The Tax Cuts & Jobs Act, directly and indirectly, impacts equity-based compensation arrangements through several key components and provisions of the law. While the effect of these provisions remains to be seen, they may provide the recipients of equity-based compensation with an array of new planning opportunities.
Tax rates & tax brackets:
Among the most widely discussed aspects of the Act are the changes made to tax rates and tax brackets. While there are still seven federal income tax brackets, the decrease in the highest marginal tax bracket from 39.6% to 37%, combined with a substantial increase in the income thresholds that apply to the top brackets, may provide a material reduction in taxes applied to equity-based compensation. Under the old law, the 39.6% bracket applied to single filers with taxable income in excess of $418,400, and $470,000 for married couples filing a joint return. Effective January 1, 2018, the top tax bracket not only decreases by 2.6%, but the income thresholds applied to the top bracket increase to $500,000 for single filers and $600,000 for married couples filing a joint return. This combination of lower marginal tax rates and a substantial increase in the income thresholds for the top brackets presents an opportunity to reduce the tax burden of equity-based compensation through smart tax planning. Whether you have restricted stock units (RSU’s), non-qualified stock options (NQSO’s), phantom stock awards, or incentive stock options, a disciplined and multi-year tax planning strategy focused on timing the receipt of taxable income and maximizing other deductions remains a highly-effective way in which to minimize the tax consequences of equity-based compensation. And although the Act is generous in its treatment of federal tax rates and brackets, its $10,000 limitation for the deduction of state and local taxes may mitigate some of these benefits for those residing in a high-tax locale.
Capital gains tax:
While there is no change in capital gain tax rates- the Act retains the 0%, 15% and 20% rates for long-term capital gains and ordinary income tax rates for short-term capital gains- the income thresholds that apply to each rate have increased. The income threshold applied to the top rate increases from $418,401 to $425,801 for single filers, and from $470,701 to $479,001 for married couples filing a joint return. Therefore, depending on your income levels, you may wish to consider compiling a multi-year tax projection and look for opportunities to realize capital gains in those years when your income falls into a lower tax bracket. A 5% reduction in capital gains tax through simple tax planning can yield substantial increases in after-tax income.
When planning for capital gains tax exposure it’s also important to keep the Medicare surtax in mind. The Medicare surtax is levied on the lesser of net investment income or the excess of modified adjusted gross income (MAGI) that exceeds $200,000 for individuals and $250,000 married couples filing a joint return. This tax was not repealed as part of the Act, but smart planning may help to mitigate its effects.
Changes to the AMT:
The alternative minimum tax impacts millions of taxpayers each year and is a particular nuisance to those that exercise incentive stock options (ISOs). The reason behind this relates to the treatment of certain income items in the calculation of the AMT. In the case of ISOs, the employee typically pays no ordinary income tax on the exercise of the ISO unless they have a disqualifying disposition. As long as the employee holds the ISO shares for the requisite period of time (2 years from the grant date and one year from the exercise) when they sell the ISO shares they will pay the long-term capital gains rate of tax on the difference between the grant price and the sale price. For AMT purposes, however, the difference between the grant price and the exercise price is considered a preference item and is treated as income in the year exercised. Thus, it’s possible to be subject to the AMT even though the exercise of the ISO had no regular tax consequence. An item worth noting, when taxpayers are subject to an AMT tax due to the exercise of an ISO, an AMT credit is allowed in future years to offset their ordinary income tax liability.
Although the AMT may appear unfair, the underlying purpose of the AMT lends some clarity as to why these so-called preference items are subject to tax. Originally enacted as a way to ensure that higher-income taxpayers with large deductions- and who had previously paid little or no income tax- would not escape income taxes entirely, the AMT was not indexed for inflation until 2013. Although the AMT calculation has not changed, the Act introduces new exemptions and phase-out thresholds intended to reduce the number of middle-income taxpayers that are subject to the tax. The 2018 AMT income exemption increases from $54,300 to $70,300 for single taxpayers, and from $84,500 to $109,400 for married couples filing a joint return. The allowed exemption is raised by $1 for every $4 in alternative minimum taxable income (AMTI) that exceeds these thresholds.
The ability to use these exemptions will phase out for high-income individuals. In 2017 these limits were set at a modest $120,700 for single filers and $160,900 for married couples filing a joint return. The new law dramatically increases the income thresholds to $500,000 for single filers and $1,000,000 for a married couple filing a joint return. In other words, the full AMT exemption can be taken by taxpayers who earn less than $70,300 (single) and $109,400 (MFJ), and based on the calculation will not phase out entirely for single filers until AMTI reaches $781,200 for single filers, and $1,437,600 for married couples.
A combination of the higher AMT income exemption amounts and the higher AMTI phase-out thresholds, make it far less likely that an exercise of ISOs alone will subject someone to the AMT. It’s important to note that both AMT and stock option valuation entails a series of complex calculations. As such, it’s crucial that you model the exercise of the options AND determine the potential impact of an exercise on your AMTI. As a result of these changes to the AMT, it’s quite possible that more companies will begin to grant ISOs in favor of other types of equity-based compensation.
Qualified equity grants for private companies:
The Tax Cuts and Jobs Act provides a new provision (Section 83(i)), that allows eligible private companies to adopt a qualified equity grant plan for issuing stock options or restricted stock units (RSUs) to eligible employees to obtain “qualified stock” in exchange for the performance of services. In effect, this affords certain employees an opportunity to defer income tax on restricted stock units (RSUs) and stock options for up to 5 years. To be eligible, a private company must have a written plan in place under which at least 80% of all full-time US-based employees are granted restricted stock units or compensatory stock options that have similar rights and privileges, as determined under the rules for Employee Stock Purchase Plans (ESPP) under Code section 423(b)(5).
The new code section 83(i) will generally permit qualified employees to make an affirmative election to convert the qualified stock into “deferral stock” within 30 days of the date when the stock option or RSU vests. This exercise in effect defers the income that would otherwise have been included in the year in which he or she receives the underlying stock. Note that a qualified employee does not include a current or former CFO or CEO, a 1% owner or any of the 5 highest-paid employees, as measured over the 10 preceding taxable years. If an eligible employee elects to acquire the deferral stock, the tax obligation is due upon the first of the following events to occur:
- The first date that the deferral stock becomes transferable.
- The date the employee is no longer a qualified employee.
- The first date that the company’s stock becomes tradable on a securities exchange.
- Five years after the date the qualified employee’s right to the stock ceases to be substantially non-vested.
- The date on which the employee revokes their deferral election.
The rules limiting the participation by owners and certain highly-compensated employees, and the stipulation that restricted stock units and/or stock options must be made available to 80% of the employees in a private company, may limit its appeal. It nonetheless provides qualifying companies and their employees with the opportunity to structure compensation packages that shift income taxation of equity-based compensation away from ordinary income rates to capital gain rates.
Changes to Code Section 162(m) and compensation:
Significant changes are made under section 162(m) as it relates to covered companies. While existing law placed a limit on the deduction that companies may take for annual compensation paid to the Chief Executive Officer (CEO) and the three most highly compensated officers (so-called “covered employees”), the new law expands the scope of covered employees to include the Chief Financial Officer (CFO).
Effective January 1, 2018, compensation in excess of $1,000,000 paid to the CEO, CFO and the three most highly paid officers is not tax deductible. In addition, the new law includes a once covered always covered provision, so that once an employee is classified as a covered employee the classification will remain for all future years.
The law also expands the definition of compensation to include qualified performance-based pay, commissions, severance, post-termination or post-death payments, as well as deferred compensation and payments from nonqualified plans. The expanded definition will capture most forms of compensation, which may result in changes such as extended vesting schedules for performance-based compensation to help mitigate the law’s impact. Following is a brief summary of the modifications to the Code Section 162(m):
- The law repeals the performance-based compensation and commission exceptions to the Section 162(m) rules and the $1,000,000 deduction limitation.
- The law expands the definition of a covered employer from a corporation that issues equity that is traded on an established securities exchange, and now includes corporations that issue publicly traded equity and publicly traded debt, as well as issuers that have a public offering (but are not listed on a securities exchange) that are required to file a registration statement under Section 15(d) of the Securities Act of 1933.
- The law revises the definition of a “covered employee” to include the principal financial officer. All individuals who hold the position of either principal executive officer or principal financial officer at any time during the taxable year are now a covered employee. Covered employees also include officers whose total compensation is required to be disclosed to shareholders by reason of them being amongst the three highest paid officers (other than the principal executive officer or principal financial officer.). This is not an operational change but conforms the statute to IRS Notice 2007-49. Finally, for a “publicly held corporation” that is not required to file a proxy statement, covered employees are determined as if these rules apply.
- The Law requires that an individual who is a covered employee for any taxable year beginning after December 31, 2016, will continue to be a covered employee for all subsequent taxable years, including years after the death of the individual.
On the plus side, the Act contains a transition rule that applies to compensation paid pursuant to a written binding contract that was in effect on November 2, 2017, and that is not materially modified. In general, payments under these plans remain subject to the current rules- meaning it is still eligible for the performance-based exception.
The Tax Cuts and Jobs Act has changed the landscape for equity-based compensation and provides a unique set of challenges and opportunities for individual taxpayers and business entities. Perhaps more than ever now is a great time to take stock of your planning needs.
Stay tuned for more on equity-based compensation issues in the forthcoming weeks.
Jonathan Gassman CPA, CFP®
The Gassman Financial Group
G&G Planning Concepts, Inc.
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