NEW! How does tax reform 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 has not changed. Below are the provisions that affect in some way the individual taxation of stock compensation. (The individual tax rates and AMT changes end after 2025, reverting to the current rates unless 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 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 While the AMT or how it applies to ISOs is not repealed, below are the new numbers in the AMT calculation (to be adjusted annually for inflation).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 (up from $120,700 in 2017) and $1,000,000 (up from $160,900 in 2017) 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.
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% (more than $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 Republicans in Congress did not seek to alter the capital gains rates themselves, they do still 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 new tax law simply repeals the penalty for not buying health insurance.
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.
What Could Have Been: Provisions Deleted During The Legislative Process
Two provisions that would have had a major impact are no longer a concern.
1. Cost basis of securities. The Senate bill sought to eliminate 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. The final bill does not have this provision.
2. Taxation of stock compensation at vesting. 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 was no longer a substantial risk of forfeiture.
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)