting and exercise restrictions that are commonly placed upon stock options, equity compensation is offered to incentivize long-term employment with a company. There are many options that companies offer, a few of which are described below. 

Stock Options

An employer grants the employee a right to purchase stock at a defined price once such right has vested. For a stock option to vest, a certain amount of time must pass or certain goals achieved. Once the option has vested, the employee can exercise such right to purchase the stock until the defined expiration date. There are two types of stock options: Incentive Stock Options and Non-qualified Stock Options. 

Incentive stock options allow an employee to (1) defer taxation on the option from the date of exercise until the date of sale and (2) pay taxes on the entire gain at capital gains rates, rather than ordinary income tax rates. To receive these benefits, the eventual sale must be a “qualifying disposition” by following a long list of rules. In general, incentive stock options are more favorable.

Non-qualified stock options are taxed once exercised by the employee. Specifically, the spread on exercise is taxable as ordinary income to the employee. Once the employee sells the shares, any subsequent gain or loss on the shares after exercise is taxed as a capital gain or loss.

Restricted Stock

Restricted Stock plans permit employees to purchase stock either at fair market value, a discount, or receive the stock at no cost. The catch, however, is that the employee is not in possession of the stock until specified restrictions lapse. While any restrictions may be imposed, the typical restriction is time-based. Employees restrict possession of the stock acquired until the employee has worked for the company for three to five years. The employer also has discretion as to whether the employee may exercise their shareholder rights (such as voting and receipt of dividends) prior to the shares vesting. 

As for the tax implications, the employee has the option to make the Internal Revenue Code Section 83(b) election. Making such an election results in taxing the “bargain element” of the award at the time of the grant as ordinary income. The bargain element is the difference between the fair market value of the stock and the amount of consideration the employee paid. If the stock was simply granted to the employee, the bargain element is the full value of the stock. 

Failing to make the Section 83(b) election requires the employee to pay ordinary income taxes on the bargain element when the restrictions lapse. In both situations, the subsequent changes in the value of stock will be treated as a capital gain or loss at sale. The main difference between making the election and not is when the taxpayer must pay the tax. 

Employee Stock Purchase Plans (ESPPs)

Employee Stock Purchase Plans (ESPPs) allow employees to set aside money over a period so that they can purchase stock at the end of the offering period. Typically, the money originates from taxable payroll deductions. There are two types of ESPPs: qualified and non-qualified plans. Qualified plans have a number of rules such as who may participate, limitations on the amount of shares offered and the offering period term, and how plans are approved. Qualified plans offer the stock at a discount (not to exceed 15%) and receive favorable tax treatment if a “qualifying disposition” takes place. 

Similar to Incentive Stock Options, to be treated as a qualifying disposition, the employee must hold the stock for at least one year after the purchase date and two years after the beginning of the offering period. The employee pays ordinary income tax on the lesser of (1) the actual profit and (2) the difference between the stock value at the beginning of the offering period and the discount price as of that date. Any other gain or loss is characterized as long term. However, if the disposition does not qualify (known as a disqualifying disposition) the employee pays ordinary income tax on the difference between the purchase price and the value of the stock as of the purchase date. 

How Can You Optimize Compensation?

As with most tax issues, due to the particularity of financial circumstances, you should consult with a tax advisor who is familiar with your financial situation and the laws of your state. That being said, here are a few common strategies you may wish to employ to optimize your compensation structure:

Be Strategic About When You Exercise Stock Options. Due to the vesting periods associated with stock options, employees have a set period within which they may exercise their stock options. Be mindful of this period and, if you choose to exercise your option, consider exercising your option when the fair market value of the underlying stock is more than the exercise price. But remember, depending on whether the option is an incentive or non-qualifying, the difference between the fair market value of the stock and the exercise price can be taxed at exercise or upon sale and as ordinary income or capital gains.

The 83(b) Election If Available. One of the benefits of exercising the 83(b) election is that the income tax and long-term capital gains tax rate that are in effect when you make the election are locked in. However, since such elections are irrevocable, you should consider the possible issues you may face if you use the election. For example, you could lose your job before the stock vests and you cannot reclaim the taxes already paid on it. In addition, if the stock value falls between the grant and vesting dates you may end up paying more in tax by making the election than you would have if you were taxed on the vesting date at ordinary income rates.

Qualifying Dispositions. Incentive Stock Options and Qualified ESPPs both have a long list of requirements for the disposition to receive favorable tax treatment as “qualifying dispositions.” Be mindful of these requirements, namely the holding period requirements. The holding period for Incentive Stock is one year from the exercise date, two years from the grant date, one year from the purchase date, and two years from the ESPP offering date for ESPPs.

Next Steps on Compensation Optimization

This is only a cursory overview of the various types of compensation and the respective tax treatments. Due to the favorable tax treatment of various types of compensation packages, it would be worth your while to explore your different options to potentially reduce your taxes through Corvee’s tax planning software.