How did the 2018 tax reforms affect stock compensation?
In effect from the start of 2018, 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. Below are the provisions that affect in some way the individual taxation of stock compensation.
Alert: The individual tax rates and AMT changes started in 2018 and end after 2025, when they will revert to the 2017 rates unless they are extended.
Provisions Affecting Stock Compensation
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 10%, 12%, 22%, 24%, 32%, 35%, and 37%. This lowered 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%).
When you are in a marginal tax bracket for all combined income higher than this minimum percentage and you have not tripped the 37% rate for total supplemental income over $1 million, the automatic withholding rate of 22% is insufficient. You will be above the 22% federal tax bracket if you are:
- single and your total taxable income in 2023 is over $95,375
- married filing jointly and your combined income in 2023 is over $190,750
Because the 24% income tax bracket begins above these thresholds, the 22% rate of withholding is inadequate for income over those levels. To cover the withholding shortfall, you may need to make estimated tax payments to ensure you pay enough tax during the year. 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 the exercise of incentive stock options (ISOs) can trigger the AMT, which warrants complex tax planning. The TCJA significantly raised the AMT income exemption amounts and the income point where the phaseout starts, making 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.
3. 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 taxes at option exercise or RSU vesting for up to five years as long as the company's equity awards meet certain conditions (the version of this provision that passed the House in 2016 allowed seven years). For details, see the related article elsewhere on this website.
4. 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 income threshold for when the rate on long-term capital gains and qualified dividends goes from 15% to 20%. 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.
5. 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. For compensation paid under written plans existing as of November 2, 2017, an exemption applies as long as the plan is not modified. While that repeal does not affect financial planning, it further reduces the incentive for companies to favor one type of equity award over another.
Tax Brackets Matter
For the many upper-middle-class employees and managers who receive stock compensation, an important issue is whether the taxable income pushes you into a higher tax bracket. At year-end, this can affect your decision about whether to defer income, such as waiting until next year to exercise nonqualified stock options (see this website's section on year-end planning).
Additional Resources For More Details
For more on the tax-reform legislation, see commentaries from the following sources.
On the final legislation:
- Andersen Tax
- Grant Thornton
- Eisner Amper
- Journal of Accountancy
- Tax Foundation
- Congressional Conference Committee Report
- Highlights of Congressional Conference Committee Report
- Joint Explanatory Statement of the Conference Committee
Impact on stock and executive compensation:
- Eisner Amper
- Ernst & Young
- Davis Polk
- National Association of Stock Plan Professionals (NASPP)
- Baker & McKenzie (for publicly traded companies)
- Baker & McKenzie (for privately held companies)
- Fenwick & West
On tax planning for nonqualified deferred compensation (NQDC):
- Pinnacle Financial Group (article at myNQDC.com, our sibling website on nonqualified deferred compensation)