Corporate executives are con-stantly under the microscope, with shareholders breathing down their necks over performance reports, quarterly earnings and stock returns. But there's a trade-off: lucrative, deeply enriching and sometimes eye-popping pay.

Stock compensation is a game corporate America plays to align the interests of corporate executives and shareholders. If executives create profits and drive up stock prices, it's a win-win for everyone. But executives sometimes have little time to absorb the complexities of their compensation packages. In fact, executives lose millions of dollars every year mishandling their compensation.

Here are a few strategies, and possible pitfalls, that executives and their advisors should be aware of to ensure they take full advantage of these compensation packages.

SEC Rule 10b5-1
If their options expire unexercised, executives will surrender a significant portion of their compensation. You would think something this dumb could never happen. But it does. Bruce Brumberg, editor of mystockoptions.com, says more than 10% of valuable options expire unexercised each year.

This happens for a combination of reasons: The executive may be too busy to realize his awards are about to expire; the company may do a lousy job keeping everyone in the loop on critical dates; or the expiration may fall within a blackout period. Most companies have gotten better at keeping employees informed, but executives with hefty pay locked up in stock options shouldn't depend on anyone other than themselves and their advisors to take full advantage of their opportunities. Executives and their advisors need to map out option expiration dates years in advance and anticipate blackout periods.

One tool all executives should have in their arsenal is the SEC Rule 10b5-1 trading plan. This allows executives to sell a predetermined amount of shares at a predetermined time and price. It makes sales automatic and allows for them during blackout periods. Rule 10b5-1 is perfect for diversifying out of company stock and making sure options aren't lost because of a lack of planning.

Instituting a 10b5-1 plan is relatively simple assuming the executive, his advisor and his legal counsel have a solid understanding of the plan and the executive's goals. The plan should include the number of shares to be sold, the share selling price and the specific dates the sales are made. Rule 144 forms need to be filed with the SEC within 24 hours after the trade on behalf of the owner.

Two Types Of Options
Mistakes happen when executives fail to understand that there are two types of stock options. The key to extracting the most value out of options is to understand each type of option and the rules associated with them.

Executive stock options come in the form of non-qualified stock options (NQSOs) and incentive stock options (ISOs). They each affect executives and their companies differently and have different tax consequences.

NQSOs are the most common form, partly because they are considered compensation and a deductible expense for corporations. That's a plus for companies, but the downside is the employee's income tax liability. These options are taxed when they are exercised, with the bargain element (the stock price minus the exercise price) treated as ordinary income, a hefty burden on the executive. Since most companies only withhold 25% in taxes on an exercise, oblivious executives will be in for a shock when their year-end tax bill arrives.

It's also crucial to understand that the sale of the securities will trigger another visit from Uncle Sam. If the employee sells the shares within a year following exercise, any appreciation since the exercise date will be considered short-term and taxed as ordinary income. If the securities are held for longer than a year, the capital gains tax kicks in.

ISOs are a different ball game. Usually reserved for the most senior executives, they must meet a variety of strict IRS criteria regarding shareholder approval, exercise limits and timing, among other requirements. They are treated differently from NQSOs for taxes.

Unlike an NQSO, an ISO does not trigger a taxable event when it is exercised. Taxes are instead triggered at the sale of the securities. This gives the executive a breath of tax-deferred air. If the ISO is held as stock for a year after exercise and two years after the grant, all gains will be taxed at long-term capital gains rates. Therein lies the big advantage of ISOs-the promise of tax-deferred gains ending in a lower rate after the sale.

It's not all peaches and cream for ISOs, however. Although the exercise is not a tax trigger, it is possible that the bargain element could be subject to the dreaded Alternative Minimum Tax (AMT). This particular issue is deserving of an article unto itself, but the point is that the AMT is a very serious hurdle and all executives and advisors need to understand the implications of it before exercising any ISOs.

Restricted Stock And 83b Elections
There's a relatively new kid on the block when it comes to stock awards. In the early 2000s, many of America's leading corporations began shifting away from the high-risk, high-reward universe of options and implemented a different system: restricted stock awards. This happened for a variety of reasons, including changes by Congress in the way options were taxed. Also employees wanted a more concrete, albeit possibly less rewarding, compensation structure.

The difference between restricted stock and stock options is relatively simple. While options give executives the right to buy a certain number of shares at a given price, they only have value if the stock is trading higher than the grant price. Restricted stock comes in the form of guaranteed, market-priced shares that are awarded according to a specified vesting schedule. There is no grant price, but executives are required to hold onto them for a good while before they're vested. Although restricted stock does not have the same mind-blowing upside potential of options, it comes with the security of knowing that there will definitely be some value-assuming the stock doesn't go to zero-when vesting occurs.

Restricted stock also has the advantage of involving fewer decisions than there are with options. No decision is required on when to exercise restricted stocks since shares are granted and received on a specified vesting date. The lack of choices can actually be a good thing since it makes it easier for the awardees to avoid the mistakes that can come with options.

The downside is that the simplicity of restricted stock means executives might put that portion of their awards on autopilot. If he does, he might miss one of the advantages of owning restricted stock: an IRS Section 83b election.

Here's how it works: When a grant of restricted stocks is made, holders can elect to be taxed at the current market value of those shares rather than the value at the time of vesting, even though they are not saleable yet. Why would anyone do this? Because making the election immediately starts the clock ticking on the capital gains clock, meaning any appreciation going forward will be taxed at the lower capital gains rate. If one were to wait, and see a dramatic increase in the stock price, the IRS would be looking for a much bigger piece of the pie when the stock vests.

So is there a possible downside to 83b? Absolutely. Imagine a situation where an 83b election was made, taxes were paid and subsequently the stock price dropped significantly. The executive would have then paid taxes on money he never saw, without the option of declaring a loss on his tax return. Or worse, what if he completely forfeited the stock for some reason? A pile of taxes would have been paid on something of zero value.

To avoid these pitfalls, 83b elections should only be used if certain criteria are met. The income tax to be paid should be tiny compared to the expected stock appreciation. The shares should be held for over a year to ensure long-term capital gains treatment. And there should be little to no chance the shares will be forfeited.

If an 83b election is deemed appropriate, time is of the essence. The paperwork must be completed and sent into the IRS within 30 days of assuming stock ownership. There is no actual 83b document, so it is important to have a signed statement saying that the election is being made under Section 83b of the Internal Revenue Code. Other relevant information to include is the date of grants, fair market value and a tax identification number.

Avoid Concentrated Positions
It's no secret that, like any high-level professional, executives have extreme confidence in themselves. Just like Kobe Bryant wants to take all the shots, or Adrian Peterson wants every carry, a successful executive believes his best investment is in his company's stock.

The system is already set up so that executives must have a certain degree of exposure to that stock in order to ensure they act in the best interest of other shareholders. What they need to take heed of is the age-old adage of not putting all their eggs in one basket. No one ever expects his or her endeavors to go south, but the truth of the matter is, failure happens and sometimes there is nothing anyone can do about it. Executives who have over 75% of their net worth tied up in their company stock should make phone calls to those who worked at Enron, WorldCom or Lehman Brothers and see if they would recommend that allocation.

The likelihood of most companies experiencing those types of monumental collapses is slim, but it certainly is possible. Even if it doesn't happen executives can still lose everything if their net worth is tied up in options because of leverage. One could have millions of dollars of net worth in a company when an exercise price is at, say, $80 while the share price is listed at $100. That may seem like a good place to be, but note that just a 20% decline in the share price would cause the executive to lose everything.

Sometimes vesting schedules or company restrictions prevent executives from getting at the eggs in their stock basket. In cases like these, there are a couple of useful hedging strategies.

A variable prepaid forward contract can be used to lock in gains and defer taxes. It works like this: An executive gives his shares to a brokerage firm to hold with an agreement that the official exchange will take place at a later date. The firm will immediately pay the stockholder somewhere between 75% and 90% in cash for the shares, which can be used to invest in a diversified portfolio. The arrangement is a form of a collar. If the stock price falls, the executive has a floor to his downside risk. If it rises, however, the executive will see a good chunk of his appreciation go to the brokerage firm. Taxes are not paid until the actual sale of the security takes place at a later date.

Another form of hedge is an equity collar, which is a simultaneous purchase of a put option and sale of a call option. This gives executives a window in which they know their stock value will stay.

Conclusion
The life of  corporate executives is stressful enough without the added downer of losing the compensation they've spent all those hours earning. Award holders need to ensure they are working with an advisor and an accountant with expertise in this area. They also need to take some time away from their hectic schedules to make sure they understand the types of awards they own and the strategies that are available to them. If executives can do that, they will unlock the full value of their paychecks.     

Derek Swedberg (www.derekswedberg.com) is a financial consultant with the private client group of RBC Wealth Management in Minneapolis, Minn.