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4 Ways Biden's Tax Proposals Could Affect Stock Comp Financial Planning

Millions of employees in the United States have stock compensation and/or holdings of their companies' shares. Many of them may be depending on these for major financial goals, such as a buying a house, saving for retirement, or funding children's college tuition. Could President Biden’s proposed tax changes impact their gains and their financial planning?

The short answer: yes, they very well could, depending on your income. While the future of the proposals remains highly uncertain, some of the proposed tax increases, such as a major hike in the top rate of capital gains tax, may require you to take action well before any new tax legislation is adopted.

The proposed tax provisions to follow are in the American Jobs Plan and the American Families Plan. The US Treasury’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, known informally as the “Green Book,” provides a summary and rationale of the tax changes.

Don’t have time to read Congressional legislation or a tome written by the US Treasury? No problem. At myStockOptions, we read that stuff so you don’t have to, along with related commentaries from law firms and other expert observers. Below is what to know about the potential impact of Biden’s tax proposals on stock compensation and company shares that you hold. For financial advisors, this provides an opportunity to reach out to clients about the possible changes and the impact on decisions involving stock options, restricted stock, ESPPs, and company stock holdings.

1. Top Tax Rate

Currently, the flat supplemental wage withholding rate, which applies to income such as stock compensation and cash bonuses, is 22% for yearly amounts up to $1 million and 37% for yearly amounts in excess of $1 million. That higher withholding rate is tied to the top tax bracket.

Under Biden’s plan, the highest ordinary tax bracket rate would go from 37% to 39.6% starting January 1, 2022 (see page 60 of the Green Book). That would therefore increase the higher rate of supplemental wage withholding to 39.6%. This rate would also apply to short-term capital gains for anyone in the top tax bracket.

ACTION STEPS: When you decide to exercise nonqualified stock options (NQSOs), you control when you will realize the taxable income at exercise, including federal tax. If you’re in the top tax bracket or will be from your option exercise, analyze whether for tax reasons it makes sense to exercise the options in 2021 instead of in 2022, when that bracket rate may be higher.

While most financial advisors would not suggest you make stock option exercise decisions solely for a 2.6% tax savings, this potential tax hike is worth evaluating as a factor for options close to expiration. For options not close to expiration, remember that NQSOs offer substantial leverage and upside, all of which ends as soon as you exercise the options (see the prior article in this blog).

Private companies with a recent or upcoming initial public offering (IPO) have a special concern. If your company has granted double-trigger-vesting restricted stock units (RSUs), in which typically the shares are not fully vested and delivered until six months after the IPO, the company may want to consider accelerating the share delivery into 2021 should the change to the top income-tax bracket be enacted. Accelerating that income into 2021 by delivering the shares this year (when the top rate is 37%) will save taxes for employees who have already met the requirements of both the time-based and the liquidity-event vesting conditions.

2. Capital Gains Tax Rate

Long-term capital gains, such as from company stock sales, currently have a top tax rate of 20% (plus the 3.8% Medicare surtax). Biden’s tax plan would raise the top rate on long-term capital gains and on qualified dividends to the highest rate of ordinary income tax for households with over $1 million in adjusted gross income ($500,000 for married filing separately).

The rate change would be retroactive to the date it was announced, considered to be April 28, 2021, when President Biden issued a Fact Sheet on the American Families Plan. The change for taxes for capital gains realized at death and with gifts, discussed below, would start January 1, 2022. (See pages 61–64 of the Green Book for more details on these capital gains proposals.)

Action Steps: With incentive stock options (ISOs) taxation, when you hold the shares more than two years from grant and one year from exercise, the full gain at sale over the exercise price is capital gain. While the tax treatment for NQSOs is fixed at exercise, for ISOs when you sell the stock without meeting the holding periods the tax treatment changes to essentially follow the ordinary income rates. Anyone with annual income of more than  $1 million will want to evaluate whether to risk holding ISO shares for the long-term capital gains rate when that rate would actually, under Biden’s plan, match their ordinary income rate.

Similar thinking applies to the decision with restricted stock about whether to make a Section 83(b) election to be taxed at grant instead of vesting. One big advantage of the election is to get an early start on the holding period for long-term capital gains. But under the proposed change, the tax rates on long-term and short-term capital gains for people in the top tax bracket may become the same anyway.

Details Murky On Proposed Change And Its Potential Impact

According to some experts, it remains unclear whether this higher capital gains rate would apply to all capital gains income or to only some portion of it (see Tax Reform In The American Families Plan from the law firm Morgan Lewis). Among the many other issues are how this change would impact the 0% rate on qualified small business stock (QSBS). The potential impact for individuals with stock by this proposed change, including the range of open issues and when to recognize capital gains income, is addressed by articles from Tech Crunch (Startup Employees Should Pay Attention To Biden’s Capital Gains Tax Plans), McDermott Will & Emery (What a Capital Gains Rate Hike Could Mean), and Morningstar (Capital Gains Tax Proposal a Wake-Up Call to Assess Concentrated Holdings).

The law firm Proskauer Rose predicts that if the capital gains rate increases, affected taxpayers will “defer sales of appreciated property and to use cashless collars and prepaid forward contracts to reduce economic exposure, and to monetize, liquid appreciated positions” (see Treasury’s Green Book Provides Details on the Biden Administration’s Tax Plan).

3. Capital Gains Realized Upon Death Or At Gifting Of Stock

Biden’s tax plan would dramatically change the capital gains treatment via gifting or upon death for transfers of appreciated property, such as company stock. For example, the ability to eliminate capital gains at death by a step-up in the basis on the shares, which allows heirs to then pay tax only on the appreciation after death, would no longer apply to gains over $1 million per person ($2 million per couple).

Alert: This does not mean that the basis for the remaining stock over these amounts is just carried forward to the person(s) inheriting it or the beneficiary, as has been misreported in some sources. Death itself triggers the recognition of capital gains tax on these amounts as if the stock was sold!

Similarly, any gifts made over these amounts would be taxable at that time to the gifter. Currently the receiver just carries forward the basis, and the giver would owe gift tax only if they did not have any of their lifetime gift/estate exemption amount remaining. Exceptions would apply, such as with transfers to a spouse, a charity, or heirs of small businesses and farms that continue to run those businesses. Donations of highly appreciated stock to charities would still avoid the capital gains tax, making it an even more popular strategy.

The Biden administration’s proposals so far do not yet include lowering the estate tax exemption from the current $11.7 million per person ($23.4 million for married couples), which was discussed during the campaign and may be forthcoming. However, that amount does automatically go down to $5.49 million per person (adjusted for inflation) at the start of 2026, when the provision sunsets at the end of 2025 under the Tax Cuts & Jobs Act (TCJA).

4. Beefed-Up Enforcement

The proposed legislation provides funding to “revitalize enforcement to make the wealthy pay what they owe” in an effort to shrink the tax gap, according to the Fact Sheet on the American Families Plan. This means with certainty an increase in audits of companies, executives, and others who are wealthy because of their stock compensation or founders’ stock. The audit rates on those making over $1 million per year, which fell by 80% between 2011 and 2018, will increase substantially. Financial institutions would be required to report information on account flows so that earnings from investments, such as from stock compensation and company stock holdings, are subject to broader IRS reporting.

Likelihood Of Tax-Law Changes

Whether any of these proposals will get adopted in their current form, and with the proposed effective dates, remains uncertain. Doubts about what will happen are raised by experts quoted in articles from Investment News (Political Reality Seen Curbing Biden’s Tax Plan) and Politico (Tax The Rich? Executives Predict Biden’s Big Plans Will Flop). The lobbyist and business group leaders quoted in the Politico article seem confident that they will pressure moderate Democrats in the House and Senate to “kill almost all of these tax hikes.”

A reminder of what tax ideas have not yet been proposed by Biden, such as taxing stock options at vesting, appears in a commentary from the law firm Brownstein Hyatt Farber Schreck (Will Biden’s American Families Plan Take Aim At Executive Compensation?). That proposal had been part of the initial draft of the TCJA, the tax-reform law enacted at the end of 2017.

myStockOptions Webinar Channel

See the myStockOptions webinar channel to register for our upcoming webinars and purchase our past webinars on demand in streaming format. On-demand webinars include:

Restricted Stock & RSU Financial Planning: Advanced Bootcamp (100 mins). This lively webinar features insights from a panel of three leading financial advisors, including case studies, to provide practical info, guidance, and expertise for restricted stock/RSUs in both public and private companies. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Stock Option Exercise Strategies: Advanced Bootcamp (100 mins). Stock options can offer great leverage, but it must be wielded wisely. It is crucial to have a strategic plan for stock option exercises. This webinar features compelling insights from a panel of three experts in option exercise strategies. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Stock Compensation Bootcamp For Financial Advisors (100 mins). Whether you are new to stock comp or want to sharpen your knowledge, our bootcamp webinar provides practical information and insights to maximize success. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

Strategies For Concentrated Positions In Company Stock (100 mins). Wealth is won and lost through the management of concentrated company stock positions. In this webinar, experts at managing concentrated stock wealth explain the wide range of strategies and solutions available for preventing losses and meeting goals. 2.0 CE credits for CFP, CPWA, CIMA, and CEP.

The Top 3 Tax Numbers You Need To Know In 2021

This January has been a doozy for us all. However, amid your busy work and personal life, Covid, the new presidential administration, and the upcoming tax-return season, don’t forget basic tax planning for 2021.

At the start of each year, key numbers in many tax-law provisions are adjusted for inflation. Many of the adjustments are important for employees, their paychecks, and their basic tax planning for 2021. While the IRS and Social Security Administration announce these figures every fall, January is really when you need to pay attention to them.

Many tax-code sections are adjusted, and it can be hard to spot those that matter to you. Some are of interest only to super-wealthy executives and other individuals, such as the federal exemption for estate tax (in 2021, $11.7 million for single taxpayers and $23.4 million for married joint filers). Others are chiefly matters for corporate benefit-plan administrators. For example, the income definition of “highly compensated employee,” which affects eligibility for employee stock purchase plans (ESPPs) and 401(k) plan non-discrimination testing, is $130,000 in 2021.

Below are the top three sets of tax figures that all employees should know. They relate to compensation from work: paycheck withholding, the potential need for estimated taxes, and your retirement savings. You can find in-depth content on all of these tax topics in the Tax Center at myStockOptions.com.

1. The Social Security Wage Base

Social Security tax (6.2%) applies to wages up to a maximum amount per year set annually by the Social Security Administration. Income above that threshold is not subject to Social Security tax (by contrast, Medicare tax is uncapped, with a rate of either 1.45% or 2.35%, depending on your income level).

In 2021, the Social Security wage cap is $142,800, up slightly from $137,700 in 2020. This means the maximum possible Social Security withholding in 2021 is $8,853.60. Once your income is over that amount, you’ll see 6.2% more in your paycheck!

2. Your Income-Tax Bracket And Withholding

The table below can help you understand how an additional amount of compensation would be taxed at your marginal tax rate (i.e. the percent of tax you pay for an additional dollar of income in your current tax bracket). This number tells you whether the taxes withheld according to your information on the revised Form W-4 will cover the total tax you will owe for 2021. To avoid “penalizing” additional income in your mind, be sure you know your effective or average tax rate.

Need To Pay Estimated Taxes?

Additional compensation received, such as a cash bonus or income from a nonqualified stock option exercise or vesting of restricted stock units, is considered supplemental wage income. For federal income-tax withholding, most companies do not use your W-4 rate. Instead, they apply the IRS flat rate of 22% for supplemental income (the rate is 37% for yearly supplemental income in excess of $1 million).

As shown by the table above, once you know your marginal tax-bracket rate, you may find the withholding rate of 22% may not cover all of the taxes that you will owe on supplemental wage income. In that case, you must either put extra money aside for the 2021 tax return you will file in 2022, pay estimated taxes during 2021, or adjust your W-4 for your salary withholding as soon as possible to cover the shortfall.

3. Your Contribution Limit For Qualified Retirement Plans

In 2021, you can elect to defer up to $19,500 from your paychecks into qualified retirement plans, such as your 401(k). The total ceiling for deferrals to defined contribution retirement plans, including any extra part contributed by your employer, rose to $58,000 in 2021, a $1,000 increase over last year’s amount. Both of these limits are $6,500 higher if you are 50 or older.

The amount of compensation income that can be considered in the calculation for qualified deferrals rose to $290,000 in 2021. Check with your company’s 401(k) plan administrator for the process of making changes in your compensation deferral election.

Want To Defer More Income?

Look into whether your company has a nonqualified deferred compensation plan, sometimes called an excess 401(k) plan or other name. For more on these plans, see our sibling website myNQDC.com.

IRS Resources

Here are resources with more details on the many adjusted 2021 tax numbers:

• Revenue Procedure 2020-45 gives inflation adjustments in various income-tax-related provisions.
• IRS Notice 2020-79 and an IRS table give the annual adjustments related to various tax-qualified retirement plans.

Webinar: Stock Compensation Bootcamp for Financial Advisors

Our latest webinar, Stock Compensation Bootcamp For Financial Advisors, is available to stream on demand. Learn what you need to know about stock options, restricted stock, RSUs, and ESPPs to best serve clients, build wealth, and prevent costly mistakes. Whether you are new to stock comp or want to sharpen your knowledge, this webinar provides practical information and insights to maximize your success.

See the webinar page for details and an agenda of topics covered.

Estimated Taxes Due July 15: Watch Out For Special Issues

As you probably know already, Covid-19 caused the IRS to delay the April 15 federal tax-return deadline to July 15. However, it isn’t just 2019 tax returns that are due. The IRS also postponed the first two 2020 quarterly estimated-tax payments, which are normally owed by April 15 and June 15.

If you receive a sudden irregular influx of income from equity compensation, such as a big vesting of RSUs or a major stock option exercise, you need to pay estimated taxes if your salary withholding isn't enough to meet the IRS rules for amount of tax paid during the year. In 2020, any estimated taxes that would have been due on April 15 and June 15 are now due on July 15. Read on to find out what you need to know to avoid IRS penalties for underpayment of tax during the calendar year.

How To Avoid The Penalty

If you are self-employed or a contractor, or a W-2 employee who does not pay enough in taxes during the year via payroll withholding, you typically pay quarterly estimated taxes in April, June, September, and January. As explained above, a big influx of extra income from equity comp can make your payroll withholding inadequate, requiring an estimated tax payment to cover the shortfall.

Why does this matter? Underpayment of taxes during the calendar year subjects you to an IRS penalty. You avoid a penalty through one of two safe harbors:

• you owe less than $1,000 in tax for the year
• you pay at least 90% of tax owed for the current year (2020), or 100% of the tax you paid for the prior year (2019), whichever is smaller

For adjusted gross income greater than $150,000 ($75,000 married filing separately) on the prior year's tax return, the percentage of last year’s tax that you must cover during this year is higher: the safe harbor is 110%. If you don’t pay enough taxes, IRS Form 2210 helps you calculate any penalty for underpayment of estimated tax.

Will The IRS Waive The Penalty In 2020?

It’s too early to say whether the coronavirus pandemic will prompt the IRS to reduce or waive the penalty in 2020 or lower the safe-harbor percentages. For 2018 taxes, the IRS lowered the 90% requirement to 80%. It also removed the requirement that estimated-tax payments be sent in four equal installments, which is already impossible for this year.

Our sources at the IRS tell us that changes in the safe harbor percentages for 2020 will “probably be considered.” However, they also say that right now it’s likely to be “at the bottom of the pile,” given all the other issues demanding immediate attention at the Treasury Department and the IRS. In our view, the IRS should make it a priority to reduce the safe-harbor percentages now so that taxpayers will have more money to spend while their finances and the economy are recovering.

Special Issues For 2020

On top of any irregular equity comp income in 2020, if you received a stimulus check, a loan from the Paycheck Protection Program (PPP), or unemployment benefits, your estimated tax picture could get even more complicated. Tax return professionals (CPAs and/or Enrolled Agents) have told me about four special issues in 2020 related to estimated-tax payments and the calculation of how much you owe:

• your stimulus check
• Paycheck Protection Program loans
• unemployment benefits
• ongoing financial hardship from the coronavirus pandemic

Stimulus Payments

Is your Covid-19 stimulus payment taxable income that needs to be considered for estimated taxes? Susan Allen, Senior Manager for Tax Practice & Ethics at the American Institute for CPAs (AICPA), cites guidance on this question in the IRS’s Economic Impact Payment Information Center. She explained to me that the IRS has clarified in its Q&A that “the payment is not included in gross income and, therefore, taxpayers will not pay tax on it.”

However, you will still need to report the stimulus payment as an advance 2020 tax credit next year when you file your 2020 tax return. “It should not affect the amount of taxes you owe or the amount of any tax refund you’re due from the IRS next year,” explained Bill Nemeth, EA, who is affiliated with Tax Audit Guardian and is the President of the George Association of Enrolled Agents.

Phyllis Jo Kubey, EA, the incoming president of the NY State Society of Enrolled Agents, does factor stimulus payments that will be credited on the 2020 tax return into her clients’ estimated-tax payments. She does this for taxpayers who were not eligible for a credit on either 2018 or 2019 income but probably will be on 2020 income. When you “can determine with reasonable accuracy that they’ll be entitled to a substantial credit on their 2020 tax returns,” she explained, “I reduce their estimated-tax payments by the expected economic impact payment” (EIP).

Example: Married joint filers with no children had income above the stimulus-check tax threshold in 2018 and 2019, but they are eligible for it on their 2020 tax return based on their decline in 2020 taxable income. Kubey factors in a $2,400 credit in the estimated-tax calculation for 2020. If initially their total 2020 estimated-tax liability was $4,000 (or $1,000 per quarter), once Kubey knows they’ll be eligible for a $2,400 EIP, that reduces the 2020 estimated-tax payments to a total of $1,600.

For additional details on stimulus payments and related income phaseouts, see a Forbes.com article by myStockOptions editor-in-chief Bruce Brumberg: Stimulus Checks Can Tell You How Much Your Friends, Relatives, And Co-Workers Earn.

Paycheck Protection Program Loans

In Notice 2020-32, the IRS took the position that no tax deductions are permitted for expenses, such as payroll, that are funded by PPP loans which are later forgiven. Under the IRS guidance, which may eventually be reversed by Congress, the inability to deduct these expenses affects the estimated-tax calculation by individuals who own businesses that pass through their income to the owners, such as with an S Corporation, Limited Liability Company (LLC), or sole proprietorship.

How does this affect the 2020 estimated-tax calculation? The loss of this deduction means their 2020 taxable income will be higher. Elliott Puretz, a CPA, tax-return preparer, and retired college accounting professor in the Boston area, told me that for now “you have to assume the deduction will not be allowed.”

Unemployment Benefits

So far in 2020, there have been over 36 million new claims for unemployment benefits. Many of these people are collecting unemployment for the first time in their lives and may be confused about the tax treatment.

Unemployment benefits are taxable by the IRS and by states that have income tax, including the special Pandemic Unemployment Assistance (PUA) and Pandemic Emergency Unemployment Compensation (PEUC). As explained on the IRS website, you do need to make estimated-tax payments on this taxable income unless you elected to have federal income tax withheld with Form W-4V, Voluntary Withholding Request.

Financial Hardship: Skipping Estimated-Tax Payments

Enrolled Agent Bill Nemeth expresses “real concerns about taxpayers actually making these estimated-tax payments if they are economically fragile.” He gave me an example of a single mother who works in a service industry as a contractor and is thus self-employed (e.g. hair or nail salon, Uber, Lyft, Grubhub, DoorDash). Because the April and June estimated taxes were postponed to July, she received temporary tax relief. However, Nemeth points out, now she must make a big estimated-tax payment by July 15 at a time when she may not even be able pay her rent and utilities because she’s been out of work for three months.

For this reason, Nemeth predicts a massive influx of IRS collection cases. On top of that, he foresees “a huge number of self-employed service industry workers who are going to have a large IRS balance due when they file their 2020 returns.”

Beth Logan, EA, who works with Kozlog Tax Advisers and is the President of the Massachusetts Society of Enrolled Agents, described to me another type of problematic situation. Many businesses that did well in January and February had to close in March under state lockdown orders and have had no meaningful revenue since then. They have been using profits received in January and February to pay bills and personal expenses during the Covid-19 shutdown. “Those who are not disciplined savers will struggle,” she observed, adding that “I would rather my clients eat and pay their bills.” Survival, she emphasizes, should come before taxes: “We’ll just have to deal with any interest for paying estimated taxes late.”

CPA Elliott Puretz explained that not paying estimated taxes on time and triggering the IRS penalty is like getting a loan from the federal and state government at a 5% to 6% annual rate calculated quarterly (not compounded). He advises that if you have “access to cheaper funds (e.g. a home-equity loan), you may want use that to make the estimated-tax payments.” However, if your only funding source for taxes is a credit-card advance, presumably with a much higher interest rate than the rate of the IRS penalty, then it makes sense “to consider not paying the estimated-tax payments.”

Tax-Return Guidance For Stock Compensation

For guidance on tax returns and estimated taxes on stock compensation (stock options, restricted stock/RSUs, ESPPs, and SARs) see the Tax Center at myStockOptions.com.

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The impacts of Covid-19 have been a wild ride. After a steep swings in the markets, financial planning continues to be tested by ongoing volatility, economic uncertainty, corporate layoffs, and indefinite employment furloughs. It is more important than ever for financial advisors to re-evaluate planning approaches.

Join us on July 22 (2:00pm–3:00pm ET) for a special webinar: Financial Planning For Stock Compensation During The Pandemic. It will cover the current state of equity comp, the related financial planning amid the pandemic, and the impact of Covid-19 on markets, the economy, and employment. Bruce Brumberg, editor-in-chief of myStockOptions, will moderate a panel discussion by three leading financial advisors and a top compensation consultant. See the webinar page for details and registration.

The Top 3 Tax Numbers In 2020 That Employees With Equity Comp Should Know

Tax-return season looms, meaning you will soon have to focus on reporting your 2019 income, including compensation from stock plans or gains from stock sales. However, before that, remember your basic tax planning for 2020.

At the start of each year, many key numbers in tax-law provisions are adjusted for inflation. It can be hard to spot those that matter to you. Below are the top three sets of tax figures that highly compensated employees should know: the Social Security income ceiling, your marginal tax rate, and how much you can put into your 401(k) plan.

1. Social Security Wage Base

Social Security tax (6.2%) applies to wages up to a maximum amount per year set annually by the Social Security Administration. Income above that threshold is not subject to Social Security tax (by contrast, Medicare tax is uncapped, with a rate of either 1.45% or 2.35%, depending on your income level). In 2020, the Social Security wage cap is $137,700, up slightly from $132,900 in 2019. This means the maximum possible Social Security withholding in 2020 is $8,537.40. Once your income is over that amount, you'll see 6.2% more in your paycheck or in the income you get from stock compensation, such as an NQSO exercise or RSU vesting.

2. Income-Tax Brackets And Withholding

The table below can help you understand how an additional amount of compensation would be taxed at your marginal tax rate (i.e. the percent of tax you pay for an additional dollar of income in your current tax bracket). This number tells you whether the taxes withheld according to your information on the newly revised Form W-4 will cover the total tax you will owe for 2020. To avoid "penalizing" additional income in your mind, be sure you know your effective or average tax rate.

RATE	TAXABLE INCOME (SINGLE)	TAXABLE INCOME (JOINT)
10%	$0 to $9,875	$0 to $19,750
12%	$9,876 to $40,125	$19,751 to $80,250
22%	$40,126 to $85,525	$80,251 to $171,050
24%	$85,526 to $163,300	$171,051 to $326,600
32%	$163,301 to $207,350	$326,601 to $414,700
35%	$207,351 to $518,400	$414,701 to $622,050
37%	$518,401 or more	$622,051 or more

Need To Pay Estimated Taxes?

Additional compensation received, such as a cash bonus or income from a nonqualified stock option exercise or vesting of restricted stock units, is considered supplemental wage income. For federal income-tax withholding, most companies do not use your W-4 rate. Instead, they apply the IRS flat rate of 22% for supplemental income (the rate is 37% for yearly supplemental income in excess of $1 million).

As shown by the table above, once you know your marginal tax-bracket rate, you may find the withholding rate of 22% may not cover all of the taxes that you will owe on supplemental wage income. In that case, you must either put extra money aside for the tax return you file in 2021, pay estimated taxes during 2020, or adjust your W-4 for your salary withholding as soon as possible to cover the shortfall.

3. Qualified Retirement Plans

In 2020, you can elect to defer up to $19,500 from your pay into qualified retirement plans, such as your 401(k). This is a $500 increase over the 2019 limit.

The total ceiling for deferrals to defined contribution retirement plans (including any additional part contributed from your employer) rose to $57,000 in 2020, a $1,000 increase. Both of these limits are $6,500 higher if you are 50 or older. The amount of compensation income that can be considered in the calculation for qualified deferrals is $285,000 in 2020. Check with your company’s 401(k) plan administrator for the process of making changes in your compensation deferral election.

Want to Defer More Income?

Look into whether your company has a nonqualified deferred compensation plan, sometimes called an excess 401(k) plan or other name. For more on these plans, see our sibling website myNQDC.com.

IRS Resources

Here are resources with more details on the many adjusted 2020 tax numbers:

• IRS Rev. Proc. 2019-44 gives inflation adjustments in various income-tax-related provisions.
• IRS Notice 2019-59 and an IRS table give the annual adjustments related to various tax-qualified retirement plans.

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Our conference is recommended in The 20 Best Conferences For Financial Advisors To Choose From In 2020 by financial-planning thought leader Michael Kitces! Please contact us (editors@mystockoptions.com) to be notified when registration starts at the early-bird discount rate.

Wealth Tax Debate: The Movie

As the 2020 presidential election year approaches, Democratic candidates, most notably Senator Elizabeth Warren, have proposed a 2%–3% wealth tax on the assets of the super-rich to help ensure that they pay their fair share along with other taxpayers.

Upon first hearing about a wealth tax, we at myStockOptions.com thought it could apply to any company founder that built a successful company, executives with substantial grants of stock options or restricted stock units, or employees who joined an early-stage startup and now have significant wealth after an IPO or acquisition. However, the proposed tax is really for the super-wealthy: billionaires and mega-millionaires. Under Senator Warren’s proposal, for example, the wealth tax would be triggered only if your household net worth, including stock holdings, is over $50 million. It would apply to individuals such as Jeff Bezos, Michael Bloomberg, Bill Gates, Larry Ellison, Larry Page, Mark Zuckerberg, and others whose enormous wealth comes from stock in the companies they founded.

To find out more, we watched the live internet-streamed seminar The Wealth Tax Debate, recently held by the Penn Wharton Budget Model (PWBM). It’s a nonpartisan research-based initiative at the Wharton School, the business school at the University of Pennsylvania. Three scholars discussed the feasibility and tradeoffs of the wealth tax proposed by Senator Warren and other Democratic presidential candidates. Below I present a few highlights from each speaker’s talk.

While this streaming video is perhaps not as exciting as Amazon Prime or Netflix, for anyone interested in tax and public policy issues it’s an absorbing drama and short enough to watch in one sitting. It runs about 90 minutes (presentations 50 minutes and Q&A for remainder), shot with a single camera and no editing, with the speakers’ slide decks on screen during their talks.

After watching the full 90-minute running time of the seminar, you’ll come away with a better understanding of the complex issues involved with the wealth tax. Those who oppose the wealth tax will give this movie a thumbs up, while supporters of the wealth tax may find parts of it tough viewing.

Wealth Tax In Brief

Many of the wealthiest US citizens have vast assets but little income, so traditional income taxes struggle to reach them. In the view of some of the Democratic presidential candidates, a wealth tax would ensure that these very richest Americans pay their fair share.

Another underlying purpose for the wealth tax concerns democracy. By reducing income inequality, the wealth-tax proposals seek to protect democracy itself by limiting political oligarchy: the amount of wealth and related political influence that the rich can accumulate. The aim is to control the potential for one tiny plutocracy to dominate election campaigns.

The Wealth Tax Debate

In the Penn Wharton seminar, Senator Warren’s proposed wealth tax is the primary focus of the three speakers. Her proposal’s research, rationale, and estimates of revenue potential were developed by Emmanuel Saez and Gabriel Zucman, two economists at the University of California, Berkeley.

Part One: Economic Growth

Richard Prisinzano, Director of Policy Analysis at Penn Wharton Budget Model (PWBM), presented his research team’s initial projection of the impact Senator Warren’s proposed wealth tax would have on revenue and the US economy. The researchers found that if the tax raises as much new revenue as intended and the revenue is used to cut the federal debt, annual economic growth in the United States would slow from the current average of 1.5% to an average of just over 1.3% over a decade.

Broadly, the PWBM finds that wealthy Americans would simply consume more, save less, and invest less to reduce taxable wealth. The resulting drop in investment would, in its modeling, reduce economic growth. “The wealth tax shrinks the economy because saving is more expensive,” Mr. Prisinzano summarized. “The results also suggest that the negative effect of the tax increases as the tax rate increases.”

For commentaries that critically review at least parts of this PWBN analysis for not fully considering the potential economic growth generated from government programs that spend the new tax revenue, see articles in Business Insider, The Week, and New York Magazine’s Intelligencer.

Part Two: Questions Of Revenue, Constitutionality, And Alternatives

Natasha Sarin, Assistant Professor of Law at the University of Pennsylvania Carey Law School, dissected the revenue estimates of Senator Warren’s wealth tax that were calculated by Emmanuel Saez and Gabriel Zucman at UC Berkeley. In short, she finds their assessment flawed and unrealistic. When she dynamically corrects what she considers “sloppy math” and unfounded assumptions about actual wealth holdings and tax compliance among the rich, she projects that the proposed wealth tax would generate $1.1 trillion, far lower than the Warren team’s estimate of $2.75 trillion.

Additionally, the task of annually assessing the net worth of the wealthy for a wealth raises difficult practical issues. Given that over 50% of wealthy assets are illiquid, how would they be valued?

Furthermore, shifting from economics to law, Professor Sarin noted that a wealth tax would almost certainly be challenged as unconstitutional and probably nixed from the start. Under the US Constitution, direct taxes must be evenly apportioned across the states. However, the roughly 75,000 super-wealthy households impacted by a wealth tax are not evenly distributed across states. Given two centuries of legal precedent against a wealth tax, she believes that the current US Supreme Court, for better or worse, would inevitably rule that a wealth tax is unconstitutional.

Professor Sarin shows in her slide deck that, instead of attempting a wealth tax that may be problematic, there are more efficient ways to raise federal revenue:

• crack down on IRS tax compliance among the wealthy (she recently wrote a paper on this with economist Lawrence Summers)
• close corporate and individual tax shelters
• eliminate the stepped-up basis of assets at death
• cap taxable deductions for the wealthy
• end pass-through deductions
• broaden the estate-tax base
• increase the corporate tax rate

She estimates that these measures would increase revenue by $2.83 trillion, slightly beating the revenue estimate of $2.75 trillion put forward by Senator Warren’s team—and hugely exceeding Professor Sarin’s $1.1 trillion estimate of the wealth tax’s actual revenue potential.

Part Three: Tax Tradeoffs

Greg Leiserson, Director of Tax Policy and Chief Economist at the Washington Center for Equitable Growth, discussed the approaches and tradeoffs of taxing wealth. He explained the issues in the different approaches of taxing wealth itself compared to taxing the income generated from wealth, and the difference between taxation based on valuation compared to when the gains are realized.

He summarized the advantage of the income approach:

• More seamless integration with existing income tax
• Greater risk sharing between taxpayer and government
• Reduced constitutional risk

He summarized the advantages of the wealth approach:

• Taxes assets that generate consumption flows
• Less volatile revenues
• Easier to explain

He concludes that any approach needs to look at who the tax is burdening, which we assume impacts compliance, and how much revenue is going to be realistically raised. (For the challenges involved in raising more tax revenue from the super-wealthy, see what financial advisors have to say in an article from The New York Times.)

Wealth Planning: Not Just For The Super-Rich

Whatever the size of your wealth from stock compensation and company stock holdings, you and your advisors will find useful planning ideas and insights in the section Financial Planning at myStockOptions.com.

Capital Gains Tax: What Democratic Presidential Candidates Are Saying And What Tax Changes Might Look Like

At myStockOptions, we are listening for policy hints from the Democratic presidential candidates that may affect equity compensation if Democrats regain control of the White House and Congress in 2020. This includes the potential for changes in the long-term capital gains tax, a stated goal for several of the Democratic candidates.

Capital Gains Tax: A Review

Capital gains on asset sales are often still associated with the wealthy and not the middle class. However, anyone who sells a house is subject to the tax rules of capital gains and losses. Anyone who sells stock, ETF holdings, or mutual funds in non-retirement brokerage accounts incurs a capital gain or loss. Nowadays, that's not just the wealthy. For example, an employee incurs a capital gain or loss when selling company shares acquired from stock option exercises, restricted stock/RSU vesting, or ESPP purchases, even if the number of shares is small. Capital gains tax has therefore become a commonplace feature of individual taxation for many US citizens, not just the wealthy minority.

While the Tax Cuts and Jobs Act made significant changes in the rates and brackets of income tax in 2018, it did not modify the long-term capital gains tax rates (15% and 20%) that apply to gains from shares acquired from stock compensation and held for at least one year. Those rates have been in place for many years.

However, if Democrats win the presidency and a workable majority in Congress, we should expect changes in the long-term capital gains tax as part of Democrat efforts to increase federal revenue and reduce income inequality. This is clear from statements made by Democratic candidates, the tax-policy positions they have issued, and research from other sources (see commentaries from Politico, The Hill, and Kiplinger). If your decisions at year-end on whether to hold or sell investments tend to be tax-driven, you could be very busy in December 2020.

Democratic Presidential Candidates: What They Are Saying

Below is a sample of specific policies for capital gains tax that Democratic presidential candidates have proposed:

• taxing capital gains income the same as compensation income (Cory Booker, Amy Klobuchar, and others)
• increasing the capital tax rates for incomes over $1 million (Joe Biden)
• eliminating the lower capital gains rates for those with household income above $250,000 (Bernie Sanders)
• a wealth tax for the richest top 0.1% that in essence taxes the gains on assets before any sale proceeds are realized (Elizabeth Warren)
• ending the step-up at death in the basis of inherited assets

Meanwhile, as we discussed in a recent blog commentary, the Trump White House is pulling in the opposite direction on capital gains. It is seriously considering a presidential executive order which would index the capital gains cost basis for inflation. That would effectively result in a tax cut—controversially, without the approval of Congress. It seems that the future of capital gains taxation could take a very different path if the Democrats do not regain the White House in 2020.

Varying Approaches To Capital Gains Taxation

While most of the Democratic candidates appear to support eliminating the different tax rates that apply to long-term capital gains compared to compensation income, those policies might not mean all the gain would be taxable. There could be an income-exemption amount for a certain percentage of gains. No candidate has mentioned this approach, which was actually part of the US tax code before the Tax Reform Act of 1986. Tax exemptions on a certain percentage of capital gains are applied by several other countries now. For example, in Canada, only 50% of capital gain is included in income, and it's then taxed at the individual's income tax rate.

Interestingly, tax policies in countries around the world embrace the rationale that capital gains should be taxed differently than employment income. For example, that is the case in Denmark, Sweden, and Germany, countries that have more progressive social-welfare programs and less income inequality than the United States. (You can sample other tax treatments of capital gains and equity compensation around the world in the Global Tax Guide at myStockOptions.com.)

Capital Gains Indexing: Tax Cut By Presidential Executive Order?

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.

Employees Must Know These 3 Key Tax Numbers In 2019

Amid their busy lives as the year begins, employees and their financial advisors must remember to consider three key numbers in the tax-law provisions that are annually adjusted for inflation by the IRS and the Social Security Administration. These impact their paychecks and basic tax planning for 2019.

Some of the adjusted tax-code sections are of interest only to super-wealthy executives and other individuals, such as the federal exemption for estate tax ($11.4 million per individual, $22.8 million per married couple in 2019). Others are chiefly matters for corporate benefit-plan administrators. For example, the income definition of “highly compensated employee,” which affects eligibility for employee stock purchase plans (ESPPs) and 401(k) plan non-discrimination testing, rose to $125,000 in 2019.

Below are the top three sets of tax figures that employees should know. They relate to compensation from work involving paycheck withholding, the potential need for estimated taxes, and your retirement savings.

1. Social Security Wage Base

Social Security tax (6.2%) applies to wages up to a maximum amount per year set annually by the Social Security Administration. Income above that threshold is not subject to Social Security tax (by contrast, Medicare tax is uncapped, with a rate of either 1.45% or 2.35%, depending on your income level). In 2019, the Social Security wage cap is $132,900, up slightly from $128,400 in 2018. This means the maximum possible Social Security withholding in 2019 is $8,239.80. Once your income is over that amount, you’ll see 6.2% more in your paycheck!

2. Income-Tax Brackets

The table below can help you understand how an additional amount of compensation would be taxed at your marginal tax rate (i.e. the next highest rate from your standard tax bracket). This tells you whether the taxes withheld according to your preference on Form W-4 will cover the total tax you will owe for 2019. To avoid “penalizing” additional income in your mind, be sure you know your effective or average tax rate.

Income Tax Brackets And Rates In 2019

RATE	TAXABLE INCOME (SINGLE)	TAXABLE INCOME (JOINT)
10%	$0 to $9,700	$0 to $19,400
12%	$9,701 to $39,475	$19,401 to $78,950
22%	$39,476 to $84,200	$78,951 to $168,400
24%	$84,201 to $160,725	$168,401 to $321,450
32%	$160,726 to $204,100	$321,451 to $408,200
35%	$204,101 to $510,300	$408,201 to $612,350
37%	$510,301 or more	$612,351 or more

Need To Pay Estimated Taxes?

Additional compensation received, such as a cash bonus or income from a nonqualified stock option exercise or vesting of restricted stock units, is considered supplemental wage income. For federal income-tax withholding, most companies use not your W-4 rate but the IRS flat rate of 22% for supplemental income (the rate is 37% for yearly income amounts in excess of $1 million).

As shown by the table above, once you know your marginal tax-bracket rate, you may find the withholding rate of 22% may not cover all of the taxes you will owe that on supplemental wage income. In that case, you must either put extra money aside for your 2020 tax return, pay estimated taxes, or adjust your W-4 for your salary withholding to cover the shortfall.

3. Qualified Retirement Plans

In 2019, you can elect to defer up to $19,000 from your paychecks into qualified retirement plans, such as your 401(k). This is a $500 increase over the 2018 limit. The total ceiling for deferrals to defined contribution retirement plans (including any additional part contributed from your employer) rose to $56,000 in 2019, a $1,000 increase. Both of these limits are $6,000 higher if you are 50 or older. The amount of compensation income that can be considered in the calculation for qualified deferrals is $280,000 in 2019.

Want To Defer More Income?

Look into whether your company has a nonqualified deferred compensation plan, sometimes called an excess 401(k) plan or other name. For more on these plans, see the website myNQDC.com.

IRS Resources

Here are resources with more details on the many adjusted 2019 tax numbers:

• IRS Rev. Proc. 2018-57 gives inflation adjustments in various income-tax-related provisions.
• IRS Notice 2018-83 and an IRS table give the annual adjustments related to various tax-qualified retirement plans.

How Tax Reform Affects Year-End Planning For Equity Comp And Company Shares

This is the first year-end season when taxpayers with stock compensation must consider the changes introduced in 2018 by the Tax Cuts & Jobs Act (TCJA). Fortunately, the new tax law doesn’t make any huge changes in the usual year-end steps that you and your financial advisor should consider when you have stock options, restricted stock/RSUs and company stock holdings.

However, there are some key points to know and discuss with your advisor. For example, the new 22% withholding rate on income from stock comp and cash bonuses (lowered from 25%) could mean you’ll end up with a big tax bill in April.

Two Major Types Of Tax Changes

“Tax reform” is the blanket term often applied to the TCJA, which made two major types of changes in the tax laws for individuals. In some areas, the TCJA made straight-up tax cuts. In others, it restructured or eliminated tax provisions. Each of those two categories affects your year-end strategies differently, as explained below.

Tax-Cut Provisions

The TCJA modified the income-tax rate and income ranges of each tax bracket, including the reduction of the top income-tax rate from 39.6% to 37%. However, we still have the same number of tax brackets (lucky seven), and the capital gains tax and the Medicare surtaxes remain unchanged.

What this means: Whenever you consider exercising stock options or selling shares at year-end (or recognize any extra income), you need to know your tax bracket. Even with the lower tax rates that took effect in 2018, you still want to consider the income thresholds that would trigger a higher tax rate and the Medicare surtax on investment income.

In general, you want to do the following multi-year planning, just as you did before the TCJA:

• Keep your yearly income under the thresholds for higher tax rates and know the additional room you have for more income in your 2018 and 2019 tax brackets.
• Recognize income at times when your yearly income and tax rates may, according to your projections, be lower.

Example: You’re a joint filer with $200,000 of taxable income in 2018 and projected taxable income of $180,000 in 2019, putting you in the 24% tax bracket. You have a $120,000 spread on your nonqualified stock options. By exercising just enough options in 2018 to generate $50,000 of additional income (giving you $250,000 for the year), you can then exercise the remaining options in 2019. This lets you avoid the higher 32% tax bracket and both the additional Medicare tax (0.9%) on the income at exercise and the Medicare surtax on investment income (3.8%) when you sell the shares.

2018 Salary	$200,000	$200,000
2018 NQSO exercise income	$50,000 when exercised over 2 years	$120,000 when income in 1 year
Total taxable W-2 income	$250,000	$320,000
Marginal tax bracket	24%	32%
Medicare taxes at sale and exercise	no	yes

The flat withholding rates for supplemental wages, including stock compensation, are tied to the seven income-tax brackets, so those changed too. For income up to $1 million in a calendar year, the withholding rate is now 22%. For amounts of income in excess of $1 million during a calendar year, the withholding rate is 37%.

What this means: The 22% rate of withholding may not cover all of the taxes you will owe on income from an exercise of nonqualified stock options (NQSOs) or a vesting of restricted stock or restricted stock units. You must therefore know the tax bracket for your total income and assess the need to (1) put money aside to pay the additional taxes with your tax return, (2) increase the withholding on your salary, or (3) pay estimated taxes.

Tax Reform/Restructuring Provisions

The TCJA significantly raised the alternative minimum tax (AMT) income exemption amount and the income point where it starts to phase out. This greatly alters the outcome of the AMT calculation for many taxpayers. The new tax law also imposed a cap of $10,000 on the amount of state and local taxes (SALT) available for itemized deductions, and it eliminated personal exemptions.

What this means: It’s much less likely that you will trigger the AMT with an exercise-and-hold of incentive stock options (ISOs), and if you did you will be able to recover it with the AMT credit more quickly than before. At year-end, you want to assess whether to sell shares acquired from an ISO exercise earlier in the year. You evaluate whether to sell those shares to avoid the AMT or exercise more ISOs up to the income threshold that would trigger the AMT. Because of the changes in the AMT calculation under the TCJA, you now have much more room to exercise ISOs and hold the shares beyond the year of exercise without triggering the AMT.

The TCJA also raised the standard deduction to $12,000 for individuals and $24,000 for joint filers. On your tax return, you can either take the standard deduction or itemize.

What this means: If you are holding shares that have greatly appreciated in value, donations of company stock, whether directly to a charity or donor advised fund (DAF), can be a tax-efficient way to both make the donation and get you over the $12,000/$24,000 point where it makes sense to itemize. If you’re not always over that amount, you may want to consider bunching donations together in a single year to exceed it.

Taxes Should Not Control Decisions

Tax reform should not be the primary factor in decision-making at year-end. In fact, tax rates in general should never be the only reason for exercising options or selling shares, or waiting to do so, at the end of the year. Instead, make investment objectives and personal financial needs, not tax considerations, the driver of your decisions.

For more ideas on year-end planning for employee stock options, restricted stock/RSUs, performance shares, or an ESPP, see the year-end-planning section of myStockOptions.com.

What To Know About Tax Reform And What To Expect From The 'Tax Reform 2.0' Proposals

"Tax Reform 2.0" has hit the headlines, a month after this blog predicted a major buzz about followup tax cuts in the wake of the Tax Cuts and Jobs Act (see our related commentary, Tax Reform Developments: Making Provisions For Individuals Permanent; Capital Gains Indexing). Many of our talking points are now being echoed in the national news media, e.g. in The New York Times this week.

One of the most significant proposed tax cuts, the indexing of capital gains for inflation, is a long-recurring idea that has yet again been reintroduced. As explained in the tax-developments session at the recent myStockOptions financial-planning conference, capital gains indexing would routinely increase the cost basis of investments, such as company stock, for inflation. That would reduce the size of your taxable proceeds at sale, as only the inflation-adjusted capital gain would be taxed.

It must be acknowledged that the proposed additional tax cuts, especially if made by executive order, are politically controversial. As the NYT article bluntly puts it, the White House "is considering bypassing Congress to grant a $100 billion tax cut mainly to the wealthy, a legally tenuous maneuver that would cut capital gains taxation and fulfill a long-held ambition of many investors and conservatives." Nevertheless, the indexing of capital gains for inflation would, in particular, also make stock compensation more attractive for employees by reducing the amount of tax paid on the gains when shares are sold. It would, however, complicate the related brokerage recordkeeping, cost-basis calculation, and tax-return reporting. 

Tax-Reform Guidance At myStockOptions.com

After the Tax Cuts and Jobs Act, which took effect at the start of 2018, and with the current focus on more tax changes, tax planning remains at the forefront of public attention in the United States. Taxpayers remain concerned about the most effective ways to minimize taxes and prevent tax mistakes. This year the new tax law added potential confusion to the already complex arena of taxation for stock options, restricted stock, restricted stock units, ESPPs, and other forms of equity compensation.

The Tax Cuts and Jobs Act has several provisions that directly and indirectly affect equity compensation, whether in personal financial planning or in company stock plan administration. While the core tax treatment of stock compensation has not been altered, the new law's changes in the income tax brackets have a big impact on taxpayers who receive additional income during the tax year from an equity award or cash bonus.

At myStockOptions.com, the impact of tax reform on individuals is clearly explained in a variety of easily understandable content:

• Interactive quiz: Tax Cuts & Jobs Act

• Podcast: How Tax Reform Affects Your Stock Compensation And Financial Planning

• myStockOptions Blog: Tax Reform Developments: Making Provisions For Individuals Permanent; Capital Gains Indexing

• Article: Six Ways Tax Reform Affects Your Stock Compensation And Financial Planning

• FAQ: How does tax reform affect stock compensation?

• FAQ: Has recent legislation changed the taxation of incentive stock options (ISOs)?

• FAQ: How does tax reform affect restricted stock and RSUs?

• Article: Private Company Stock Options And RSUs: 10 Facts To Know About The New Tax-Deferral Opportunity

• Our patented calculators and modeling tools

"Tax reform affects financial planning for everyone, even strategies for estate planning and charitable giving," says Bruce Brumberg, the Editor-in-Chief of myStockOptions.com. "When you have stock compensation and holdings of company stock, you layer on an additional set of complex tax rules. With our content and tools, we help our site members and licensing clients make sense of it all."

Pro Membership: Crucial Edge For Advisors With Clients Who Have Equity Compensation

Beyond the Basic and Premium Memberships at our website, myStockOptions.com Pro is a special membership level for financial advisors, CPAs, and other professionals who have clients with stock compensation. It gives full access to the whole website plus special features in the tools, where advisors can track and model stock grants for multiple clients. Access to the vast library of content at myStockOptions.com puts answers to tough client questions right at the fingertips of advisors, who can create PDFs of crucial content with their logo on it for distribution to clients.

Tax Reform Developments: Making Provisions For Individuals Permanent; Capital Gains Indexing

The Tax Cuts and Jobs Act (TCJA) will be back in the news soon, as our editor-in-chief Bruce Brumberg predicted at our recent sold-out financial-planning conference. The provisions in the law that changed individual taxation and affect stock compensation are all scheduled to end after 2025 (see the article Six Ways Tax Reform Affects Your Stock Compensation And Financial Planning at myStockOptions.com). In 2026, the current tax law will revert to the 2017 rates and rules unless it is extended. Leading up to the November midterm elections, Republicans in the House of Representatives plan to vote on making the provisions permanent ("Tax Reform 2.0"), similar to the corporate tax changes. Kevin Brady (R–Texas), the House Ways & Means Committee Chairman, plans to distribute a draft of a second tax package after the July 4 recess, release the "legislative outline" in early August, and hold a vote on it during the fall, as reported by The Hill. Republicans are attempting to make this a campaign issue in the midterm elections and see it as a way to highlight their legislative achievement in the TCJA.

The legislation may also include some favorable tax changes related to retirement plans and may increase the amount of tax-free benefits companies can provide for education assistance and student-loan repayment, according to the Society for Human Resource Management. While the bill is likely to pass the House, efforts to make the individual tax cuts permanent stand little chance in the Senate, given that 60 votes would be needed to enact it. The Senate will not use the procedure that allowed the TCJA to pass with a simple majority and will instead require the 60 votes needed to stop a filibuster.

Capital Gains Indexing

The indexing of capital gains for inflation is a long-recurring idea that has been recently reintroduced. As explained at the tax-developments session at the recent myStockOptions financial-planning conference, capital gains indexing would routinely increase the cost basis of investments, such as company stock, for inflation. This would reduce the size of your taxable proceeds at sale, as only the inflation-adjusted capital gain would be taxed.

Example: Imagine restricted stock units (RSUs) vested when the stock price was $20 per share, or you bought company stock in the open market at that price. 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 at $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.

The concept of capital gains indexing has been around for a while, as shown in a report issued by the Congressional Budget Office back in 1990, when long-term capital gains did not have preferential tax rates. It seems likely to be part of the "Tax Reform 2.0" provisions for several reasons: Brady mentioned it; the Capital Gains Inflation Relief Act of 2018, recently introduced in the Senate, seeks to make this the tax treatment for assets held at least three years; and similar legislation was introduced in 2006 by the current vice president when he was in Congress.

What is increasing the likelihood of capital gains indexing is that Larry Kudlow, the new national economic advisor at the White House, is a big supporter of it (see an article he wrote). In addition, it's been reported that the president is considering an executive order that would require the Treasury Department to issue new regulations that index the capital gains cost basis for inflation. This route to a tax change would be controversial, as it would have a budgetary impact and would probably be perceived as yet another tax break for the wealthy (see an analysis by the Wharton School at the University of Pennsylvania). Nevertheless, capital gains indexing was considered by some past presidents, as noted in an article from Bloomberg. The regulatory issue is whether the definition of "cost" in Internal Revenue Code Section 1012 is vague enough to allow for interpretation through new rules. Should that happen, it will have a disruptive effect on many financial-planning strategies, though it could make stock compensation even more attractive.

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.

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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 Trump/GOP Tax-Reform Framework: What It Means For Stock Compensation

Last week the Trump administration and Republican leaders in Congress released an outline of a joint framework for tax reform. It leaves many decisions and details for Congress to work out. While nothing in the proposals specifically affects stock compensation, various provisions could make equity comp more or less attractive, or make plans harder or easier to administer.

As the myStockOptions.com blog pointed out in April, when President Trump released a one-page outline of tax-reform principles, the proposed changes that are likely to have an indirect impact on stock compensation include:

• simplification of individual income-tax rates
• elimination of the AMT
• elimination of the estate tax

Notably, the framework proposes to give Congress the prerogative to create a higher top income tax rate for the wealthiest individuals, in addition to the three tax rates presented. That would almost certainly apply to executives with stock compensation. Perhaps the current top income-tax rate of 39.6% will remain.

The framework implies that Congress would eliminate various unstated corporate tax benefits to help pay for the reduction of individual taxes. Some deductions related to stock compensation could be on the radar. For example, one oft-mentioned tax provision which is ripe for elimination is the performance-based exception that removes the limitation on the corporate tax deduction under IRC Section 162(m).

For more on the recent tax-reform framework, how it could impact stock compensation, and links to law, accounting, and consulting firm memos about it, see an FAQ on myStockOptions.com.

Obamacare Repeal And Replacement, Take Two: Impact On Stock Compensation

Repealing and replacing the Affordable Care Act (Obamacare) has become a top priority for the Trump administration and the Republican-controlled Congress. This controversial desideratum appears to be a higher priority than the general tax reform proposed by the president (discussed in an article on myStockOptions.com).

Earlier this month, the House of Representatives passed the American Health Care Act (AHCA), its second attempt to repeal and replace Obamacare (the first effort failed in March). To be enacted, the legislation must still be adopted by the Senate, where changes are expected. For details on the bill, see a special report from CCH.

The AHCA would eliminate the Net Investment Income Tax: a 3.8% Medicare surtax on investment income, including capital gains, dividends, and interest. Meanwhile, an amendment to the House bill would delay until 2023 the repeal of the Additional Medicare Tax (0.9%) on ordinary income (see Sections 213 and 251). Those taxes currently apply to everyone with yearly modified adjusted gross income (MAGI) of more than $200,000 (individuals) or $250,000 (married joint filers). The AHCA would also eliminate the $500,000 limit on the corporate deductibility of compensation for officers, directors, and employees at health insurers.

The important debate over health care and public policy raised by the Obamacare repeal is beyond the scope of myStockOptions.com. It is our role, however, to acknowledge the effect that the law's repeal would have on the taxation of stock compensation.

Impact On Withholding For Stock Compensation

As explained in detail by an FAQ on myStockOptions.com, the tax provisions in question both directly and indirectly affect stock plans and individual tax planning, so you will want to follow the related developments. Currently, under the associated IRS guidelines (starting at Question 33), companies must withhold the 0.9% additional Medicare tax on any type of pay, including that from stock compensation (e.g. NQSO exercise or RSU vesting), when an employee's wages for the year are more than $200,000. While the legislation would remove that requirement, it would not do so until after 2022.

Impact On Tax Planning With Stock Compensation

The 3.8% Medicare surtax on investment income also can be triggered by stock compensation (though you pay the surtax with your tax return rather than through withholding). For example, an exercise of nonqualified stock options or a vesting of RSUs could push your MAGI over the related income thresholds. If you were to sell shares in the same year, your income would then trigger the 3.8% surtax on top of the capital gains tax (15% or 20%) on the investment income from the stock sale. We have found that people with stock comp and their financial advisors often develop strategies to avoid the surtax. If it is eliminated, that planning concern would go away.