If your employment agreement has deferral of compensation provisions, you may very well see a section or paragraph captioned “Internal Revenue Code Section 409A” or simply “409A.”  Its official citation is 26 U.S. Code Section 409A – Inclusion in gross income of deferred compensation under nonqualified deferred compensation plans.

This section is too complex and tedious for most lay person executives to understand and figure out.  Your reading Section 409A of the IRS Code is certainly an instant cure for insomnia.080914_jmanscratchhead_tnb

At the outset, before you execute an employment agreement, your retaining an attorney is necessary to interpret and apply Section 409A to the various scenarios of deferral of compensation to ascertain whether such compensation adheres to Section 409A’s deferrals and distributions timing rules.

Failure to comply with the rules concerning deferred compensation has onerous consequences of 1) inclusion of such deferred compensation as gross income for the subject taxable year, 2) payment of the amount of interest on the underpayments, and 3) a penalty amount equal to 20% of the deferred compensation which is required to be included in gross income.IRS_tnb

Accordingly, employers often have a Section 409A provision in the employment agreement that allows the employer to adjust payments under the agreement to comply with Section 409A and allows the employer to disclaim any liability to the employee.

A typical provision can be lengthy paragraphs and include some language like the following:


“Anything in this Agreement to the contrary notwithstanding, the parties intend that   all payments and benefits under this Agreement comply with Section 409A of the Code and the regulations promulgated thereunder and, accordingly, to the maximum extent permitted by law, this Agreement shall be interpreted in a manner in compliance therewith.  To the extent that any provision hereof is modified in order to comply with Section 409A, such modification shall be made in good faith and shall, to the maximum extend reasonably possible, maintain the original intent and economic benefit to you  and the Employer of the applicable provision without violating the provisions of Section 409A.  Notwithstanding the foregoing, the Employer shall not be required to assume any increased economic burden in connection therewith.  Although the Employer intends to administer this Agreement so that it would be exempt or comply with the requirements of Code Section 409A, the Employer does not represent or warrant that this Agreement will be exempt from, or otherwise comply with, Code Section 409A or any other provision of applicable law.  Neither the Employer, its affiliates, nor their respective directors, officers, employees or advisers shall be liable to you (or any other individual claiming a benefit through you) for any tax, interest, or penalties you may owe as a result of compensation paid out pursuant hereto, and the Employer shall have no obligation to indemnify or otherwise protect you from the obligation to pay taxes pursuant to Code Section 409A.”


The point of this blog post is that your deferred compensation provisions could trigger 409A tax consequences and your employer, through its employment contract with you, is shifting the risk to you as employee.


We have noted in other blog articles how “restricted stock” is a widely used form of executive compensation.  Restricted stock is a grant of stock that vests over time and may or may not be tied to performance measures like year-end profitability. Restricted stock is frequently tied to length of time working for an employer.   A typical grant provides that the shares will vest at the end of a fixed period, e.g., five years from the date of grant, if the executive remains employed by the company.

Any Executive who is eligible to receive restricted stock ought to know about the availability of an Internal Revenue Code Section 83(b) election.  Not knowing about a Section 83(b) election could result in serious tax consequences to the Executive.

An Executive who is about to receive restricted stock should immediately consult a tax accountant or tax attorney.

I asked my law firm tax partners, Richard Sawdey and Richard Harbaugh, to give me an updated primer on Section 83(b) and they contributed substantially to this post.  Here is a snapshot of Section 83(b) and why it is so important.

When a company transfers restricted stock to an Executive in connection with employment, Section 83 provides that the Executive will recognize ordinary income in an amount equal to the excess of the fair market value of the stock as of the date when they are no longer subject to a real risk of forfeiture over the amount, if any, paid for the stock.

In the example we are discussing, the Executive’s restricted shares are subject to a substantial risk of forfeiture until the five-year vesting period has expired.  Thus, under Section 83, the fair market value of the stock at the end of the five-year period will be the amount of taxable income resulting from the grant.

Section 83(b) permits the executive to make an election, instead, to include the fair market value of the shares in income in the year in which the award was made.  If this election is made, the amount of income is determined based on the then value of the shares without regard to the possible forfeiture of the shares.

A major caveat is that the Executive must make the election within 30 days of the Executive’s receiving the stock.  The election form must be sent to the IRS office with which the Executive files his personal income tax return.  Also, the election form should be sent by certified mail (return receipt requested) to ensure the executive has a record that the IRS has received it.

A Section 83(b) election requires careful consideration of the possible benefits and risks.  The possible benefit is a saving of income taxes if the value of the shares at the end of the five-year vesting period is higher than their value at the time of grant.  The Executive will have shielded from ordinary income tax rates the entire amount of the appreciation during the vesting period.  Upon a later sale of the shares, the appreciation that took place during the vesting period will instead be taxed as capital gain.

However, the election also carries significant risks.  If the Executive’s employment is terminated  during the vesting period and a Section 83(b) election was made, the Executive will forfeit the shares but will not be entitled to a deduction for the income taxes paid in the year of the grant. Thus, taxes will have been paid on shares that never will be received.

If the Executive believes the stock will rise in value, believes there is little risk of forfeiture of the stock, and knows that the income that will be reported upon election will be modest, then there may be a strong case to make the Section 83(b) election.

In the context of a restricted stock grant with a five-year vesting period, in our example, the safest, lowest risk course is to forgo a Section 83(b) election and recognize the income in the year when the grant vests.  The Executive knows in that case that he is paying tax on stock that he owns and that he has avoided the out-of-pocket tax cost that could have resulted had he paid the income tax when he received the stock followed by forfeiture of the very same stock.

Again, the Executive should immediately consult with a tax accountant or tax attorney to analyze the Executive’s particular employment situation and stock restrictions to determine whether a Section 83(b) election makes sense and to accomplish the election in a timely fashion when the election is warranted.


G. A. Finch interviews Brian D. Wodar who is a Director of the Wealth Management Research at Bernstein Global Wealth Management.  Although Mr. Wodar has several areas of expertise, Mr. Finch sought to obtain his insights into concentrated single-stock exposure and stock option exercise planning.  After having had a private meeting with Wodar’s colleagues, David D. Spieske and John M. Patnaude, about Bernstein’s strategies for concentrated stock exposure, Finch learned that Wodar was one of Bernstein’s in-house gurus.  Below is an interview to hear what Wodar has to say on these topics.


FINCH:     Brian, we know that the usual mix of executive compensation comprises cash, restricted stock and stock options.  What are the investment questions an executive should be asking at the outset for these three buckets of compensation?

WODAR:     The most important questions at the outset regard the executive’s financial goals. For example, is he or she still building wealth for retirement, or about to retire?  Investment goals, tolerance for risk, tax situation, and other factors will also play a role. So the first question should be: What are my financial goals at this stage in my life—and how can my share-based compensation help me achieve those goals?

FINCH:     How does Bernstein define its investor profile?

WODAR:     We’re an investment firm with all types of clients, from individuals to small foundations and endowments, so there is no single profile. However, we do have many executive clients, and we work closely with them and their other professional advisors to create wealth planning strategies.  Besides our investing expertise, what we bring to the table is a focus on planning, and a powerful planning tool we call the Wealth Forecasting System.

FINCH:     For the executive investor profile, what kind of scenarios have you contemplated for Bernstein’s Wealth Forecasting

WODAR:     We recently completed a major research study on executive compensation and how to manage it, so we used our Wealth Forecasting System to model all types of scenarios. For the sake of illustration, we created three hypothetical executives in different situations: a 50-year-old considering a new job offer with stock options; a 55-year-old who has amassed millions in company stock and is wondering whether to reduce her risk profile; and a 65-year-old preparing for retirement and considering wealth transfer strategies.

For each one of these scenarios, we were able to show how the executive would apply different strategies to grants of company stock and stock options.  But these simply stand as interesting examples.  Our goal is to provide a customized analysis for individual executives so each of them can make well-informed decisions about their assets.  And I should add that we don’t charge for such an analysis regardless of whether someone is or is not our client.

FINCH:     I understand that Bernstein’s Wealth Forecasting System accommodates current and expected future grants of  share-based compensation, integrates effect of inflation, taxes and spending, and integrates multiple investment vehicles such as taxable or retirement accounts and trusts.  You then use 10,000 simulated observations resulting in distribution of 10,000 outcomes and a probability distribution.  Pretty impressive stuff.  So what can it tell us, probability wise, about the things that can happen with an executive’s allocation of investments of cash, restricted stock and stock options?

WODAR:     Thank you, G.A. It is impressive, and it’s how we are able to conduct this research. One of the first things we did was a simple comparison of the risk/reward characteristics of these three types of compensation.

To do this, we assumed equal grants of $100,000: one paid in cash, one paid in restricted stock, and one paid in 10-year stock options. And we modeled the probable results after 10 years—after taxes and adjusted for inflation. For a fair comparison, we assumed the cash was re-invested in diversified global stocks, and we used similar vesting assumptions for all three grants.  (For all the details of our modeling and tax assumptions, I’d recommend your readers get a copy of our research report titled “Executive Decisions.” The results were striking: After ten years, the cash grant (invested in global stocks) generated the highest median return. That means, in typical market conditions, it is the safest form of compensation. It also provided the best return in poor market conditions. But its upside, compared to restricted stock or options, was limited. The restricted stock provided a wider array of returns. Its potential downside was lower, but its upside was much greater. However, its median return after ten years was 25% less than the cash grant.

Finally, the stock options, not surprisingly, had tremendous upside—you could quadruple your initial grant in ten years, if the stock performed in the upper decile of outcomes. But the downside risk was also tremendous. In almost half the outcomes the options expired worthless. And the median result was the lowest of the three grants.

Brian D. Wodar

But here’s an important point: This simple comparison assumed a passive management strategy—in other words, holding the restricted stock after it vested, and holding the options until just before their expiration. The most important conclusion of our research is that by employing an active strategy to stock-based compensation, you can tremendously increase the chances of meeting your financial goals.

FINCH:     I like Bernstein’s notion of goal-based planning and establishing priorities.  Could you outline those concepts for our readers?

WODAR:     Sure. We apply what we call a “core and excess” framework as a simple but effective way to segregate wealth for planning purposes. Core capital is the amount you need to live the lifestyle you want for the rest of your life, calculated to a very high degree of confidence. Once you have enough core capital, excess capital is everything beyond that—your financial legacy. It is wealth you intend to leave to heirs, or give away to charity, or spend on completely discretionary activities, or invest more aggressively.

This framework can help you determine how to best manage company stock or stock options. For example, when building your core capital, our analysis shows that it’s generally best to sell restricted stock as soon as it vests and reinvest the proceeds in a diversified portfolio. All else being equal, the risks associated with single-stock concentration reduce the likelihood of meeting retirement spending goals. However, if you have already accumulated your core capital in a diversified portfolio, the higher reward potential of restricted stock may justify holding it.

Generally speaking, excess capital can be invested more aggressively, creating the opportunity to take on greater risk with stock-based compensation.

FINCH:     Tell us how age and spending can affect core capital.

WODAR:     Dramatically. Put simply, the less you spend in retirement, the lower your core capital requirement will be. And as you grow older, your core capital number shrinks, because your remaining lifespan, unfortunately, is growing shorter.

The core and excess framework provides a more nuanced guide for spending in retirement than common rules of thumb like 3% or 4% of your assets. In fact, we’ve compiled tables that show the core capital requirements for an individual or couple spending different levels annually, at different ages.  (Again, our research report provides the details of this analysis, including mortality assumptions.)

So for example, a 60-year-old couple spending $200,000 annually will have a core capital requirement of $7.4 million. (This is calculated to a 95% degree of confidence, which is very conservative.) That would mean this couple is spending 2.7% of their wealth annually. But the same couple at age 70, spending the same amount, will have a core capital need of $6.1 million. That would be a 3.3% rate.  At age 80, their core declines to $4.5 million, or a 4.4% rate. This may have ramifications on their estate planning, because if their assets are growing faster than their core needs, they will have excess capital that could be subject to estate taxes.

FINCH:     How does single stock volatility affect the equation in determining core capital?

WODAR:     Again: dramatically. The numbers I just outlined assumed the couple held their wealth in a diversified portfolio of 60%  stocks and 40% bonds. But if a single stock represented one-quarter of a 60-year-old couple’s portfolio, their core need would increase to $8.7 million! That’s an 18% jump. If a single stock represented half of their portfolio—which is not unusual for senior executives—their core need increases to $11.1 million!

The culprit is volatility. Single stocks will almost always be more volatile than a diversified portfolio, and if you are calculating your core capital requirement, you have to take that volatility into account. We call the effect of this volatility “risk drag,” because it represents a drag on your expected returns—despite the attractive potential upside of single stock. And since we calculate core capital requirements in light of very challenging investment experiences, those challenges can be much more difficult the more concentrated the portfolio is.

FINCH:     To what degree would cash or bonds offset single stock risk?

WODAR:     This was a fascinating aspect of our research. You would expect that a simple way to hedge against single stock risk  is by offsetting the stock with an equal amount of ultra-conservative holdings, such as short-term Treasury bonds.  But when we crunched the numbers, we learned that this strategy simply doesn’t work.  If you hold 50% of your portfolio in a single stock, it hardly matters how many bonds you put in the rest of your portfolio—the likelihood of a severe loss (anywhere from 20% to 50% from peak to trough) during a 20-year period is roughly the same. The problem is that this “barbell” approach to investing doesn’t address the real issue: A large exposure to company stock in a portfolio remains the dominant driver of investment results, regardless of how the remaining half of the portfolio is allocated.

FINCH:     Should an executive diversify to meet his goals?

WODAR:     It depends on what the goals are. If your goal is to build up your core capital or protect it, then yes, diversification helps reduce single-stock risk and can help you build and preserve capital faster. And you should always keep your core capital well-diversified. Of course, once the executive’s core capital has been securely funded, the rest of the concentrated portfolio can remain as concentrated as the executive would like.  If that stock skyrockets thereafter, they’ll be very wealthy.  But if the stock plummets for any reason, the executive will know that their core capital will be unimpeded.  Furthermore, if your goal is to transfer wealth to children or charity, single stock lends itself well to certain wealth transfer strategies.

It’s also worth noting that most executives face obstacles to selling company stock.  There may be company-imposed restrictions, and there are securities regulations regarding when stock can be sold.  But that’s why it’s all the more important to define one’s goals and actively manage your company stock and options to reach those goals.

FINCH:     What are the perils of a passive hold strategy?

WODAR:     The main risk is that you won’t reach your financial goals, or that it will take longer to reach them than you want.

The outlier risk—but a very real one, as we saw in 2008—is that even the healthiest-seeming company can see its stock value plunge, or even go to zero.  If your wealth is tied up in company stock, that’s a chilling scenario. I think that before 2008, most executives thought this could never happen to their company. Nowadays, people have a more realistic attitude toward risk.

FINCH:     What is the case for active management of restricted stock?

WODAR:     It’s about applying the best strategy to your goals. Our research shows that when building core capital, it’s generally best to sell restricted stock as soon as it vests and reinvest the proceeds in a diversified portfolio. But if you’ve already accumulated your core capital in a diversified portfolio, then the reward potential of the restricted stock may justify holding it.

FINCH:     What is the case for active management of your stock options?

WODAR:     Again, it’s about the best strategy for your goals. When building core, we found that the optimal time to exercise stock options is when their time value has declined to approximately 30% of their total value.   Above core, you can afford to wait until the time value is 10% of total value. But waiting to exercise options until just before expiration results in significantly poorer risk-adjusted returns. The calculations for time value of stock options can be complex, but a good financial advisor can help you with that.

 Brian D. Wodar may be reached at 312-696-7886 and or his colleague, David Spieske, may be reached at 312-696-7819 and 


Note on Bernstein’s Wealth Forecasting System:

The Bernstein Wealth Forecasting System (WFS) uses a Monte Carlo Model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, Bernstein’s forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Copyright © 2011 by G. A. Finch. All rights reserved.


I had lunch with a couple of guys from Bernstein Global Wealth Management, Vice President David Spieske and Director & Principal John Patnaude.  While this is not an endorsement, I believe the Bernstein folks excel at equity research and analyst services, so I readily accepted their invitation to hear their ideas on executives “making the most of their stock-based compensation.”

As I have noted in earlier posts, the equity portion of executive compensation has increased as performance metrics and the length of time spent at a company are utilized to incentivize executives and to justify and rationalize compensation.

I am not at liberty to recap for my readers the private and confidential presentation. What I will say is that executives must plan early and comprehensively to understand their capital needs for retirement,  to determine the extent of their remaining capital, and, then, to invest accordingly.

The first thing to scrutinize is the amount of concentrated stock (or single stock) holdings.  The second thing is to have an appropriate plan for disposition and diversification of your concentrated stock.   Failure to do so could affect where you ultimately end up financially.  Despite an executive’s sentimental feelings about the stock of the company that made her initial fortune, putting all her eggs in one basket, could leave her with a lot of cracked eggs (how is that for a financial metaphor).

I have discussed concentrated stock position strategies in a previous blog postYour stock grants and options do not take care of themselves. In a nutshell, an executive must be continually engaged in managing her equity compensation in order to maximize her returns and protect her assets.

Tax Alert: The Impact of the 2010 Tax Relief Act on Your Estate Plan

I recommend to my executive and professional readers the following topical article authored by the estate planners and tax planners of my law firm, Hoogendoorn & Talbot LLP:

The flurry of tax legislation enacted by Congress and approved by President Obama in mid-December left almost everyone a bit breathless.  Numerous news articles have already been published about the major provisions and many financial advisors have circulated e-mails on details of the legislation.  Estate tax legislation was a prominent part of the action and it is important for every client to take note of the major items from that legislation which may have an impact on a client’s personal estate and on estate planning considerations.  

Estate Tax Provisions

In 2001, the new Bush administration enacted estate tax legislation which substantially increased the federal estate tax exemption to $3,500,000 by 2009. We fully expected Congress to enact legislation extending the 2009 estate tax provisions prior to 2010. Instead, nothing was done and the federal estate tax expired for 2010, being replaced by special capital gains tax provisions.

The estate tax rules that existed prior to the 2001 act, namely an estate tax exemption of $1,000,000, was scheduled to be reinstated in 2011, barring Congressional action.

Surprisingly, in mid-December the lame duck Congress reinstated the 2009 estate tax with several revisions as follows:

1. The estate tax exemption is increased to $5,000,000 per individual (adjusted for inflation beginning in 2012).

2. Any portion of the $5,000,000 personal exemption not used at the death of the first to die of a married couple can be used by the surviving spouse (referred to as “portability”).

3. The estate and gift taxes were reunified, thus increasing the gift tax exemption from $1,000,000 to $5,000,000. In other words, the $5,000,000 exemption can be either used during life or preserved until death.

4. The generation-skipping tax exemption likewise is increased to $5,000,000.

5. The estate, gift and generation-skipping tax rate applicable in 2011 and 2012 is 35%, replacing the 45% rate applicable in 2009.

6. Unless Congress and the President take further action by December 31, 2012, the estate tax rules that existed prior to the 2001 act (namely a $1,000,000 exemption without portability between spouses and a maximum 55% tax rate for estate, gift and generation-skipping tax purposes) go back into effect.

Estate Planning Responses

While most estate planning decisions are driven by concerns for immediate family and possible charitable interests, state and federal tax concerns have provided a significant overlay for those family and community concerns.

At Hoogendoorn & Talbot, our basic estate planning advice, employing “pour over” wills, living trusts and powers of attorney for property and health care, will not be affected by this new tax legislation. Furthermore, the tax planning modification that could be envisioned for those whose estates cannot realistically be expected to ever exceed the $5,000,000 per person or $10,000,000 per couple exemption amounts, must await more permanent Congressional action by late 2012 before eliminating tax planning complexities.

We have continued to revise the tax provisions in our estate planning language to cover the ever changing federal estate tax scenarios. Furthermore, state estate tax scenarios often have been as unstable as the federal scenarios. While about half of the states have no estate tax, the other half have either an inheritance tax or an estate tax.

Those with an estate tax generally are tied closely to the federal system as it existed in 2001 before any changes were made. As an example, the Illinois estate tax with a $2,000,000 per person exemption in 2009 expired at the end of 2009, coinciding with the expiration of the federal estate tax. At the time of the December federal tax legislation, there was no Illinois estate tax. However, on January 11 the Illinois legislature in a late night session not only increased the individual Illinois income tax rates by 67% but also reintroduced the Illinois estate tax in effect in 2009 with a $2,000,000 tax exemption. This substantial difference between the state and federal exemptions is a reality in numerous states and does necessitate the inclusion of special provisions in living trusts.

While many people deferred new estate plans or reviews of existing estate plans during 2010 awaiting clear direction from Washington, additional deferral of planning or reviews would appear to be futile. Long periods of certainty on the estate and gift tax fronts appear to be a condition of the past. While our principal estate and gift tax planning advice will be based on the assumption that Congress is psychologically and politically incapable of taking back what once has been given (suggesting the permanence of the $5,000,000 per person exemption and the 35% maximum rate), our wills and trusts will continue to cover the possibility that a highly polarized Congressional situation in Washington could result in a temporary return to the $1,000,000 per person/55% maximum rate in 2013.

Those individuals who have been looking for additional gifting opportunities, having used up most or all of their $1,000,000 lifetime gift tax exemption in effect over the last ten years, may want to consider taking early advantage of the new $5,000,000 gift tax exemption in effect for 2011 and 2012.

There is no assurance that this large gift tax exemption will be maintained beyond 2012, even if the exemption available at death remains at $5,000,000. Furthermore, lifetime gifts are not taxed in most states. Accordingly, transfers during life completely avoid any transfer tax in those states which have only an inheritance or estate tax. Those tax rates generally reach 16%.

In summary, we encourage our clients to use this opportunity to revisit their estate plans and to continue periodic estate planning reviews, recognizing that personal, familial and financial changes will remain the central focus of such reviews, and that federal and state tax considerations will continue to be based on ever changing laws.

Income Tax Provisions

The December tax legislation included numerous income tax provisions that are of interest to every client. The reduced income tax rates that were scheduled to expire, especially the 15% rate on dividends and capital gains, has not escaped the attention of most people. A number of additional benefits for both middle and upper income taxpayers were included, such as a Social Security tax reduction on the employee portion of the tax from 6.2% to 4.2% for two years, no phase out of the personal exemption for higher income taxpayers, no reduction of the itemized deduction for higher income taxpayers, an increase in the alternative minimum tax exemption, and a host of other relatively minor tax benefits.

More immediately relevant to longer term estate and tax planning has been the extension through 2011 and 2012 of two provisions impacting individual retirement accounts. Anyone over age 70½ may donate up to $100,000 per year from their IRA to charity, thereby satisfying their required minimum distribution on a dollar for dollar basis. Additionally, anyone with an IRA, regardless of age and income level, may elect to withdraw the IRA, pay the tax due on the withdrawal and roll the withdrawn amount into a Roth IRA, withdrawals from which will be entirely free of federal income taxes (subject to certain early withdrawal and age limitations).

It is important to be aware that the ability to give required minimum distributions to charity is primarily beneficial to residents of states which tax retirement benefits. Residents of states such as Florida and Illinois, which either have no state income tax or do not tax qualified retirement benefits, currently realize virtually no benefit from this tax provision unless they are bumping up against the charitable deduction limitation of 50% of adjusted taxable income – a not unusual situation for retired individuals with relatively substantial assets and relatively modest income.

It is also important to be aware that the conversion of an IRA into a Roth IRA generally is recommended only for those who (1) always are likely to be in or near the highest income tax rates, (2) would prefer not to make IRA withdrawals to cover normal living expenses but would prefer to let the IRA accumulate and (3) are not considering a gift of remaining, untaxed IRAs to charity at death.


These comments are intended to provide a bird’s eye view of those aspects of the December tax act that are more directly applicable to estate planning clients. There may be other features of the law about which you have read and about which you have further questions. Whether your questions relate to these tax concerns or to estate planning questions apart from these tax issues, we encourage inquiries and requests for an appointment for an estate planning review, both for existing clients and for any reader who would like to consider becoming a client.  This Alert is a publication of Hoogendoorn & Talbot LLP and is intended to provide clients and friends with information on recent legal developments. This Alert should not be construed as legal advice or an opinion on specific situations. For further information, feel free to contact members of the firm.

Copyright 2011 by Hoogendoorn & Talbot LLP
All rights reserved.


G. A. Finch queries Jason D. Garcia, a vice president in the Wealth Strategies Group of Northern Trust based in Chicago.

Jason Garcia


FINCH:  Jason, first of all, I want to thank you for coming in and telling me and my partners and my associates about all the interesting things you and your company are doing.  I know the readers of Your Executive Life Blog would also benefit from hearing about some of the things you and your company do. Your title is “Wealth Strategist.”  We all know what wealth is and what strategy means.  How does that translate as a job description and function for you?


GARCIA:  Thank you G.A.  The role of the Wealth Strategist at the Northern Trust Company is part business development and part relationship management.  We are charged with the responsibility of identifying prospective new clients for the bank, in the arena of investment management, commercial and personal banking, trust administration, philanthropic & legacy planning and comprehensive financial planning.

The Wealth Strategist will engage a prospective client in a holistic wealth management conversation, identifying the needs important to that individual or family—and then bring to bear the top intellectual capital from the bank to meet those needs, (i.e., portfolio managers, trust administrators, financial planners, private bankers, etc.).

The Wealth Strategist will also act as the client’s Relationship Manager or central contact as the client gets acclimated with their new team, ensuring that all of the client’s needs are met.  That, in a nutshell, is the role of the Wealth Strategist.

FINCH:  You have briefed me about Northern Trust’s Executive Officer Initiative by which you provide information to executives on ways to preserve and maximize their compensation, benefits, and investments.  Tell us about concentrated stock position strategies.

GARCIA:  One of the concerns that Executive Officers have, from a number of different sectors and industries, is their exposure to risk, per the concentration of company stock they accumulate throughout the course of their careers.  Due to some rules and regulations, they are limited as to the action they may take with their stock throughout their tenure at the company.  As they prepare for retirement, there are also tax and dividend income replacement concerns that they will face as they endeavor to unwind their concentrated positions.

The Northern Trust presents tools and solutions such as Net Unrealized Appreciation, 10b5-1 Strategies, Tax Advantage Equity and Zero Premium Collars to help remedy some of these issues.

FINCH: What should an executive know about zero premium collars?

GARCIA:  The Zero Premium Collar is for the individual that has a large quantity of a single stock.  The individual does not want to sell the position but he or she would like to minimize the downside risk, without any cash outlay.  A zero premium collar is essentially a contract between one individual and a counterparty (typically a broker-dealer) that established both a “floor” and a “ceiling” price on the individual’s stock.  The contract guarantees that the value of the stock will remain somewhere in between that “floor” and “ceiling” price.

The mechanics of the zero premium collar may be further explained as follows.  You would purchase a put option—which gives you the right to sell the stock at a certain “floor” price.  This effectively limits the amount of money you can lose, establishing the “floor” price, otherwise known as the “put strike price.”  You can offset the cost of the put option by selling a call option, which gives the counterparty the right to buy your stock at a “ceiling” price.  So, your potential upside gain for your stock would be limited to this “ceiling” price, otherwise known as the “call strike price.”  Since you buy and sell the put and call contracts simultaneously, there is no premium to be paid.

Zero premium collars generally involve European-style options, which means the counterparty cannot exercise the options before the contract matures.  However, you can terminate the contract at your discretion.  We can help you determine the most appropriate “floor” and “ceiling” targets based on the volatility of the stock.

The bottom-line benefits of using a zero premium collar are:

  • You limit your downside risk;
  • You maintain market value appreciation up to a certain level;
  • You are not required to make an initial cash outlay;
  • You retain your voting rights during the contract term;
  • Your taxes are deferred until the contract is settled;
  • You can borrow against the position

Consulting with your financial planner and tax advisor is the best course to determine whether or not a zero-premium collar strategy is best for you.  At the Northern Trust, we execute these reviews often.

FINCH:  What about Net Unrealized Appreciation?

GARCIA:   Net Unrealized Appreciation or NUA is another useful financial tool.   If you participate in a 401(k), ESOP, or other qualified retirement plan that lets you invest in your employer’s stock, you need to know about net unrealized appreciation–a simple tax deferral opportunity with an unfortunate complicated name.

When you receive a distribution from your employer’s retirement plan, the distribution is generally taxable to you at ordinary income tax rates.  A common way of avoiding immediate taxation is to make a tax-free rollover to a traditional IRA.  However, when you ultimately receive distributions from the IRA, they’ll also be taxed at ordinary income tax rates.   But if your distribution includes employer stock (or other employer securities), you may have another option.  That is, you may be able to defer paying tax on the portion of your distribution that represents net unrealized appreciation (NUA).  You won’t be taxed on the NUA until you sell the stock.  What’s more, the NUA will be taxed at long-term capital gains rates–typically much lower than ordinary income tax rates.  This strategy can often result in significant tax savings.

So, the mechanics of NUA operate as follows:

A distribution of employer stock consists of two parts:  (1) the cost basis (that is, the value of the

stock when it was contributed to, or purchased by, your plan) and (2) any increase in value over the

cost basis until the date the stock is distributed to you.  This increase in value over basis, fixed at the time the stock is distributed in-kind to you, is the NUA.

For example, assume you retire and receive a distribution of employer stock worth $500,000 from your 401(k) plan, and that the cost basis in the stock is $50,000. The $450,000 gain is NUA.  How does the NUA tax strategy work?

At the time you receive a lump-sum distribution that includes employer stock, you’ll pay ordinary income tax only on the cost basis in the employer securities.  You won’t pay any tax on the NUA until you sell the securities.  At that time the NUA is taxed at long-term capital gain rates, no matter how long you’ve held the securities outside of the plan (even if only for a single day).  Any appreciation at the time of sale in excess of your NUA is taxed as either short-term or long-term capital gain, depending on how long you’ve held the stock outside the plan.

At the end of the day, the following are the advantages of electing NUA:

  •  Your distribution of NUA will be taxed at long-term capital gains rates, rather than ordinary income tax rates.
  •  Your distribution won’t be subject to the required minimum distribution rules that would apply if you rolled the distribution over to an IRA.  You need never sell the stock if you don’t want to.
  •  The NUA portion of your distribution will never be subject to the 10% early distribution penalty tax.

Consulting with your financial planner and tax advisor is the best course to determine whether or not NUA is best for you.  Again, at the Northern Trust, we execute these reviews often.

FINCH:  Could you give our readers a primer on 10B5-1 strategy?

GARCIA:   G.A., as you well know, determining the best time to purchase and sell stock to take full advantage of the market is never simple.  Company blackout periods and insider trading restrictions can make it even more difficult for corporate executives to manage their liquidity and find an opportunity to increase (or reduce) their single-stock exposure.

By way of background, we know that insider / executives have historically experienced difficulty in trading their company stocks due to blackout periods established by their own companies.  In October 2000, the SEC created 10b5-1, which dramatically expanded the time period during which such trading could occur.  As long as an insider / executive established a trading plan while not in possession of material inside information, future trading can occur at any time, even during blackout periods.

A 10b5-1 trading plan allows for the purchase and sale of stock at a predetermined time and price.  Once established, the plan remains in effect even during times when you are aware of material, nonpublic information that might have influenced your trading decision.  It’s important to note that a properly executed 10b5-1 trading plan becomes a documented affirmative defense against allegations of insider trading.

It’s also important to note that company executives remain subject to legal compliance.  So, establishing a 10b5-1 plan does not relieve them from compliance of their company’s insider trading policies.  It is recommended that any corporate executive considering this trading plan engage legal counsel like your law firm, G. A. – as well as investment professionals experienced in 10b5-1 trading plans like my team at Northern Trust.  Ultimately,  the trading plan should also be approved by the executive’s company counsel.

FINCH:  What can you tell us about tax advantaged equity?

GARCIA:   We all  know that taxes can significantly reduce investor returns.  Indeed, taxes can represent the single largest cost of investing for taxable investors.  Tax considerations are especially important for investors who:

  • Have or are about to experience the sale of a business;
  • Have or are about to sell a significant concentration of company stock or;
  • Are tax sensitive.

Fortunately, portfolios can be effectively managed to preserve wealth through a tax advantaged equity (TAE) strategy.

The mechanics of TAE operate as follows.  It combines an equity benchmark exposure with a proprietary active tax management process.  Within a separately managed account, we approximate the risk and return characteristics of a particular benchmark, (e.g., S&P 500).  We then proactively harvest losses in a manner customized to your individual tax and investment goals.  This approach can help protect the returns obtained through a traditional active manager by:

  • Realizing losses in specific securities that have decreased in value and
  • Limiting the turnover in securities that have increased in value.

In addition to managing risk to meet client specifications, we also consider the impact of security sales and resulting tax implications that may affect the portfolio.  This tax-efficient solution can be used alone or in combination with a core investing approach or other satellite strategies such as single-stock exposure management; active fixed income; and hedge fund, private equity or a manager-of-managers programs.

At the end of the day, employing an effective TAE strategy can field the following benefits:

  • Provide pre-tax returns similar to a benchmark (minimizing tracking error);
  • Deliver after-tax, value added returns through active management (particularly loss harvesting);
  • Provide customized management in a separate account vehicle;
  • Reflect specific stock or sector limits based on social screens or other concentrated positions.

Anyone who may have an interest in employing this loss harvesting strategy should consult with their tax advisor and financial planner.  The Northern Trust can provide guidance here.

FINCH:  Do you have any other wealth strategy observations you would like to share with executives and professionals?

GARCIA:  There are a plethora of strategies that one may employ, all based on time horizon, risk tolerance, income needs, philanthropic & legacy planning and overall estate planning.  Wealth strategy solutions can be as unique as the individual client.  The best course of action for any executive, professional or anyone who has questions as to what options are available to them—in the wealth management arena—is to meet with his current wealth advisor to explore ideas based on his needs.  We at Northern Trust are certainly available to provide this kind of advice.

I appreciate your interviewing me on these wealth preservation and enhancement strategies.   



Copyright © 2010 by G. A. Finch. All rights reserved.
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