Before the Tax Cuts & Jobs Act, whick took effect at the start of 2018, the previous big tax legislation was the American Taxpayer Relief Act (ATRA), which took effect at the start of 2013. The ATRA did not have any provisions that directly related to stock compensation, though increases in the rates on income tax, capital gains, and dividends indirectly affected the value of grants and the related tax planning. The following changes in tax rates applied to income from stock option exercises, restricted stock and RSU vesting, ESPP purchases, sales of stock, and dividends. (See related FAQs that show the taxes and withholding rates for various types of equity awards.)
- The top federal withholding rate on supplemental income rose to 39.6%. Supplemental income, such as stock compensation, is subject to one of two flat rates that are linked to income tax rates. For aggregate supplemental wage payments totaling up to $1 million during the year, the rate became 25% (the rate of the third income tax bracket). For aggregate supplemental wage payments that exceed the level of $1 million in a calendar year, the rate became 39.6% (the rate of the highest income tax bracket). Note that the Tax Cuts & Jobs Act, which took effect in 2018, changed those rates to 22% and 37%.
- The Social Security rate returned to 6.2% after a temporary cut to 4.2% in 2011 and 2012, as the tax law did not extend the reduction in payroll tax. Social Security tax applies up to a certain amount of yearly income ($128,400 in 2018) and not to yearly income above that threshold.
- The capital gains tax rate that applies to the proceeds from a stock sale increased to 20% for people whose yearly taxable income exceeds a certain amount. The tax rate on dividends grew to 20% for these same taxpayers. This applies to any qualified dividends received on company stock you own or on unvested restricted stock for which you have filed a Section 83(b) election. For taxpayers whose yearly taxable income is below the 20% threshold, the top tax rate on capital gains and qualified dividends remains 15%.
- For people with incentive stock options, the new tax law indexed the income exemption amounts (commonly known as the "AMT patch") for calculating the alternative minimum tax. Additionally, the new tax law indexed the annual AMT income exemption amounts permanently for inflation and made two other important changes.
- Separately from the American Taxpayer Relief Act, in 2012 the Affordable Care Act increased the Medicare tax rate on compensation income for high-income taxpayers from 1.45% to 2.35%, and a new 3.8% Medicare surtax now applies to investment income, such as capital gains from stock sales. Both of these tax changes became effective on January 1, 2013.
The income thresholds for increased tax rates under the ATRA, the new Medicare taxes, and the return of exemption/itemized deduction phaseouts made it more appealing for high-income taxpayers to:
- defer income into the future with restricted stock units and performance share units that allow the deferral of share delivery (see a related FAQ)
- defer salary and bonus in nonqualified deferred compensation plans
- receive stock options, as options offer the ability to time the year for recognizing income, depending on when you exercise them
These approaches focus on two planning goals: (1) keeping your yearly income under the thresholds for higher tax rates and (2) recognizing income at a future time when your yearly income and tax rates will, you believe, be lower.
For people in the highest tax bracket, the tax advantages of ISOs over NQSOs were slightly reduced by ATRA, which lowered the spread between the highest ordinary income rate and the capital gains rate (plus the 3.8% Medicare surtax). However, the larger gap between the higher top ordinary income rate and the top AMT rate makes it less likely that individuals in the top income-tax bracket will trigger the AMT from an ISO exercise/hold.
Details of planning strategies and ideas related to the American Taxpayer Relief Act, and other tax changes, are discussed in various articles on myStockOptions.com.