Alert: Tax Reform Impacts Equity Comp
While it's not quite tax "reform," at least for individual taxation, major tax-law changes are coming in 2018. The "Tax Cuts & Jobs Act" has provisions that directly and indirectly affect equity compensation, whether in personal financial planning or in company plan administration. Compared with some earlier proposed provisions that didn't survive the legislative process, these are not really significant beyond the change in the alternative minimum tax (AMT), which affects ISOs.
The core tax treatment of equity compensation has not changed. Below are the provisions that affect its individual taxation. (The tax rates and AMT changes end after 2025, reverting to the current rates unless extended.)
1. Changes in the rates of individual income tax. The "Tax Cuts & Jobs Act" keeps the current seven tax brackets, reducing the rates and changing the income thresholds that apply. The new rates are 10%, 12%, 22%, 24%, 32%, 35%, and 37%, with the top bracket starting at $600,000 for joint filers ($500,000 for single filers).
The flat supplemental rate of federal income tax withholding on equity compensation is based on the seven brackets. For amounts up to a $1 million it is linked to the third lowest rate (22%) and for amounts over $1 million it is linked to the highest rate (37%). The 22% rate of withholding may not cover the actual taxes you will owe, so you need to know the tax bracket for your total income and assess the need to put money aside or pay estimated taxes.
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 While the AMT (and how it applies to ISOs) is not repealed, below are the new numbers in the AMT calculation (to be adjusted annually for inflation).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 (from $120,700) and $1,000,000 (from $160,900) for married couples.
- This AMTI exemption amount is phased out for high-income individuals by 50 cents (up from 25 cents) for every dollar of AMTI over those specified thresholds.
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.
3. A version of the "Empowering Employees Through Stock Ownership Act" is part of the final legislation. 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 (a prior version that passed the House in 2016 allowed seven years). For details, see our coverage in a commentary at the myStockOptions Blog.
4. 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. While there is no change in these rates, the tax law creates a new income threshold for when the rate on long-term capital gains and qualified dividends goes from 15% to 20% ($479,000 for married joint filers and $425,800 for single taxpayers). That threshold is no longer similar to that of that top tax bracket.
Furthermore, while the Republican 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 share sales, that is paid by high-income taxpayers to fund healthcare. The new tax law does, however, repeal 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.
For further details about the impact of the tax legislation on equity comp, including links to in-depth tax resources, see the extensive FAQ at myStockOptions on this topic.
Editor's Note: Save the date for the first myStockOptions conference! Here at myStockOptions, we are planning to hold our first-ever conference. It will be a one-day event: Financial Planning for Public Company Executives & Directors (Monday, June 18, 2018). Taking place in the Boston area, this is a must-attend national conference for financial advisors working with or wanting to counsel executives and directors. We have a wonderful group of expert speakers and a very substantive agenda of sessions on various stock-related and financial-planning topics. For details, see the December issue of the myStockOptions newsletter.