UPDATES! How The Trump Presidency And Tax Reform May Affect Stock Compensation
In numerous ways, the presidency of Donald Trump may affect equity compensation and employee ownership. Most immediately, potential tax changes under the Republican president and the Republican-controlled Congress in 2017 or 2018 may have a meaningful impact on stock compensation.
Tax Reform: Proposed Legislation Contains Opportunities And Surprises For Stock Compensation
In September 2017, the Trump administration and Republican leaders in Congress outlined their joint framework for tax reform that left many decisions and details for Congress to work out. In November 2017, both the House of Representatives and the Senate prepared their own tax bills. The House and Senate bills have provisions that directly and indirectly affect stock compensation, whether in personal financial planning or in company stock plan administration. They are summarized in the following paragraphs. Over the weeks ahead, these are the provisions to follow as they go through the legislative process.
Alert: On Nov. 16, the House of Representatives passed the Tax Cuts & Jobs Act. The Senate passed its own tax bill on December 2. The next step will be a conference committee with the House to work out differences in the provisions.
1. Simplification of individual income-tax rates. For example, the House bill proposes to shift from the current seven tax brackets to new brackets with rates of 12%, 25%, 35% (the Senate bill keeps seven brackets but changes the rates). Additionally, under the House bill the current top tax rate of 39.6% would continue, though with a higher income threshold (over $1 million for married joint filers and $500,000 for unmarried individuals and married individuals filing separately). The Senate bill would set the top rate at 38.5%. How changes in income-tax rates would tie into the flat supplemental rate of withholding on stock compensation is unclear and would need clarification, as the structure of the rate is based on the current seven brackets.
2. No change the capital gains rates (15% and 20%). A reduction in ordinary income rates would lower the difference between your income tax rate and your capital gains rate. This reduced differential might affect your tax-planning decisions, e.g. whether to hold shares at exercise, vesting, or purchase. Neither bill in Congress would change the capital gains rates. However, the House bill seeks to create a new income threshold for the 20% rate that is slightly above the current threshold for the 36% income-tax bracket ($479,000 for married joint filers and $425,800 for single taxpayers).
Furthermore, while Trump and the Republican Congress do not seek to alter the capital gains rates themselves, they do want to repeal the 3.8% Medicare surtax on investment income, including stock sales, that is paid by high-income taxpayers to fund Obamacare. The Medicare surtax is also targeted for elimination by the separate legislation to repeal and replace Obamacare.
3. Repeal of the alternative minimum tax? Among those who receive grants of incentive stock options (ISOs), much rejoicing would occur if the alternative minimum tax (AMT) were repealed. Currently, the income spread at ISO exercise can trigger the AMT, which warrants complex tax planning.Alert: As reported by The New York Times on Dec. 1, the Senate bill was amended to increase the AMT income exemption amounts and does not seek to eliminate the AMT.
What would pay for the end of the AMT is the elimination of 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 can trigger the AMT. Strangely enough, if they are eliminated along with the AMT, taxpayers with ISOs may actually see less tax savings than they might otherwise expect to get from the AMT repeal.
4. Elimination of the estate tax. The termination of the estate tax would end any need for most of the current gifting strategies for company stock, including those involving transferable stock options. The tax-reform legislation in the House proposes the eventual elimination of the estate tax, along with large increases in the related exemption until then (see a commentary on this from the law firm Nixon Peabody). The Senate version just doubles the current exclusion amount. However, estate-tax repeal might also end the step-up in the basis of investments, such as company stock, that currently occurs with a deceased person's holdings. This could eventually become a feature of the final tax legislation as a way to increase revenue to pay for other tax cuts, though it is not currently. If so, that would create the need for other estate-planning strategies.
5. The performance-based exception to the Section 162(m) limit on deductible compensation would be repealed. Publicly traded companies would 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.
6. The Empowering Employees Through Stock Ownership Act could become part of the final legislation. That legislation, which passed in the House in 2016 but was not voted on in the Senate, sought to allow an employee in a privately held company to defer taxes at option exercise or RSU vesting for up to seven years as long as the company's equity awards met certain conditions. The tax bill passed by the House of Representatives on Nov. 16 (the Tax Cuts & Jobs Act) includes the provision but reduces that deferral period to five years.
7. Cost basis of securities. The Senate bill eliminates the ability to specifically identify stock for purposes of determining gains and losses, providing instead that stock will be considered to be sold on a "first in, first out" (FIFO) basis. That could lead to unintended ESPP or ISO disqualifying dispositions if you have multiple lots of company stock and a sale pulls shares you intended to hold to get favorable tax treatment. Under the current rules, while the default order is automatically FIFO, changes are allowed up to the settlement date.
8. Under proposals initially made in both the House and the Senate bills but later dropped, stock and nonqualified deferred compensation (NQDC) would have become taxable once there is no longer a substantial risk of forfeiture. This would have been a major change. Under IRC Section 409A, tax is deferred until the income, e.g. deferred salary or a deferred bonus, is distributed (see myNQDC.com, our sibling website on NQDC plans). Stock options and stock appreciation rights were getting caught up in the definition of NQDC. If this had happened in the final bill, it would have led to taxation at vesting! Taxation would also no longer have been delayed for RSUs that defer share delivery or for any grant with special retirement-eligibility provisions.
In its Tax Cuts & Jobs Act, the House dropped the provision (Section 3801) that would have imposed the changes described above for NQDC and equity compensation. The amendment making this change was issued on November 9. (See also an alert from FW Cook.) The Senate's tax-reform bill initially introduced a similar provision, but it too was dropped in alignment with the House version (see an alert from the law firm Fenwick & West).
How Do Trump And His Supporters View Stock Compensation?
What is the president's own attitude toward stock compensation? Does he have one?
To get a sense of Trump's views on stock comp, the myStockOptions staff did some in-depth research into SEC filings made by him and his companies. In 1995, the board of Trump Hotels & Casino Resorts adopted what it called its 1995 Stock Incentive Plan, which it amended in 1996 to increase the number of authorized shares it could issue (see pages 20–22 of the company's 1996 proxy statement). Trump himself received 500,000 stock options per year between 2000 and 2002 (see the tables, text, and footnotes on pages 16–18 of the company's 2003 proxy statement). Later, when Trump was chairman of the board at Trump Entertainment Resorts, the company adopted a stock plan at its 2005 annual meeting as part of its reorganization, and it canceled its prior plan and all of the grants made under it (see Proposal 3 on page 35–41 and Annex A of the company's 2005 proxy statement).
Like other senior executives, Trump had to file Form 4 with the SEC to report his grants under the rules of Section 16 (see, for example, the reporting of his 2002 grant). Therefore, we can assume that Trump is familiar with stock options and restricted stock, though his company's subsequent bankruptcy eliminated the value of its grants.
It doesn't take a degree from Trump University to know that stock compensation made broadly to a company's employees, along with employee stock purchase plans and other forms of employee ownership (e.g. ESOPs), are a form of egalitarian capitalism that can spread a company's wealth and reduce income inequality (see the recent commentary on that topic in this website's blog). Trump's supporters seem likely to approve of such a populist approach to employee compensation. However, the recent narrowing of stock grant eligibility and the huge equity comp gains made by senior executives have perhaps given stock compensation an elitist image that Trump's blue-collar supporters can be expected to find deplorable.
Outlook For The Future
With little risk of tax increases in 2018, there is no pressing tax-law reason to accelerate income into 2017. You may even be considering the opposite (e.g. to defer 2017 income) if you think that your tax rates will be lower next year. However, tax-rate predictions should never be the only planning consideration for stock options and company stock at year-end. Instead, you may want to let investment objectives and personal financial needs, not tax considerations, drive your year-end planning.
In the long term, your company's stock price, not tax legislation, is likely to be the most crucial factor for 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 and we avoid the falling prices of a bear market, we can perhaps reasonably expect that stock compensation, ESPPs, and employee ownership will continue to thrive, especially when these opportunities are granted broadly to most or all employees in an egalitarian way. Additionally, the success of stock compensation depends not only on a company's share price but also on the efficacy with which it both communicates its stock plan to employees and provides them with educational resources on their grants.