NEW! Six Ways Tax Reform Affects 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 tax reform on individual taxation and stock compensation. For more interviews with experts, see our podcasts page.
After reading this article, test your knowledge with a fun, interactive quiz on tax reform
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 has not changed. Detailed below are six provisions that affect in some way the taxation of stock compensation or holdings of company stock. The changes in the income tax rates, AMT, and estate tax end after 2025, when they will revert to the current rates and rules, unless they are extended or made permanent.
Alert: See the year-end section of this website for ways in which the tax changes affect planning strategies in the last few months of 2018.
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%, with the top bracket starting at $600,000 for joint filers ($500,000 for single filers). 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.
|RATE||TAXABLE INCOME (SINGLE)||TAXABLE INCOME (JOINT)|
|10%||$0 to $9,525||$0 to $19,050|
|12%||$9,526 to $38,700||$19,051 to $77,400|
|22%||$38,701 to $82,500||$77,401 to $165,000|
|24%||$82,501 to $157,500||$165,001 to $315,000|
|32%||$157,501 to $200,000||$315,001 to $400,000|
|35%||$200,001 to $500,000||$400,001 to $600,000|
|37%||Over $500,000||Over $600,000|
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 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.
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 (15% And 20%)
The reduction in 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 is no change in the long-term capital gains rates, the tax law created a new inflation-indexed income threshold above which the rate on long-term capital gains and qualified dividends goes from 15% to 20% (over $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, many Republican legislators still want to repeal the 3.8% Medicare surtax on investment income, which continues to affect tax planning. It is paid by high-income taxpayers to fund Obamacare. The new tax law simply repeals the penalty for not buying health insurance.
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). An exemption applies to compensation paid under 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 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 doubled the estate, gift, and generation-skipping transfer (GST) tax exemption to $11.18 million ($22.36 million for married couples), with future yearly increases for inflation (though the exemption may revert to its pre-2018 level after 2025). 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.
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 compensation. 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.