Soon after Donald Trump was elected president, we blogged about the likelihood of tax reform and its impact on stock compensation. We expected that to be the initial top priority of President Trump, but after his inauguration other matters took precedence. Finally, however, during the last week of April, his administration released general tax-reform principles in a one-page outline. Generally consistent with proposals Trump made during his election campaign, they include the following:
1. Simplification of individual income tax rates. The outline proposes just three income-tax rates: 10%, 25%, and 35%. As we have mentioned, how changes in income-tax rates would tie into the flat supplemental rate of withholding on stock compensation is unclear and would need clarification, as the structure of the rate is based on the current seven tax brackets.
2. No change the capital gains rates (15% and 20%), but a cut in tax on investment income. While Trump does not seek to alter the capital gains rates, he does want to the repeal of the 3.8% Medicare surtax on investment income, including stock sales, that is paid by high-income taxpayers to fund Obamacare. A reduction in the difference between ordinary income rates and the capital gains rates might affect tax-planning decisions, e.g. whether to hold shares at exercise, vesting, or purchase. As for the Medicare surtax, we have found that individuals and their financial advisors often develop strategies to avoid it. If it were eliminated for tax years after 2017, that planning need would go away in 2018. However, for the remainder of 2017, you would want to consider whether you can defer income (e.g. NQSO exercises) into 2018 if that income would push you over the threshold for triggering the Medicare surtax in 2017.
3. Termination of the alternative minimum tax (AMT). Among those who receive grants of incentive stock options (ISOs), much rejoicing would occur if the AMT were repealed. Currently, the income spread at ISO exercise can trigger the AMT, which warrants complex tax planning.
4. Elimination of the estate tax. That would end the need to implement most gifting strategies with company stock, including those involving transferable stock options. However, estate-tax repeal might also end the step-up in the basis of investments, such as company stock, that currently occurs with a deceased person's holdings. That would create the need for other estate-planning strategies.
Don't expect the Trump administration's tax plan to become adopted legislation soon. As an article in The New York Times points out, numerous obstacles stand in the way of its enactment this year. In addition, as the political news website The Hill reports, the lack of detail in the tax-reform plan is setting off aggressive lobbying efforts, which will take time to play out. Plus, as columnist Bernie Becker notes at the news and commentary website Politico: "THIS THING HAS TO GET THROUGH CONGRESS: That sort of goes without saying, but there's really no better idea how that happens than there was before the newest Trump principles."
Tax Brackets Matter
For the many upper-middle-class employees and managers who receive stock compensation, there is an important issue to follow with any type of tax reform (though we remain uncertain about whether Trump's proposal represents reform, simplification, or just a big tax cut). That issue involves the taxable income that would fit into the three proposed tax brackets (the Republican tax-reform blueprint takes a similar approach with rates of 12%, 25%, and 33%). Journalists in the news media tend to focus on the tax rates themselves, not the tax-bracket thresholds, which are also significant aspects of any tax law.
The proposals merely cut off the current top tax brackets, which could mean that anyone currently in the brackets between 25% and the new top bracket would get stuck paying a higher rate both on ordinary income and on short- and long-term capital gains. (The 20% top rate on long-term capital gains and qualified dividends is currently tied to the top income-tax bracket.) For example, in 2017 if you have taxable income between $153,100 and $416,700 (married, filing jointly) or $91,900 and $416,700 (single), you are currently in the 28% or 33% tax bracket. Aside from the most senior executives, individuals with stock compensation tend to be in that income range.
In the interests of both economic growth and fairness, myStockOptions.com has long contended that it would be better to keep the current top income-tax rate of 39.6% and instead broaden the 25% rate to encompass those in the current 28%, 33%, and 35% marginal tax-rate brackets. It is the upper middle class in this income range that would be most likely to either spend the money from this tax reduction, boosting the economy, or save it to bolster lagging college and retirement savings.
For more on the tax-reform principles released by the Trump administration, see commentaries from Ropes & Gray, Latham & Watkins, and PwC. In addition to the potential impacts we describe here, the NASPP blog covers further ways in which the proposals could affect stock compensation.