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.