Tax "Reform" And Its Impact On Stock Compensation

While it's not quite tax "reform," at least for individual taxation, major tax-law changes have now been adopted. The Tax Cuts & Jobs Act has provisions that directly and indirectly affect stock compensation, whether in personal financial planning or in company stock plan administration. (See a handy interactive version of the legislation from the law firm Davis Polk.) Compared with some earlier proposed provisions that didn't survive the legislative process, these are not really significant beyond the change in the alternative minimum tax (AMT), which affects incentive stock options.

The core tax treatment of stock compensation has not changed. Below are the provisions that affect individual taxation of stock compensation. (The individual tax rates and AMT changes end after 2025, reverting to the current rates unless extended.)

1. Changes in the rates of individual income tax. The Tax Cuts & Jobs Act keeps the current seven tax brackets, reducing the rates and changing the income thresholds that apply. The new rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, with the top bracket starting at $600,000 for joint filers ($500,000 for single filers).

The flat supplemental rate of federal income tax withholding on stock compensation is based on the seven brackets. For amounts up to $1 million it is linked to the third lowest rate (22%). For amounts over $1 million it is linked to the highest rate (37%). The 22% rate of withholding may not cover the actual taxes you will owe, so you need to know the tax bracket for your total income and assess the need to put money aside or pay estimated taxes.

2. Changes in the calculation of the alternative minimum tax (AMT). The income spread at incentive stock options (ISOs) exercise can trigger the AMT, which warrants complex tax planning. While the AMT or how it applies to ISOs is not repealed, below are the new numbers in the AMT calculation (to be adjusted annually for inflation).

  • The 2018 AMT income exemption amount rises to $70,300 (from $54,300) for single filers and to $109,400 (from $84,500) for married joint filers.
  • The income where this AMT income exemption starts to phase out in 2018 is substantially adjusted upward to begin at $500,000 for individuals (from $120,700) and $1,000,000 (from $160,900) for married couples.

These higher AMT income exemption amounts, and the much higher income point where the phaseout starts, make it much less likely that ISOs will trigger the AMT. With fewer employees at risk of triggering the AMT by exercising ISOs and holding the shares, companies may start to grant ISOs more frequently, given their potential tax advantages for plan participants.

What pays in part for this change in the AMT calculation is the $10,000 cap on the deduction for state and local income taxes and real-estate property taxes on tax returns. Given the odd way in which the AMT is calculated, those deductions may have triggered or added to your AMT in the past. Strangely enough, given that new cap, a taxpayer who has been paying the AMT may see less tax savings than they might otherwise expect to get from the AMT change.

3. New type of qualified stock grant for privately held companies. The final legislation adopted as one of its provisions a version of the Empowering Employees Through Stock Ownership Act. This provision lets an employee in a privately held company elect to defer taxes at option exercise or RSU vesting for up to five years as long as the company's equity awards meet certain conditions (the version of this provision that passed the House in 2016 allowed seven years). For details on the provision when it was part of the Empowering Employees Through Stock Ownership Act, see the coverage in the myStockOptions.com Blog.

4. No change in the capital gains rates (15% and 20%). A reduction in ordinary income rates would lower the difference between your income tax rate and your capital gains rate. This reduced differential might affect your tax-planning decisions, e.g. whether to hold shares at exercise, vesting, or purchase. While there is no change in these rates, the tax law creates a new income threshold for when the rate on long-term capital gains and qualified dividends goes from 15% to 20% ($479,000 for married joint filers and $425,800 for single taxpayers). That threshold is no longer similar to that of the top tax bracket.

Furthermore, while the Republican Congress did not seek to alter the capital gains rates themselves, they do still want to repeal the 3.8% Medicare surtax on investment income, including stock sales, that is paid by high-income taxpayers to fund Obamacare. The new tax law simply repeals the penalty for not buying health insurance.

5. Repeal of the performance-based exception to the Section 162(m) limit on deductible compensation. Publicly traded companies will no longer be able to deduct annual performance-based compensation (e.g. stock options, performance shares) in excess of $1 million for the CEO, CFO, and the top three highest-paid employees. For compensation paid under written plans existing as of November 2, 2017, an exemption applies as long as the plan is not modified. While that repeal does not affect financial planning, it further reduces the incentive for companies to favor one type of equity award over another.

For further details about the impact of the tax legislation on stock comp, including links to in-depth tax resources, see the extensive FAQ at myStockOptions.com on this topic.


Editor's Note: Save the date for the first myStockOptions conference! Here at myStockOptions, we are planning to hold our first-ever conference. It will be a one-day event: Financial Planning for Public Company Executives & Directors (Monday, June 18, 2018). Taking place in the Boston area, this is a must-attend national conference for financial advisors working with or wanting to counsel executives, directors, and high-net-worth employees. We have a wonderful group of expert speakers and a very substantive agenda of sessions on various stock-related and financial-planning topics. For details, see the December issue of the myStockOptions newsletter.

Tax Reform: Proposed Legislation Contains Opportunities And Surprises For Stock Compensation

The Tax Cuts and Jobs Act, now under consideration by the Ways and Means Committee in the House of Representatives, is the first effort in Congress at providing tax-reform specifics. See a handy interactive guide to the legislation from the law firm Davis Polk.

Alert (Nov. 21): On Nov. 16, the House of Representatives passed the Tax Cuts & Jobs Act. Its future remains unclear in the Senate, which is preparing its own tax-reform bill. That bill has been approved by the Senate Finance Committee.

Parts of the draft legislation would have an indirect impact on stock compensation (nonqualified deferred comp too), while other sections would have a major impact. They are summarized in the following paragraphs.

1. Simplification of individual income-tax rates. The bill proposes to shift from the current seven tax brackets to new brackets with rates of 12%, 25%, 35%. Additionally, the current top tax rate of 39.6% would continue, though with a higher income threshold (over $1 million for married joint filers and $500,000 for unmarried individuals and married individuals filing separately). 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 brackets. Since the 39.6% bracket has survived, contrary to earlier GOP discussions, and the 25% rate still exists, perhaps the flat withholding rates on stock compensation would stay the same.

2. No change in the capital gains rates (15% and 20%). The draft legislation does not change the capital gains rates. However, it creates a new income threshold for the 20% rate that is slightly above the current threshold for the 36% income-tax bracket ($479,000 for married joint filers and $425,800 for single taxpayers).

3. The 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. Companies might then use incentive stock options more frequently. The proposed AMT repeal is part of the House's draft legislation, as are new rules on how AMT credit carryforwards could be refundable through 2022. Under the provision, you would be able to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) for the tax years 2019, 2020, and 2021. In 2022, you would be able to claim a refund of any remaining credits.

What would pay for the end of the AMT is the elimination of the deduction for state and local income taxes and real-estate property taxes on tax returns. Given the odd way in which the AMT is calculated, those deductions can trigger the AMT. Strangely enough, if they are eliminated along with the AMT, taxpayers with ISOs may actually see less tax savings than they might otherwise expect to get from the AMT repeal.

Other Provisions With Potentially Big Impacts

1. Nonqualified deferred compensation would become taxable once there is no longer a substantial risk of forfeiture. This would be a major change. Currently, under IRC Section 409A, tax is deferred until the income, e.g. deferred salary or a deferred bonus, is distributed (see myNQDC.com, our sibling website on NQDC plans). Stock options and stock appreciation rights could get caught up in the definition of NQDC, at least in the House draft legislation. If so, that could lead to taxation at vesting! However, considering the way in which stock options and SARs were initially penalized in the early versions of the Section 409A regulations, we would expect that if this provision continues it will be amended to apply only to discounted grants. According to the Description Of HR 1, The "Tax Cuts And Jobs Act" (see page 209), prepared by the Joint Committee on Taxation, what the report refers to as statutory options (ISOs and tax-qualified ESPPs) would be exempt from the definition of nonqualified deferred compensation under the proposed tax-law change.

Alert: In its Tax Cuts & Jobs Act, the House dropped the provision (Section 3801) that would have imposed the changes described above for NQDC and equity compensation. The amendment making this change was issued on November 9. (See also an alert from FW Cook.) The Senate's tax-reform bill initially introduced a similar provision, but it too was dropped in alignment with the House version (see an alert from the law firm Fenwick & West).

2. The performance-based exception to the Section 162(m) limit on deductible compensation would be repealed. Publicly traded companies would no longer be able to deduct annual performance-based compensation (e.g. stock options, performance shares) in excess of $1 million for the CEO, CFO, and the top three highest-paid employees.

3. The Empowering Employees Through Stock Ownership Act, which passed in the House in 2016 but was not voted on in the Senate, could become part of the final legislation. That legislation sought to allow an employee in a privately held company to defer taxes at option exercise or RSU vesting for up to seven years as long as the company's equity awards met certain conditions. The current draft legislation in the House has a similar provision but reduces the deferral period to five years.

Further Reading

For a broader summary and analysis of the tax-reform legislation, including links to commentaries from law, accounting, and consulting firms, see the related FAQ at myStockOptions.com.


The Dreaded AMT: How To Find Out Whether Your ISO Exercise Will Trigger The Alternative Minimum Tax

Generally, for each tax year you pay either your regular-tax liability or your alternative minimum tax (AMT) liability, whichever is higher. For most people, the regular-tax liability always turns out to be greater, so the AMT never comes into play. Unfortunately, however, the AMT is hitting a growing number of mere middle-income taxpayers, including people who exercise incentive stock options (ISOs) and hold the shares. This risk is especially pertinent for those who live in high-tax states, itemize tax deductions, and/or have significant personal exemptions, particularly if they exercise and hold ISOs with a big spread. To help your AMT planning, a recently updated FAQ at myStockOptions.com presents a table showing AMT trigger points across a wide range of yearly incomes. For example, if in 2013 you have regular taxable income of $200,000, all it takes to trigger the AMT is a positive adjustment (e.g. ISO spread at exercise) of only $9,163 for joint filers or $8,090 for a single filer.

Over the past several years, Congress has had to take special measures to restrain the spread of the AMT and thus keep it from unfairly taxing millions of people (see the related FAQ on recent developments). In the American Taxpayer Relief Act of 2012, Congress made three major changes in the AMT calculation but did not eliminate the AMT (see the FAQ with details of the changes).

If you are in danger of triggering the AMT, you may be interested in our FAQ that explains various ways to minimize AMT exposure. One strategy involves year-end or year-beginning exercise. Some advisors suggest exercising ISOs at the end of each year, when you can safely estimate whether you will owe AMT for that year. The idea here is to exercise ISOs up to a point at which the aggregate ISO spread will not trigger the application of AMT (i.e. to equalize your AMT and regular-tax liability). For more on this strategy, see a related FAQ on myStockOptions.com. Others advise employees to exercise ISOs in the first quarter of a year: if the stock price drops you can sell the ISO shares later during the same calendar year and avoid paying AMT on paper profits. (See a related FAQ with examples of tax treatments that may apply after a disqualifying disposition in the same year as exercise.) Alternatively, if the stock price rises, you hold the shares. By tax-return time the following year, you will have satisfied the ISO holding periods, so all your gain over the exercise price will be long-term capital gain. When you file your tax return before April of the next year, should you then sell some of the ISO stock to pay AMT, you will at least receive long-term capital gains tax treatment on the appreciation of the sold shares.


The Alternative Minimum Tax Calculation: Major Changes Under New Tax Law

While the American Taxpayer Relief Act (ATRA) did not end the alternative minimum tax (AMT), it has three provisions with a major impact on the AMT calculation. These are important for high-income taxpayers—particularly those who exercise incentive stock options.

  1. ATRA set the AMT income (AMTI) exemption amounts for 2012 at $50,600 for single filers and $78,750 for married joint filers. It also permanently indexed the AMT income exemption amounts for inflation in future years (this had never been done before). From 2013 onward, the AMT income exemption amounts will be automatically raised slightly each year in accordance with inflation. The exemption amounts for 2013 are $51,900 and $80,800, according to IRS Rev. Proc. 2013-15 (see page 8).
  2. The law indexed the income thresholds where the phaseout of the AMT income exemption begins (the first time this has ever been indexed). AMTI exemption amounts are phased out by 25 cents for every dollar of AMTI over specified exemptions. In 2013, for married joint filers the phaseout range starts at $153,900 of AMT income; for single filers, the phaseout starts at $115,400 of AMT income. Therefore, in 2013 the exemption is fully phased out when AMTI is equal to or exceeds $477,100 for joint filers and $323,000 for single filers.
  3. Achieving yet another first, ATRA also indexed the income threshold where the 26% AMT rate ends and the 28% AMT rate begins. In 2013, for unmarried single filers and married joint filers alike, this threshold is $179,500; for married people filing separate returns, the threshold is $89,750.

The permanent indexing of the AMT income exemption amounts for inflation was an important development. Before ATRA, Congress had enacted temporary AMT relief every year for several years as a stopgap measure to keep middle-income people from being unfairly hit by the AMT. This worked as an interim measure, but the annual process in Congress for passing each patch was tortuous, politically charged, and full of uncertainty. Eventually, there was a consensus that the matter was too important to be left to last-minute legislative activity every year. Without annual increases to control the spread of the AMT, the AMT exemption amounts would have returned to the low levels of 2000 ($45,000 for joint filers and $33,750 for singles), imposing the AMT on a vast population of middle-income taxpayers it was never intended to tax. By essentially automating the annual AMT patch, the inflation-indexing of the exemptions obviated the former annual need for Congressional action and eliminated the related yearly uncertainty.

Even if, after these three changes, you are still stuck with the AMT, there are planning techniques that can help. See FAQs on myStockOptions.com about how to minimize AMT liability, or how to manage it if you know you must pay it.


Acquiring A Taste For The Alternative Minimum Tax: Planning Opportunities In The AMT Sweet Spot

Calculating and limiting the alternative minimum tax (AMT) in connection with incentive stock options (ISOs) is complex and can be confusing. On myStockOptions.com, the basic facts and issues of the AMT and ISOs are presented in our perennially popular article Dr. Strange Tax, Or: How I Learned To Stop Worrying And Love The AMT. (Film buffs will surely recognize the allusion.) Learning to love the hated AMT: how could we ever top that feat of tax-planning bravado?

Well, we have. This week, we published an article on ISO tax planning that shows how the AMT can become not just something you learn to live with but actually a sophisticated acquired taste. Indeed, the authors even go so far as to compare the AMT to "an upscale eating club with a high fee to get in the door—but once you're inside, the meals are tasty and cheap." In The Alternative Minimum Tax Sweet Spot: Planning Opportunities, financial advisors Tom Davison and William Whitaker take a look at an advanced tax-planning technique that can turn the top AMT rate of 28% to your advantage if you are in a high tax bracket for ordinary income but get socked with the AMT after an ISO exercise-and-hold. Intrigued? We were too. Read the article to find out the workings of the AMT Sweet Spot.

For an appetizer (or perhaps dessert), you may also want to peruse our other content on the alternative minimum tax. On myStockOptions.com, you can find plenty of articles and FAQs on the AMT, running through topics from the basic to the complex, in the sections ISOs: AMT and ISOs: AMT Advanced.


Buckle Up: 2012 Tax-Rate Uncertainty May Be A Wild Ride For Stock Compensation & Nonqualified Deferred Comp

Although nobody expects it will survive this election year in its current form, President Obama's budget for the 2013 fiscal year was recently published by the White House. It is the first line to be drawn in the mighty battle over taxes predicted to rage later this year, as the sun (once again) sets on the tax rates that were enacted under President Bush in 2001 and 2003 and then extended for a further two years by Congress in 2010. To anybody familiar with Mr. Obama's tax policies, the 2013 budget contains few surprises—in fact, it closely resembles his ill-fated 2010 budget, which lost out to the extension of the tax cuts through 2012.

Basic Policy Outline

Like its predecessor in 2010, President Obama's 2013 budget seeks to extend the current tax rates for everybody whose annual income does not exceed $200,000 ($250,000 for married joint filers) but promises higher tax rates for incomes above that level. For those high earners, rates in 2013 would revert to pre-Bush levels:

  • the 33% and 35% ordinary income rates would rise to 36% and 39.6%
  • the 15% rate on long-term capital gains would go back up to 20%
  • qualified dividends would lose their favorable 15% rate and would be taxed as ordinary income, up to the top rate of 39.6% (this differs from previous budget plans, which proposed to let the lower rate continue)

In addition to these potential rate increases, a new 3.8% Medicare tax on investment income will become effective in 2013. It was adopted with President Obama's law for health-care reform.

End Of The AMT?

A fresh twist in this budget is a proposal to replace the alternative minimum tax (AMT) with a simpler tax law for the wealthy. The new law would ensure that people with annual incomes of more than $1 million always pay at least 30% of their income in federal tax. This is the so-called "Buffett" rule, named after billionaire Warren Buffett, who famously pointed out that people who make most of their income from investments (like him) have lower tax rates than many wage-earners who toil for a living (like his secretary). However, this proposed change in the tax code faces a long road of opposition in Congress.

Ending the AMT would help everyone who has incentive stock options, as the spread at ISO exercise is currently part of the AMT calculation. While there are strategies to minimize the AMT, they are a hassle for anybody who exercises ISOs and holds the shares.

Helpful Articles On Financial Planning In An Uncertain Tax Environment

For people with equity grants or deferred compensation, financial planning in 2012 may end up feeling a lot like it did in 2010. There will be uncertainty about future tax rates and probably no decisive action by Congress until after the election in November. However, unlike the situation in 2010, tax change is now much more likely to occur—one way or another. Either the current tax cuts will expire, raising the rates, or the tax code will be reformed altogether. Having already deferred these tough tax-law decisions for two years in 2010, Congress and the White House (whoever has it after the election) will be under much more political pressure this time to find a tax system that is seen to be fair while still having a meaningful chance of reducing the federal budget deficit.

With tax increases in mind, now may be a good time to re-evaluate your current financial-planning strategy. Should you take action with equity awards and company shares now or wait until new rates apply? On myStockOptions.com, see our article series How Tax Rate Changes Impact Your Stock Grant Strategies, in the section Financial Planning: Advanced. The articles provide an analytical framework to help you determine the impact of a tax increase. In general, the analyses and examples in the articles show that, in most situations, the likelihood of higher tax rates in the near future does not on its own make a good reason to exercise nonqualified stock options or sell shares received from restricted stock vesting or an employee stock purchase plan. Even a modest appreciation in your company’s stock price will offset the tax increase.

For people with nonqualified deferred compensation, our website myNQDC.com will be an essential resource this year and beyond. For guidance on decision-making about income deferral with higher future tax rates, the website has much helpful content, including the following:

Depending on the length of the deferral period, even with higher future tax rates you typically come out ahead by deferring your salary or bonus, as these commentaries and our NQDC calculator show.


Everything You Want To Know About The Special 0% Tax Rate On QSB Capital Gains

Editor's Note: In December 2010, the special 0% rate on QSB capital gains discussed below was extended through 2011 by the Tax Relief Act of 2010. See item #8 in the relevant FAQ at myStockOptions.com.

The tax exclusion for capital gains stemming from the sale of qualified small business (QSB) stock has been increased by Congress and the pen of President Obama, who signed the Small Business Jobs & Credit Act of 2010 earlier this week. For QSB stock issued between September 27, 2010, and the end of 2010, the exclusion is now a whopping 100%. The exclusion therefore results in a 0% tax rate on gains from the sale of QSB stock issued between now and the end of the year. Also, for the duration of this measure, tax-excluded capital gains from QSB stock are also temporarily omitted from the alternative minimum tax (AMT) calculation. A memo from the law firm Cooley Godward Kronish explains more about the workings of the credit and some of the related issues.

Before the recent change in QSB taxation, the exclusion was 75% (making a 7% tax rate under the rules) for qualified small business stock issued between February 17, 2009, and September 27, 2010. That law was passed with the American Recovery and Reinvestment Act of 2009. In 2011, the exclusion will return to the usual 50% (a 14% tax rate), and excluded capital gains will then also return to being part of the AMT calculation.

In the section Financial Planning: High Net Worth, myStockOptions.com has an article series on tax strategies involving QSB stock and specialized small business investment companies.


Rates Of Passage

It seems we will probably have to wait until after the November elections before Congress will make any decisions about post-2010 tax rates for ordinary income, capital gains, dividends, or the estate tax, or about the AMT income exemption amounts for 2010. (For a detailed summary of the issues in play, see a recent memo from Deloitte.) If Republicans regain control of the House and pick up more Senate seats, the result could be either no change in current tax rates or a continuing stalemate. Whatever happens, the last few months of 2010 in Congress promise to be exciting, whether you're a tax professional or merely a taxpayer. We will continue to follow related developments closely.

Our July tax alert considered the changes in some of the tax rates that will occur if the Bush tax cuts simply expire (or "sunset") without further action by Congress or, alternatively, if President Obama's proposals are enacted. While Mr. Obama has declared that he will not seek to extend the Bush tax cuts, there is some support for extending them until the economy recovers (see, for example, this article in Bloomberg BusinessWeek).

For a number of years, we have foreseen the uncertainty about post-2010 tax rates that is now flooding the headlines, and we have considered the prospects of a tax increase after 2010. Alongside our insightful articles on financial-planning strategies for possible higher tax rates in 2011 and beyond, our tools can help you with the calculations. All of our tools allow you to easily edit for changes in tax rates and stock price. In most of the situations analyzed by our authors and other experts, tax increases alone should not be the sole basis of your decision to exercise options or sell stock in 2010.