By David G. Strege, CFP®, CFA
Employees that have stock based compensation can have large yearly swings in income. The employee has little control of when taxable income is reported for vesting restricted stock or performance shares. They do have some control of when and how to exercise non-qualified and qualified stock options.
In unusually large income years consider deploying charitable giving techniques. A gift of cash or low basis stock to a Donor Advised Fund provides the donor control for coordinating the timing of the charitable gifts in conjunction with their stock transactions, along with the normal income tax deductions. First a donor connects with a public 501(c)(3) charity that administers Donor Advised Funds. The Donor Advised Fund is quick and easy to establish, requiring only nominal paperwork provided by the public overlay charity and an initial gift amount. There is normally not a set-up charge and a common annual administrative fee is about 1% of the balance in the fund. For this fee the public charity handles the administration– accepting donor grant requests, verifying the selected charity is a qualified 501(c)(3) and distributing the checks. Some will handle the investing of the funds and others will allow the donor to guide the investment strategy in the Donor Advised Fund.
The value of the asset gifted to the Donor Advised Fund provides a current year federal and state income tax deduction. There currently is no annual distribution requirement from the DAF since a public charity would be the recipient of the proceeds. The donor can determine how much to grant to various qualified charities in the future. The one major no-no is to make sure a personal pledge has not been made to the charity that is being fulfilled through the Donor Advised Fund. The donor also specifies how the balance in the Donor Advised Fund is to be handled upon his death. The balance can be distributed to selected charities, run by successor advisers (usually family members) or determined by the public charity holding the Donor Advised Fund.
When an employee is pushed up into higher tax brackets by a stock compensation transaction he should consider pooling a number of future years worth of charitable giving into this unusual year. If someone is pushed from a 28% marginal tax bracket into a 35% bracket then a $10,000 charitable gift provides an additional $700 in federal income tax savings.
Planning how Incentive Stock Options (ISOs) are exercised can also lead to additional tax saving strategies. When ISOs are exercised using stock swaps the net new shares produced have close to a zero basis for ordinary income purposes. There will also be a parallel Alternative Minimum Tax (AMT) basis for the net new shares. The shares used for the swap retain their same basis. If the employee has charitable intent then he can acquire some very low basis shares of company stock through swapping. After holding the shares for at least one year the low basis company shares can then be donated to a Donor Advised Fund in future high tax years.
The market value on the date of the gift is the amount donated and therefore the deductible amount. Once the shares are in the Donor Advised Fund account they can be sold with no taxable gain to the donor. If the company is a Sub-S corporation and the shares aren’t going to be sold right away the public charity may not accept them because there are some unrelated business income tax issues for the charity. Projecting income taxes over a number of years helps reveal the timing of strategies that can further reduce the employee’s income taxes.
David G. Strege, CFP®, CFA
Senior Fee-Only Financial Planner
Syverson Strege and Company
West Des Moines, Iowa