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 Among those who receive grants of incentive stock options (ISOs), much rejoicing would occur if the AMT were repealed.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.
