Solved: Hunter's Compensation Package

Hunter is a single 45-year-old who is employed by an engineering firm that includes a diverse array of taxable and nontaxable fringe benefits within the overall compensation package it offers its employees. Employees receive a base salary in addition to occasional incentive awards (i.e. bonuses); the incentive awards are often in the form of noncash perks. The company also offers different forms of equity-based compensation to reward its highest performing employees.  

Hunter does not itemize deductions, and he does not have any available tax credits or estimated tax payments. His employer withheld $23,668 from his paychecks for income tax withholding.  

Hunter’s base salary for calendar-year 2018 was $101,350. He embarked on an all-expenses-paid 5-day Caribbean cruise in April 2018, which he received from his employer in lieu of a cash bonus. The cruise and related travel expenses would have cost Hunter $4,025 if had paid for the trip out-of-pocket. His employer agreed to give Hunter an extra $1,375 in cash to cover his tax liability on the value of the cruise (referred to as a “tax gross-up“). Tax gross-up payments are included on an employee’s paycheck as ordinary wages subject to income and payroll taxes.

Hunter also took advantage of the following pre-tax payroll deductions:

• Annual employee contribution to employer’s 401(k) qualified plan = 6% * $101,350 base salary = $6,081/year (his employer provides a 75% match as well, i.e. $4,560.75/year)
• Annual employee contribution to a flexible spending account (“FSA”) = $2,400/year
• Annual employee contribution to health insurance plan = $1,440/year

A summary of the above-mentioned compensation details is provided in the following table:

Hunter is a highly-valued engineer at the company and thus has been rewarded quite handsomely the past few years with several equity-based compensation awards. In 2018 Hunter decided to sell 4,360 shares of stock that he received pursuant to the terms of these awards.

In addition to his base salary, incentive award and equity-based compensation, Hunter also received the following taxable AND non-taxable fringe benefits from his employer during 2018:

1. Compute the amount of cash that Hunter saved in 2018 because he chose to take advantage of payroll deductions made available to him by his employer.  Hint: Payroll deductions related to 401(k) contributions only reduce the amount of an employee’s taxable wages reported on Form W-2, Box 1 (i.e. employees still owe FICA taxes on the portion of their payroll deductions related to 401(k) contributions). In contrast, payroll deductions related to flexible spending accounts and health insurance premiums reduce the amount of an employee’s taxable wages reported on Form W-2, Boxes 1, 3 and 5.

Hunter’s marginal tax rate of 24% (income tax rate only) and 31.65% (income tax rate + Social Security tax rate + Medicare tax rate) should be used as applicable for this analysis and your answer should be shown as a positive amount and rounded to ZERO decimal places.  

2. What amount (if any) will Hunter’s employer report as taxable wages on his 2018 Form W-2 with respect to his restricted stock equity awards? If Hunter does not have any 2018 taxable wages related to his restricted stock equity awards, please input 0 for your response (i.e. do not leave the answer blank).

3. When employees make a Section 83(b) election with respect to their restricted stock grant, they do so under the assumption that the company’s stock price is going to increase before the restricted stock vests.

There are certain trade-offs the employee must be willing to live with if they make a Section 83(b) election:  (1) the possibility of having to recognize taxable wages in an earlier tax year (if the vesting date occurs in a year subsequent to the grant date), (2) the risk that the stock price will actually decrease instead of increase, and (3) the risk that they may leave the company or otherwise forfeit their right to the restricted stock before the vesting date.

Compute the amount of cash that Hunter could have saved if he had the benefit of hindsight and could avoid making any unfavorable Section 83(b) election decisions. In other words, if Hunter could have minimized his taxable wages related to his restricted stock grants in 2016, 2017 and 2018, what would the difference have been in the total income taxes and FICA taxes he actually paid?

You may assume Hunter’s taxable wages each year were taxed at a combined rate of 31.65% (24% marginal tax rate + 7.65% FICA). Do not consider any present value implications when computing the cash savings that Hunter missed out on.

4. What amount (if any) will Hunter’s employer report as taxable wages on his 2018 Form W-2 with respect to his non-qualified stock options (“NSOs”)? If Hunter does not have any 2018 taxable wages related to his NSOs, please input 0 for your response (i.e. do not leave the answer blank).

5. What amount (if any) will Hunter’s employer report as taxable wages on his 2018 Form W-2 with respect to his incentive stock options (“ISOs”)? If Hunter does not have any 2018 taxable wages related to his ISOs, please input 0 for your response (i.e. do not leave the answer blank).

6. Compute Hunter’s short-term capital gain he must include in taxable income as a result of his 2018 stock sales.

Combine the short-term capital gain from each type of equity-based compensation award (if applicable) – i.e. if the short-term capital gain was $10 for the restricted stock and $12 for the NSOs, but there was no short-term capital gain from the sale of ISOs, your answer would be $22.

7. Hunter’s tax liability associated with his short-term capital gain will be taxed at his marginal tax rate of 24%. How much cash could Hunter have saved if he had waited until after January 1st, 2019 to sell the shares of stock that were acquired on January 1st, 2018?

Hint: Hunter is not in the bottom two or top income tax bracket. Determine the appropriate preferential rate that would apply instead for a long-term capital gain. To calculate the cash savings Hunter missed out on by selling those shares before 1 year had passed, multiply his short-term capital gain you computed in the previous question by the difference between his marginal tax rate and the applicable preferential tax rate.

8. Compute Hunter’s long-term capital gain he must include in taxable income as a result of his 2018 stock sales.

Combine the long-term capital gain from each type of equity-based compensation award (if applicable) – i.e. if the long-term capital gain was $10 for the restricted stock, $12 for the NSOs and $8 for the ISOs, your answer would be $30.