UPDATES! 4 Ways Biden's Tax Proposals Could Affect Stock Comp Financial Planning
Editor's Note: This article was written before the developments in tax legislation that unfolded in Congress in the fall of 2021. For the latest updates, see the section at the end of this article.
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 an increase 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.
For updates on the possibility of new tax laws, see the section at the end of this article.
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 a related article).
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 the proposed 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.
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.
The final version of the infrastructure bill, known as the Infrastructure Investment and Jobs Act, has "relatively few tax provisions," according to article in the Journal of Accountancy, which also notes that more extensive tax changes may still occur in the near future. It reports Congress is considering a fiscal-year-2022 budget reconciliation bill that includes provisions related to corporate and international tax.
Proposed tax changes that could affect equity compensation or company stock holdings, whether directly or indirectly, are explained in:
- Proposed Minimum Tax On Book Income Would Hit Stock-Based Compensation (Tax Foundation)
- House Ways & Means Proposes Accelerating Changes To Section 162(m) (Shearman & Sterling)
- Biden’s QSBS Tax Plan Would Have Unintended Consequences For Startups (Techcrunch)
- Wyden's Billionaires Tax (Cadwalader)
The Biden administration's separate "Build Back Better" bill has spending provisions reported to cost $1.75 trillion over 10 years, along with revenue offsets believed to add up to nearly $2 trillion over the same period. According to an update from PwC, the bill's revised version appears to have abandoned key tax-rate-increase provisions of the initial Ways and Means bill. Those included raising the top rate of individual income tax from 37% to 39.6% and a new 25% rate for long-term capital gains and qualified dividends. If the top rate of income tax does go up, that will also raise the rate used for supplemental income withholding on equity compensation for yearly amounts over $1 million, as the two are tied together.
The revised bill does have a new surtax on very high-income individuals, starting with modified adjusted gross income in excess of $10 million ($5 million for a married individual filing separately). This would apply to sales of stock acquired from equity compensation. Whatever is adopted could encourage executives and employees to sell before year-end. However, as an article elsewhere on this website explains, experts often recommend that tax rates should never be the only reason for exercising options or selling shares, or waiting to do so, at the end of the year. They suggest that investment objectives and personal financial needs, not taxes, should be the primary driver of decisions.
The Build Back Better Act that the House passed on November 19 does include provisions for:
- imposing a surtax of up to 8% on the very wealthy
- allowing SALT (property and state tax) deductions up to $80,000
- limiting qualified small business stock (QSBS) income exclusions to 50% for sales after September 13, 2021
For details, see The Build Back Better Act: Understanding The House Act from The Northern Trust Institute.