The American Taxpayer Relief Act of 2012, which took effect at the start of 2013, does not have any provisions that directly relate to stock compensation, though increases in the rates on income tax, capital gains, and dividends indirectly affect the value of grants and the related tax planning. The following changes in tax rates apply to income from stock option exercises, restricted stock and RSU vesting, ESPP purchases, sales of stock, and dividends. (See related FAQs that show the taxes and withholding rates for various types of equity awards.)
- The top federal withholding rate on supplemental income rose to 39.6%. Supplemental income, such as stock compensation, is subject to one of two flat rates that are linked to income tax rates. For aggregate supplemental wage payments totaling up to $1 million during the year, the rate is 25% (the rate of the third income tax bracket). For aggregate supplemental wage payments that exceed the level of $1 million in a calendar year, the rate is now 39.6% (the new rate of the highest income tax bracket).
- The Social Security rate returned to 6.2% after a temporary cut to 4.2% in 2011 and 2012, as the new tax law did not extend the reduction in payroll tax. Social Security tax applies up to a certain amount of yearly income ($118,500 in 2015 and again in 2016) and not to yearly income above that threshold.
- The capital gains tax rate that applies to the proceeds from a stock sale increased to 20% for people whose yearly taxable income exceeds a certain amount. In 2015, the thresholds are $413,200 for single filers and $464,850 for married joint filers. (In 2014, the thresholds were $406,750 for single filers and $457,600 for married joint filers. In 2013, they were $400,000 and $450,000.) For taxpayers whose yearly taxable income is below these thresholds, the top rate of capital gains tax remains 15%. The tax rate on dividends grew to 20% for these same taxpayers. This applies to any qualified dividends received on company stock you own or on unvested restricted stock for which you have filed a Section 83(b) election. (For taxpayers whose yearly taxable income is below these thresholds, the top tax rate on qualified dividends remains 15%.)
- For people with incentive stock options, the new tax law indexed the income exemption amounts (commonly known as the "AMT patch") for calculating the alternative minimum tax. Additionally, the new tax law indexed the annual AMT income exemption amounts permanently for inflation and made two other important changes. The legislation did not extend the refundable AMT credit that was available for the tax years 2007 through 2012.
- For qualified small business stock issued before the end of 2014, 100% of the gains are excludable from capital gains tax (0% rate) and omitted from the AMT calculation. This provision is retroactive to September 27, 2010. The exclusion helps anyone buying stock in a small privately held company, including stock from an option exercise or restricted stock vesting.
- Separately from the American Taxpayer Relief Act, in 2012 the Affordable Care Act increased the Medicare tax rate on compensation income for high-income taxpayers from 1.45% to 2.35%, and a new 3.8% Medicare surtax now applies to investment income, such as capital gains from stock sales. Both of these tax changes became effective on January 1, 2013.
For high-income taxpayers, the new income thresholds for increased tax rates, the new Medicare taxes, and the return of exemption/itemized deduction phaseouts will make it more appealing to:
- defer income into the future with restricted stock units and performance share units that allow the deferral of share delivery (see a related FAQ)
- defer salary and bonus in nonqualified deferred compensation plans
- receive stock options, as options offer the ability to time the year for recognizing income, depending on when you exercise them
These approaches focus on two planning goals: (1) keeping your yearly income under the thresholds for higher tax rates and (2) recognizing income at a future time when your yearly income and tax rates will, you believe, be lower.
For people in the highest tax bracket, the tax advantages of ISOs over NQSOs have been slightly reduced, as the spread between the highest ordinary income rate and the capital gains rate (plus the 3.8% Medicare surtax) is now 15.8% (39.6% – 23.8%). This is less than the previous spread of 20% (35% – 15%). However, the larger gap between the higher top ordinary income rate and the top AMT rate (still 28%) makes it less likely that individuals in the 39.6% bracket will trigger the AMT from an ISO exercise/hold.
Details of planning strategies and ideas related to the American Taxpayer Relief Act, and other tax changes, are discussed in various articles on myStockOptions.com.