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Annotated diagram of Schedule DTax errors can be costly! Don't draw unwanted attention from the IRS. Our Tax Center explains and illustrates the tax rules for sales of company stock, W-2s, withholding, estimated taxes, AMT, and more.

Tax Center: Tax Changes 2003–2017

NEW! How will tax reform affect stock compensation?

It all depends on what is eventually adopted. In September 2017, the Trump administration and Republican leaders in Congress released an outline of a joint framework for tax reform that left many decisions and details for Congress to work out. Since then, both the House of Representatives and the Senate have prepared their own tax-reform bills.

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.

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 below. Over the weeks ahead, these are the provisions to follow as they go through the legislative process.

Provisions Affecting Stock Compensation That Are Likely To Be Adopted

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 makes some changes in the rates and the income triggers). 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. The termination of the alternative minimum tax (AMT). Among those who receive grants of incentive stock options (ISOs), much rejoicing would occur if the AMT were repealed. Currently, the income spread at ISO exercise can trigger the AMT, which warrants complex tax planning. AMT repeal has been considered in the development of the legislation.

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.

Also under consideration are changes in the rules on how AMT credit carryforwards can be used. Under the House bill, you would be able to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) for the tax years 2019, 2020, and 2021. In 2022, you would be able to claim a refund of any remaining credits.

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.

Other Provisions With Potentially Big Impacts

1. 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.

2. 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, as does the Senate bill.

3. Cost basis of securities. When selling or gifting stock, investors have the flexibility to select shares with the highest basis to reduce potential capital gains (or realize/increase losses). The Senate bill eliminates the ability to specifically identify any stock sold for the 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. For further details on this topic, see a commentary in the blog of the National Association of Stock Plan Professionals.

4. 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).

Further details about the impact of tax reform on employee benefits is available in a commentary from Seyfarth Shaw.

Prospect Of Tax Reform Has Already Affected Tax Planning For Some

Although Republicans say they want tax-reform law to be finalized before year-end (see an article in The Wall Street Journal), the Trump/GOP framework for tax reform faces challenges before becoming adopted legislation. Ironically, however, all of this talk about tax cuts since the election has prompted some taxpayers to delay recognizing income, such as gains from selling appreciated company stock. This has meaningfully lowered government tax revenues. An article in The Washington Post reports that, according to federal data and the anecdotal experiences of tax advisors, wealthy taxpayers seem to be "postponing cashing out on investments and other financial decisions, hoping to pay less later if the White House and Congressional Republicans pass a huge reduction in tax rates" (see Americans Are Taking Their Sweet Time Paying Taxes, And The Government Is Running Out Of Cash, June 1, 2017).

Tax Brackets Matter

For the many upper-middle-class employees and managers who receive stock compensation, there is an important issue to follow with any type of tax reform. That issue involves the taxable income that would fit into the proposed tax brackets. Under the House legislation, some taxpayers currently in the 33% tax bracket would move into the 35% bracket for compensation income and short-term capital gains. For example, the current (2017) 33% tax bracket for married joint filers goes from $233,350 to $416,700 of taxable income. The income range for the proposed 35% bracket would start at $260,000, so income above that threshold would move you up to the 35% marginal tax rate.

Additional Resources For More Details

For more on the tax-reform legislation, see commentaries from the following sources.

On the Senate legislation:

Comparisons of House and Senate legislation:

Impact on stock and executive compensation

On tax planning for NQDC amid tax-reform uncertainty:

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