Editor's Note: Although this article was written in 2003, it has been updated for new developments since then, and its concepts and summary of the 2003 tax law still apply. In December 2010, the 2010 Tax Relief Act extended the Bush tax cuts yet again, this time through 2012.
The Bush administration's 2003 tax cuts and later extensions (through 2012) contain no provisions that deal directly with employee stock options or restricted stock. But several of the provisions affect tax strategies for NQSOs, ISOs, and restricted stock. A companion pair of articles and FAQs address the impact of dividends on employees with options and restricted stock and discuss the applicable tax rate.
Tax-Bracket Changes
Review Of Past Tax Laws That Still Apply Now
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All the tax brackets above 15% are lower, reducing your absolute tax dollars. |
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The 2003 law is rooted in the tax changes of 2001, which implemented lower tax rates in stages. Marginal tax rates for the 28% and higher brackets decreased by 1% on July 1, 2001, and were scheduled to fall again in 2004 and 2006 before they were accelerated by the 2003 tax cut. The automatic flat withholding rate on NQSO exercises and restricted stock vesting (i.e. supplemental income) dropped along with the changes to the 28% tax bracket, making it 25% under the 2003 tax cut.
Editor's Note: From January 1, 2005, the American Jobs Creation Act of 2004 made the flat rate 35% for aggregate amounts of supplemental income in excess of $1 million during any tax year.
2003 Law
Income-tax rates at the end of 2002 were 10%, 15%, 27%, 30%, 35%, and 38.6%. The 2003 law accelerated the 2004 and 2006 cuts, reducing the rates above 15% to 25%, 28%, 33%, and 35%, respectively. If you were in the 27% bracket, the marginal-bracket changes save you 2%, or $20 of tax on every $1,000 of income. If you had $50,000 of option income, for instance, your savings would be roughly $1,000.
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2001 RATES |
RATES 2003–2012 |
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10% |
10% |
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15% |
15% |
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27% |
25% |
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30% |
28% |
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35% |
33% |
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38.6% |
35% |
On top of this acceleration in the brackets, the 2003 law made several changes to the tax brackets and standard deductions for married couples who file jointly. Congress has continued to extend and expand such measures to eliminate the "marriage penalty" before income phaseouts.
Impacts On Optionholders
Everyone who is at least in the 15% tax bracket can take advantage of the tax changes mentioned above. All the tax brackets are lower, reducing your absolute tax dollars. It is important to remember that in higher brackets part of your income is taxed at your marginal bracket, and the rest of your income is taxed at each bracket below yours. For example, even if you are in the top 35% bracket, you will take advantage of the expanded 10% and 15% brackets.
You see more impact at the extremes: someone in the 15% bracket who jumps in option income experiences a smaller incremental hit. Someone who springs to the highest bracket from a middle bracket also sees a smaller increase. For example, if you were a 30% taxpayer with substantial extra option income in 2002, you would have jumped 8.6% to the 38.6% top rate; under the 2003 law and its extensions, you see a smaller 7% marginal tax increase, from 28% to 35%.
Less Reason To Defer Exercise
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Provisions in the 2003 law and its extensions govern the long-term capital gains tax and the dividend tax. |
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The 2001 tax law dropped marginal rates in 2004 and 2006. With its extensions, the 2003 law locks in these marginal tax through 2012, so you no longer have this immediate incentive to defer option exercises. (See the article series on strategies for handling tax increases, now possible in 2013, for NQSOs, ISOs, and restricted stock.
More Gains Mean Less Tax
Other changes that may affect optionholders even more are the reduction in long-term capital gains tax from 20% to 15% (for the 10% and 15% income-tax brackets, the capital gains rate is 0% through 2012). The tax cut on dividends was even more dramatic (see the related articles). Dividends were taxed as income, at rates up to 35%. The 2003 tax cut dropped the tax on most dividends to 15%. Short-term capital gains and interest continue to be taxed as income.
The 25% reduction in the top rate of capital gains tax, from 20% to 15%, may encourage employees who hold shares of company stock with an unrealized capital gain to bite the tax bullet and go ahead and diversify. The reduction in long-term capital gains taxes makes it much cheaper to sell the stock. On the other hand, it may encourage other optionholders to exercise and hold more shares of their stock.
ISO Regular Tax Advantage Increased
ISOs qualify for special tax treatment when you exercise and hold the shares two years from grant and one year from exercise. When you do, the entire spread between the exercise price and the sale price is long-term capital gain. The advantage of ISOs comes from the fact that capital gains tax rates, now 15%, are lower than income tax rates.
The 2003 tax law reduced capital gains tax by 5%, from 20% to 15% for most optionholders. That's larger than the 2% to 3.6% reductions in marginal rates. At top income levels, capital gains are less than half the 35% tax rate on income.
Example: You were granted 1,000 ISOs at $10 each, and the stock price today is $30. If you exercise and sell now, you will have additional income of $20,000 [($30 - $10) x 1,000]. Assuming you're in the 25% tax bracket, you will owe an additional $5,000 in tax (0.25 x $20,000). If instead you exercise and hold for a year, and the stock price stays the same, you will owe just $3,000 (0.15 x $20,000) in capital gains tax, for $2,000 in tax savings. Now look at your risk over the next year. You are holding 1,000 shares. A drop of $2 is roughly equivalent to the $2,000 tax savings.
Under the 2001 law, you would have been in the 27% income-tax bracket, and you would have owed $5,400 tax if you did an exercise and simultaneous sale, or $4,000 in tax for the exercise and hold, for a $1,400 savings. You can see that in either exercise scenario you are better off under the 2003 law.
The conclusion is that for anyone who is not affected by the alternative minimum tax, the reduced capital gains tax rates make exercising and holding shares for long-term capital gains treatment more attractive than before.
ISO Exercise And Sell
As the example shows, the 2003 tax law also eases the tax bite if you do an exercise and immediate sell for ISOs, just as it does for NQSO. The tax bite is lessened as well if you exercise and later do a disqualifying disposition, also triggering ordinary income.
ISOs And Alternative Minimum Tax
AMT Basics
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The 2003 tax law made one direct change to the AMT system that pushes AMT down. |
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Remember the general rule about alternative minimum tax (AMT): you figure your taxes both in the regular tax system and in the AMT system, and you pay the higher of the two.
The provisions described above that reduce regular taxes for a certain level of taxable income tend to expose more people to AMT. Therefore, if the 2003 tax law and extensions push your regular tax down but do not push the AMT down, you are more likely to owe AMT. This is the down side of decreases in the tax brackets. (To explore general guidelines for assessing when AMT may hit you, see a related FAQ.)
Small Change In AMT Exemption Amount
Since 2003, there has been one direct change to the AMT system that pushes AMT down. Under the AMT system an income exemption replaces the personal exemptions and standard deductions from the regular tax system. The temporary AMT income exemption amounts for 2011 were $74,450 for married joint filers and $48,450 for single filers. (The AMTI exemption amounts for 2012 have not yet been determined and will probably not be set until late in the year, after the presidential election.)
Taxpayers who have very high incomes see no effective AMT reduction. The AMT income exemption amount is phased out for high-income individuals by 25 cents for every dollar of AMTI over specified thresholds. For joint filers, this phaseout range starts at $150,000 of AMT income; for single filers, the phaseout starts at $112,500. For the tax year 2011, the exemption was fully phased out (i.e. was zero) when AMTI equaled or exceeded $447,801 for joint filers and $302,301 for single filers.
AMT Credit
When you pay AMT that is triggered by exercising and holding ISOs, or for certain other adjustments, you get an AMT credit. This makes AMT a "prepaid tax" that you can get back in the future. You hope that in future years your AMT will be lower than your regular tax. If so, you use the credit to reduce the regular tax to the level of the AMT bill for that year, carrying forward any unused amount of credit. See a related FAQ.
AMT Credit Recovery Now More Difficult
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ISOs are now more attractive when you aren't subject to AMT. But when you are, credit recovery is harder. |
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Even with the new provisions for using refundable credits (see the alert below), three things still make AMT credit recovery more difficult under the 2003 tax law.
First, when you pay AMT with ISOs, the primary method of AMT credit recovery comes from selling the stock you have held for more than a year. The AMT and regular tax long-term capital gains rate is now 15%, down from 20%. For regular tax, you pay long-term capital gains on the amount the stock sales price exceeds your grant price. AMT capital gains is computed from the difference between the stock's sales price and its fair market price when you exercised (which will be equal to or higher than the grant price).
Thus the long-term gain will usually be larger for regular tax than for AMT, and the capital gains tax will be higher for regular tax than for AMT. This gap allows you to reclaim the difference from your AMT credit. As the capital gains rates are smaller now, there is less tax to offset the AMT credit, and AMT credit recovery is more difficult.
The second factor to consider comes from the lower regular tax rates. In years when you do not sell ISO stock, AMT recovery is also more difficult than it was under the 2001 tax law. With the AMT marginal rates of 26% and 28% very similar to the 2003 law's regular income tax rates of 25%, 28%, 33%, and 35%, regular tax is pushed down towards, or lower than, AMT. This leaves less "cushion" between them, and it is the cushion that is used to reclaim the AMT credit.
Editor's Alert: When you are in this exemption phaseout zone, your effective AMT rate is higher than 26% or 28% (it can be as high as 35%), and your effective capital gains rate can be as high as 22%, even though the top rate is 15% (see an article at the blog The Finance Buff).
The third factor to consider is the future uncertainty of AMT. So far, there have been only short-term bandages and no effective attempts at AMT reform. Without an AMT change, the number of taxpayers exposed to AMT across the country will dramatically increase, and full AMT credit recovery may be impossible for many people (for ideas on minimizing the AMT, see a popular FAQ and another FAQ on planning when you cannot avoid the AMT).
ISO Exercise And Sell Causing AMT
You may be surprised to find that if you exercise and sell your ISOs (treating them as NQSOs), you will draw the AMT anyway. This is particularly true if your income as a married taxpayer is between $150,000 and $500,000. This is not because of the special tax treatment that is normally associated with ISOs but simply because AMT is catching more people.
When the AMT is triggered by regular income, and not by the special tax-adjustment item for the ISO exercise/hold or for other items that let you defer reporting income, no AMT credit is generated. You face an extra tax and not a prepaid tax that you have a chance of recovering later. If you are going to draw the AMT from exercising and selling your ISOs immediately, you may prefer to exercise and hold at least some shares to sell later in a qualifying disposition. Waiting to sell some shares may not change the total tax that is due in the year you exercise, but you have at least a possibility of recovering part of the tax later. The increased likelihood of AMT is another reason to do a tax projection before you do an option exercise.
ISO Summary
The 2003 tax law, now extended at least through 2012 by the 2010 Tax Relief Act, makes ISOs more attractive in years when you are not subject to the AMT. Everyone is now more likely to trigger the AMT, even without an ISO exercise and sale and thus without a companion AMT credit. If the traditional ISO exercise/hold does push you into the AMT, you do get an AMT credit, but the lower rates on ordinary income make AMT credit recovery more difficult.
Overall, ISOs have become more complex. A suggestion might be to do a two-year tax projection, both assuming you exercised and sold and assuming you exercised and held. At the end of the second year, look at the net investment wealth, total taxes paid, and AMT credit available.
State Taxes
All these changes occurred in the federal tax system. Depending on the tax policy in your state, you may either enjoy full advantages of the changes or experience a muted effect. Some states tax long-term capital gains as income, without a special lower rate. Many states tax dividends as income, at the full income-tax rate. In a state with 7.5% tax rates, the state tax is half the long-term capital gains tax or dividend tax.
To the extent that states and local districts raise taxes, the advantages of lower federal taxes will be further muted. The overall exposure to federal AMT will rise, as state and local taxes, including property taxes, are deductible under the regular tax system but not under the AMT system.
Tom Davison is a financial advisor at Summit Financial Strategies in Columbus, Ohio. He regularly counsels individuals who have stock options and equity compensation. This article was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.
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