Advisors increasingly deal with executive benefits when creating an estate plan for business executives. What are the best options available, the best fit for the client’s situation, and the tax and legal implications for the client’s estate plan?

Kathleen Bilderback, counsel with Sandberg Phoenix, listed the considerations that advisors must know when creating an estate plan for an executive during a recent webinar for the National Association of Insurance and Financial Advisors.

The most important step when dealing with executive benefits in the client’s estate plan is to read the benefit plan documents, she said. Estate planners must be able to differentiate among different types of benefits and their impact on the client’s estate.

Bilderback said the first question she asks of an executive client who wants to create an estate plan is: “At the end of the day, do you want your executive team to have equity or not?” The answer to that question forms the basis of the plan.

Two buckets

Plans for executives fall into one of two buckets, she said: equity plans and nonequity plans. Equity plans include incentive stock options, nonqualified stock options and restricted equity. Nonequity plans include cash bonus plans, split-dollar plans, traditional nonqualified deferred compensation plans and what she called “synthetic equity plans,” which include phantom equity and appreciation rights.

Both types of plans can meet client objectives of recruiting, retaining and rewarding talent, Bilderback said. But plans that grant equity also can be used as part of the business owner’s succession plan.

“Incentive stock options are the gold standard in plans that grant equity,” Bilderback said. Incentive stock options are available only to C corporations. They grant the participant the right to buy a fixed number of common shares at a fixed price over a specified period and may include a vesting schedule or other terms.

The stock must be held for at least two years from the date the options were granted and at least one year from when the options were exercised. If those holding period requirements are met, then the owner of the stock pays income tax at capital gain rates only when selling the acquired stock.

Nonqualified stock options are available in C corporations, S corporations and limited liability corporations taxed as partnerships, Bilderback said.  When a participant receives nonqualified stock options, there is no tax when the options are granted. But when the options are exercised, there is a tax on the difference between the “strike price” and the fair market value of the equity being purchased. When the stock is sold, the difference between the sale price and the basis is taxed at capital gain rates.

Bilderback said a client may not transfer any incentive stock options during their lifetime. Incentive stock options are permitted at death to a designated beneficiary if the plan permits, or by “will or the laws of descent and distribution.” These options must be exercised within 12 months of death or permanent and total disability. Nonqualified stock options may be transferred and exercised as directed by the benefit plan.

Life insurance can provide liquidity

Beneficiaries and heirs will need liquidity to exercise the options, and life insurance can provide that liquidity, Bilderback said.

Bilderback listed several challenges in plans that grant equity. They include:

• Valuation issues
• Options and restricted equity result in additional equity owners.
• Whether the owner has the right to transfer the equity to a trust. Are there conditions? Are approvals required?
• May the owner transfer equity to a charity? Does the charity want to receive it? Does either the company or the charity need to approve the transfer?
• What happens to the owner of the equity if they die or become disabled?
• Must the new owner’s estate planning documents be amended or revised due to equity ownership?

Plans that don’t grant equity

Synthetic equity plans are one type of plan that does not grant equity. Bilderback explained that synthetic equity plans are nonqualified deferred compensation plans where the ultimate benefit to the executive is generally a cash payment based on the performance of company equity. The payment is frequently subject to a vesting schedule. All vested accrued benefits become immediately taxable, and the taxable amount is also subject to a 20% penalty and interest charges.

Phantom stock is the right to receive cash at a specified future date based on the performance of the company’s equity over a specified time, Bilderback explained. This may include “dividend equivalent rights” – cash bonuses paid when owners receive distributions. An executive is normally taxed at ordinary income rates when the benefit is made.

Synthetic equity has its own set of planning challenges, which Bilderback listed:

• It’s included in the owner’s gross estate for estate tax purposes.
• Valuation issues.
• The plan documents or award agreements generally permit the participant to designate a beneficiary, but the documentation requirements must be followed.
• Plan documents generally have a default beneficiary – frequently it’s the participant’s estate.
• A company may desire to “informally finance” the benefit with life insurance.

Because payments are taxable to the recipient, nonqualified plan payments are excellent tools for funding charitable gifts, Bilderback said. The simplest way to accomplish this is to designate the charity as the primary or contingent beneficiary of all or part of the benefit payable.

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