Capital gains tax affects everyone with employee stock compensation. Anyone who sells shares acquired from equity comp is subject to the tax rules of capital gains and losses.
Now capital gains tax is back in the news in a big way. According to media reports, the Trump White House is seriously considering a presidential executive order which would require the United States Treasury to issue new regulations that index the capital gains cost basis for inflation. That would effectively result in a tax cut—but without the approval of Congress.
While this has been a "sleeper" issue so far, not getting much coverage in the news media or in publications used by many tax professionals, it's a big deal. A tax change by executive order, bypassing the power of the purse in Congress, would be constitutionally controversial. It would have a major impact on the federal budget (see an analysis by the Wharton School at the University of Pennsylvania). The legal challenges against it would be prolonged, complicating its implementation.
How Capital Gains Indexing Would Work
The concept of capital gains indexing has been around for a while. As long ago as 1990, when investors did not have the current preferential long-term capital gains tax rates of 0%, 15%, and 20%, it was mentioned in a report issued by the Congressional Budget Office.
How would indexing work? In brief, the cost basis of an investment is the number you subtract from your sale proceeds to determine the size of your gain (or loss). Capital gains indexing would increase the cost basis of investments, such as stock, for inflation. With indexing, the cost basis would be floating and no longer a fixed number.
Currently, the income trigger points for long-term capital gains tax rates are indexed. If the basis itself were indexed, you would reduce the size of your taxable proceeds at sale, as only the inflation-adjusted capital gain would be taxed.
Example: Your restricted stock unit (RSU) grant vested at $20 per share. Under current tax treatment, that will be the cost basis of those shares whenever you sell them. With capital gains indexing, assuming 2% inflation per year for five years before you then sell the stock, with a sale price of $30 per share your basis would instead be approximately $22 at sale. You would then have $8 in long-term capital gain, compared with a $10 gain under the current tax treatment.
Controversy Over Indexing
The big issue is whether the definition of "cost" in Internal Revenue Code Section 1012 is vague enough to allow for interpretation through new Treasury rules without approval by Congress. Should the Treasury decide it has the authority to make this happen through executive order, it will require detailed regulations on actually how and when the indexing occurs, potentially disrupting many financial-planning and charitable-donation strategies based on its application to different assets. The policy of inflation-indexing capital gains has both its supporters (see Tax Foundation and Americans for Tax Reform) and its critics (see Institute on Taxation and Economic Policy and the Tax Policy Center).
From our experience at myStockOptions.com in developing and updating tax-return-reporting guides for brokerage firms, indexing the cost basis will strain their administrative, reporting, and IT systems. They report to the IRS and brokerage customers the cost basis and other purchase/sale information on Form 1099-B, which is hard enough to get right even when the basis is fixed. The inevitable and lengthy legal challenges to the executive order would also create uncertainty about the actual size of the after-tax gains from any asset sale.
See the Tax Center at myStockOptions.com for detailed information about recent tax changes and their impact on stock compensation.
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