6 Ways The 2018 Tax Reforms Affect Your Stock Compensation And Financial Planning
Podcast included: In addition to reading this article, listen to our engaging interview with securities and tax attorney Arthur Myers, who explains the impact of the Tax Cuts & Jobs Act on individual taxation and stock compensation. For more interviews with experts, see our podcasts page.
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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 an interactive version of the legislation from the law firm Davis Polk.)
The core tax treatment of stock compensation did not change under the TCJA. Detailed below are six provisions that affect in some way the taxation of stock compensation or holdings of company stock.
Alert: The individual tax rates and AMT changes started in 2018 and will end after 2025, when they will revert to the 2017 rates unless they are extended.
1. Changes In The Rates Of Individual Income Tax
The Tax Cuts & Jobs Act keeps the current seven income tax brackets, reducing the rates and changing the income thresholds that apply. The rates are now 10%, 12%, 22%, 24%, 32%, 35%, and 37%. This means you have lower rates for compensation income, interest, ordinary dividends, and short-term capital gains.
The flat supplemental wage rate for 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%).
As shown by the table below, the 22% rate of withholding may not cover the actual taxes you will owe on the additional taxable income from stock compensation. You must therefore know the tax bracket for your total income and assess the need to put money aside or pay estimated taxes.
Income Tax Brackets And Rates In 2023
|Income tax rate||Single filers||Married joint filers|
|10%||$0 to $11,000||$0 to $22,000|
|12%||$11,000 to $44,725||$22,000 to $89,450|
|22%||$44,725 to $95,375||$89,450 to $190,750|
|24%||$95,375 to $182,100||$190,750 to $364,200|
|32%||$182,100 to $231,250||$364,200 to $462,500|
|35%||$231,250 to $578,125||$462,500 to $693,750|
|37%||$578,125 or more||$693,750 or more|
For stock compensation, multi-year planning remains useful to minimize when the added income pushes you into a higher tax bracket.
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 current numbers in the AMT calculation (adjusted annually for inflation).
2023 AMT income exemption amounts, phaseouts, and rate thresholds
|Filer status in 2023||AMT income exemption amount||Exemption amount phaseout starts||Exemption amount phaseout ends||Point where rate
26% to 28%
(married filing separately: $110,350)
For comparison, in 2017 (before the TCJA) the AMT figures were much lower:
- The AMT income exemption amount was $54,300 for single filers and $84,500 for married joint filers.
- The AMT income exemption started to phase out at $120,700 for individuals and $160,900 for married couples.
Under the TCJA, the higher AMT income exemption amounts and 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.
Alert: When you are deciding whether to exercise ISOs and hold the shares, you still want to determine whether the difference between your long-term capital gains rate and your short-term capital gains rate (same as your income tax rate) justifies the risk of holding shares for a qualifying disposition. That you don't have to pay the pesky AMT should not, on its own, be the determining factor in your ISO strategy.
3. No Change In The Long-Term Capital Gains Rates (0%, 15%, 20%)
The reduction in the ordinary income rates, which apply to short-term capital gains, lowers the difference between your short-term and long-term capital gains rates. This reduced differential may affect your tax-planning decisions, e.g. whether to hold or sell shares at exercise, vesting, or purchase.
While there was no change in the long-term capital gains rates, the tax law created new inflation-indexed taxable income thresholds above which the rate on long-term capital gains and qualified dividends goes from 0% to 15% and 15% to 20%. These thresholds no longer line up with federal income tax brackets. In 2023, the 20% capital gains rate applies to single taxpayers with yearly income of more than $492,300 and married joint filers with yearly income of more than $553,850.
4. 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 (see the related FAQ for details). Once you qualify as a "covered employee" for purposes of this deduction limit, you will always be treated as a covered employee who is subject to the deduction limit in subsequent years, including during retirement. An exemption applies to compensation paid under binding written plans existing as of November 2, 2017, as long as the plan is not modified.
While this repeal does not affect your personal taxes and financial planning, it may cause companies to change the features in future stock grants and cash bonuses, and it reduces the incentive for companies to favor one type of equity award over another. For example, before the TCJA, companies often granted awards with performance-based vesting (as opposed to time-based vesting) merely to get a tax deduction, but now they no longer have that motivation.
5. 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 income for federal tax purposes at NQSO exercise or RSU vesting for up to five years as long as the company's equity awards meet certain conditions. It is too soon to fully evaluate the advantages this type of grant may have over early-exercise stock options. For details on the provision, see our article about this new type of equity award.
6. Increases In The Exemptions For Estate Tax And Gift Tax
The TCJA greatly increased the estate, gift, and generation-skipping transfer (GST) tax exemption, with yearly increases for inflation (though the exemption may revert to its pre-2018 level after 2025). In 2023, the exemption is $12.92 million for unmarried taxpayers and $25.84 million for married taxpayers. This affects wealth-transfer strategies for estate planning and gifting for employees who are lucky enough to have become very wealthy from company stock. The stock and other assets held at death, you still get a step-up in basis to their fair market value as of the date of death.
For more details on the TCJA, see the additional resources listed at the end of the FAQ on tax reform elsewhere on myStockOptions.com. They include summaries and commentaries from law, accounting, and compensation consulting firms.
Outlook For The Future
Tax rates should never be the only planning consideration for stock compensation and company shares. Instead, you may want to let investment objectives and personal financial needs, not tax considerations, drive your financial planning and use of stock compensation to fund key life events.
In the long term, your company's stock price, not taxation, is likely to be the most crucial factor in the value of your equity comp. When a stock price falls after grant or becomes excessively volatile, equity grants tend to lose their perceived value (even if stock options do not actually go underwater). Therefore, if stock prices continue to perform well, it is expected that stock compensation, ESPPs, and employee ownership will continue to thrive.