The Senate passed its version of the Tax Cuts and Jobs Act late Friday night (well, technically, it was very early Saturday morning in DC). Here’s a comparison of where the final Senate and House bills stand with respect to the provisions that directly or indirectly impact stock compensation:
Individual Tax Rates
The House version of the bill has four individual tax rates: 12%, 25%, 35%, and 39.6%
The Senate version of the bill has seven individual tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 38.5%. The rates sunset after 2025, at which time they revert back to the current rates.
In both bills, the highest rate kicks in at $500,000 of income for single taxpayers ($1 million for joint filers)
Supplemental Withholding Rate
For employees who have received supplemental payments of $1 million or less during the year: 35% under the House bill; 22% under the Senate bill.
For employees who have received supplemental payments of more than $1 million during the year: 39.6% under the House bill, 38.5% under the Senate bill.
AMT (for Individuals)
Repealed under the House bill.
The Senate bill doesn’t repeal the AMT, but it does increase the exemption amounts and phaseout thresholds.
Corporate Tax Rate
Both bills reduce the corporate tax rate to 20%. The reduction doesn’t take effect until 2019 in the Senate bill.
Estate Tax
Both bills increase the estate tax threshold to about $11 million.
The House bill repeals the estate tax altogether after 2024.
The Senate bill sunsets the increased threshold after 2025.
Section 162(m)
Both bills expand the employees subject to 162(m) to once again include the CFO and to include anyone serving as CEO during the year (rather than only the CEO at the end of the year).
Under both bills, once individuals are covered employees, they remain covered employees for as long as they receive compensation from the company.
Both bills also eliminate the exception for stock options and performance-based pay.
The Senate bill includes a transitional provision that would exempt compensation paid via a written binding contract that was in effect as of November 2, 2017. This is broader than the transitional provision that was originally proposed, which would have only exempted arrangements vested as of December 31, 2016. There is no transitional provision in the House bill, so all prior awards would be subject to the new rules under that bill.
Qualified Equity Grants
Both bills include a provision that would allow employees in privately held companies to elect to defer tax on stock options and RSUs until five years after the arrangements vest, provided certain conditions are met.
Stock Options and RSUs Taxed at Vest
This provision has been removed from both bills, so there is no change to the tax treatment of stock options, SARs, or RSUs.
Determination of Cost Basis
The Senate bill still includes the provision I blogged about last week that requires taxpayers to sell securities of the same type on a FIFO basis (when held in the same account). This provision is not in the House bill.
What’s Next?
As you can see, there are lots of areas where these two bills don’t agree (and this is just the tip of the iceberg—there is even more disagreement in areas of the bills the don’t relate to stock compensation). All of these differences have to be reconciled before the bill can become law, so the bill now goes to a conference committee comprised of members of both the Senate and House that will resolve the differences between the two bills.
The Trump Administration released its long-awaited tax reform proposal yesterday. The proposal is a long ways away from being final; legislation still has to be introduced into Congress and passed by both the House and the Senate, and the proposal, consisting of a single-page of short bullet points, is lacking in key details. The NY Times refers to it as “less a plan than a wish list” (“White House Proposes Slashing Tax Rates, Significantly Aiding Wealthy,” April 26, Julie Hirschfeld Davis and Alan Rappeport).
Here are six ways the proposal, if finalized, could impact equity compensation.
1. Lower Individual Tax Rates: The proposal would replace the current system of seven individual tax rates ranging from 10% to 39.6% with just three tax rates: 10%, 25%, and 35%. The plan doesn’t indicate the income brackets applicable to each rate, but it will clearly be a significant tax cut for many taxpayers (except those already in the lowest tax bracket).
Lower individual tax rates mean that employees take home a greater percentage of the income from their equity awards (and all other compensation). This will impact tax planning and may change employee behavior with respect to stock holdings and equity awards. Employees may be less inclined to hold stock to qualify for capital gains treatment and tax-qualified awards and deferral programs may be less attractive.
2. New Tax Withholding Rates: It’s not clear yet what would happen to the flat withholding rate that is available for supplemental payments. The rate for employees who have received $1 million or less in supplemental payments is currently pegged to the third lowest tax rate. But with only three tax rates, this procedure no longer makes sense.
The rate might stay at 25% or, with only three individual tax rates, the IRS might dispense with the supplemental flat rate altogether and simply require that companies withhold at the rate applicable to the individual. This could have the added benefit of resolving the question of whether to allow stock plan participants to request excess withholding on their transactions.
3. Lower Capital Gains Rate. The plan calls for elimination of the additional 3.8% Medicare tax imposed on investments that is used to fund Obamacare. This will increase the profit employees keep from their stock sales.
4. No More AMT. If you’ve been putting off learning about the AMT, maybe now you won’t have to. The plan would eliminate the AMT altogether (there aren’t any details, but I assume taxpayers would still be able to use AMT credits saved up from prior years). This would be a welcome relief for any companies that grant ISOs.
5. Elimination of the Estate Tax. With elimination of the estate tax, the strategy of gifting options to family members or trusts for estate-planning purposes would no longer be necessary.
6. Lower Corporate Tax Rate. The plan calls for the corporate tax rate to be reduced from 35% to 15%. A lower corporate tax will reduce corporate tax deductions for stock compensation, which will mitigate the impact of the FASB’s recent decision to require all tax effects for stock awards to be recorded in the P&L.
The Chairman of the House Ways and Means Committee has released a discussion draft of proposed legislation that could dramatically change the tax treatment of stock compensation as we know it. Here is a summary of the proposals.
No More Deferrals of Compensation
The good news is that Section 409A would be eliminated; I still don’t fully understand that section of the tax code and maybe if I just wait things out a bit, I won’t have to. But the bad news is that it would no longer be permissible to defer taxation of stock compensation beyond vesting. Instead, all awards would be taxed when transferable or no longer subject to a substantial risk of forfeiture.
This would eliminate all elective deferral programs for RSUs and PSUs. The NASPP has data showing that those programs aren’t very common, so you probably don’t care so much about that. On the other hand, according to our data, about 50% of you are going to be very concerned about what this will do to your awards that provide for accelerated or continued vesting upon retirement. In addition to FICA, these awards would be subject to federal income tax when the award holder is eligible to retire. Say goodbye to your good friends the rule of administrative convenience and the lag method (and the FICA short-term deferral rule)–those rules are only available when the award hasn’t yet been subject to income tax. This could make acceleration/continuation of vesting for retirees something we all just fondly remember.
As drafted, this proposal would also apply to stock options, so that they too would be subject to tax upon vest (the draft doesn’t say anything about repealing Section 422, so I assume that ISOs would escape unscathed). But one practitioner who knows about these things expressed confidence that there would be some sort of exception carved out for stock options. I have to agree–I don’t have data to support this, but I strongly suspect that the US government gets a lot more tax revenue by taxing options when they are exercised, rather than at vest (and that someone is going to figure this out before the whole thing becomes law).
Section 162(m) Also Targeted
The proposal also calls for the elimination of the exception for performance-based compensation under Section 162(m). This means that both stock options and performance awards would no longer be exempt from the deduction limitation. At first you might think this is a relief because now you won’t have to understand Section 162(m) either. I hate to rain on your parade, but this is going to make the tax accounting and diluted EPS calculations significantly more complex for options and performance awards granted to the execs subject to this limitation.
And that’s a bummer, because the proposal says that once someone becomes subject to the 162(m) limitation, they will remain subject to it for the duration of their employment. Eventually, you could have significantly more than five execs that are subject to 162(m). That’s right–five execs. The proposal would make the CFO once again subject to 162(m), a change that’s probably long overdue.
And There’s More
The proposal would also change ordinary income tax rates, change how capital gains and dividends are taxed, and eliminate the dreaded AMT (making the CEP exam just a little bit easier). And those are just the changes that would impact stock compensation directly. There is a long list of other changes that will impact how you, your employees, and your employer are taxed. This memo by PwC has a great summary of the entire discussion draft. In addition, we are in the process of recording a podcast with Bill Dunn of PwC on the draft–look for it soon in the NASPP podcasts available on iTunes.
When Does This All Happen?
That’s a very good question. This proposal has a long ways to go on a road that is likely to be riddled with compromise. As far as I can tell, it hasn’t even been introduced yet as a bill in the House. It has to be passed by both the House and the Senate and then signed into law by the President. So I wouldn’t throw out those articles you’ve saved on Sections 409A and 162(m) and the AMT just yet. It’s hard to say what, if anything, will come of this.
Since it is a holiday week, I have a couple of lighter topics for my blog entry.
Behind Every Half-Baked Law Is an Over-Sensationalized Cause In his May 21 Compensation Blog entry on CompensationStandards.com, Mike Melbinger of Winston & Strawn states “…nearly every bad law in the field is the result of Congressional or agency reaction (or overreaction) to some widely publicized occurrence.” To prove it, Mike created a game in which readers can match each half-baked law (Mike’s phrase) with its cause. So you can join in on the fun, I’ve reproduced it here. Match the law on the left with its cause on the right.
Law
Cause
1. 280G
A. Enron executives
2. 409A
B. Change in control payments made to Bill Agee of Bendix in 1982
3. AMT
C. 2007 World Financial Crisis (Wow, was it really that long ago? Shouldn’t my investments have recovered by now?)
4. Dodd-Frank Act
D. Enron, Worldcom, Anderson
5. SOX
E. Treasury Secretary Joseph Barr testifies that, in 1967, there were a total of 155 individuals with incomes over $200,000 who did not pay any federal income taxes; twenty of them were millionaires.
10 pts to anyone who gets all five right. Answers next week.
Deal Cube Wars I’m not quite sure what a deal cube is–I guess it is some sort of souped-up paperweight given to lawyers to commemorate a deal they worked on–but that hasn’t stopped me from enjoying the Deal Cube Tournament that Broc Romanek is running in his blog on TheCorporateCounsel.net. Check out the cubes (he’s gotten readers to send in pictures of over 130 of them) and vote for your favorites. Some of them are quite clever. Broc’s blog is available for both subscribers and nonsubscribers, so anyone can join in on the fun.
Don’t Miss Out: Conference Early-Bird Expires on Thursday The early-bird rate for the 20th Annual NASPP Conference expires this Thursday. You can see by the program that this is going our most informative Conferences ever. You’re going to want to be there, so make sure you register by Thursday to save on your registration.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so we keep an ongoing “to do” list for you here in our blog.
Register for the 20th Annual NASPP Conference in New Orleans. Don’t wait, the early-bird rate is only available until this Thursday, May 31.
Ah, 1969–the summer of love…and the birth of AMT. The Tax Reform Act of 1969 created a minimum tax designed to ensure that individuals with high incomes could not avoid paying federal income tax (thus, the concept of a minimum amount of tax that must be paid by high income filers). This was in response to a scandalous statement that 150 tax payers making over $100,000 paid no income tax. This minimum tax evolved into what is now the Alternative Minimum Tax. Although AMT receives regular bombardment on all sides, the revenue stream that AMT provides the federal government has made it prohibitive for anyone with the power to change the system to speak up and push for a solution (However, many politicians are perfectly happy to talk about the problem).
The Confusion
The fundamental differences between regular income tax and AMT are that AMT has only two tax brackets and that many exemptions and itemized deductions are not available under AMT. Because AMT is a parallel tax system, it’s difficult for many individuals to even determine if they are subject to AMT or not. In any given year, all tax payers theoretically need to consider whether they are subject to ordinary income tax or AMT. There is no one test to determine if you need to pay AMT; essentially, you must compute your taxes due under both systems and determine which is higher. A lot of middle income tax payers assume that their tax filing is so simple that surely they don’t need to worry about AMT. However, even if you have only personal exemptions and take the standard deduction, it is possible (extremely unlikely, but possible) to end up being subject to AMT. Fortunately, virtually all tax programs incorporate questions to help you determine whether or not you are subject to AMT and the IRS provides a handy little AMT Assistant that will help you determine if you should even bother.
ISOs and AMT
Incentive stock options create a special set of confusions and misunderstandings when it comes to AMT. Here are a few reasons why:
If an employee exercises an ISO and doesn’t sell shares in the same tax year, she or he needs to file Forms 6251 and 8801 for the year of exercise – regardless of whether or not AMT is due. Now that the IRS is being notified of ISO cash exercises courtesy of Form 3921, it’s especially important that your employees are aware of this.
If an employee exercises and sells ISOs in the same year, resulting in a disqualifying disposition, there is no AMT income from the ISO exercise (provided all the shares are sold) because you the preferential tax treatment on the exercise is eliminated. It’s important that your employees are aware that Form 3921 does not take any disposition into account.
ISOs fall into a special category of AMT income that is eligible for a tax credit in subsequent year. However, in order to calculate–or even qualify–for the credit, a tax payer must file Forms 6251 and 8801 every year until the credit can be claimed. Claiming an AMT credit is particularly tricky and a fabulous reason to rely on a tax professional, which brings up the topic of tax and financial planning resources for your employees. Calculating the credit is difficult, too, because it is limited to AMT income that is in excess of regular income. Consider partnering with your broker(s) or other service provider to help put employees in contact with tax professionals.
Disqualifying dispositions that occur in a year subsequent to exercise are a mess because the employee could end up with AMT in the year of the exercise and ordinary income in the year of the sale. However, that ordinary income could result in a favorable AMT adjustment when calculating AMT in the subsequent year.
Find out more about ISOs on the NASPP’s Incentive Stock Options portal. Also, the NASPP’s fabulous and freshly updated Stock Plan Fundamentals course starts in April. The entire second session (of six) is dedicated to the taxation of equity compensation, including ISOs.
Back in February, I blogged about tax rate increases in the UK. Now that we’ve gotten past the end of the UK tax year, it’s time to focus on the United States. Although not quite as dramatic, tax rates are expected to increase here beginning next year–yep, just six months from now.
What Did You Expect With a Democratic Administration?
The tax rates that are in effect now are a legacy of the Bush administration and are due to expire at the end of this year. As it stands now, all individual tax rates are expected to increase beginning in 2011. Ordinary income tax rates and short-term capital gains rates currently range from 10% to 35% and will increase to 15% to 39.6%. Long-term capital gains are currently taxed at 15%; this will increase to 20%.
In addition, the tax rate on qualified dividends will increase from 15% to the new ordinary income tax rates. This isn’t such a big deal for stock compensation, since dividends on unvested stock awards are usually already taxed at ordinary income tax rates, but where employees are receiving dividends on vested stock that they hold, this could be important for them to know.
Prior limitations on personal exemptions and itemized deductions will also be reinstated and the estate tax will be restored.
Will Congress Save Us From These Taxes?
Wholesale relief is not expected and an act of Congress is required to extend any of the Bush tax cuts. As daunting as that sounds, I understand that the Obama administration has indicated support for extending the current tax rates for low to middle-income taxpayers. It seems fairly certain, however, that the expected increases in tax rates that apply at higher income levels will happen. Ditto for the increase in the long-term capital gains rate, reductions in allowable personal exemptions, and limitations on itemized deductions. Short-term capital gains are taxed at the same rates as ordinary income, so whatever happens to ordinary income rates will also apply to short-term capital gains. There seems to be some question about what will happen to the qualified dividend rate.
What Isn’t Changing?
The two tax rates that aren’t changing are the rates that apply under the Alternative Minimum Tax–this may be the first good news we’ve heard for ISOs in a long time. If ordinary income tax rates increase but AMT rates stay the same, then ISO exercises will be less likely to trigger AMT liability. And with ordinary income tax rates increasing, holding ISO shares long enough to convert the spread at exercise to a long-term capital gain may be more tempting for employees.
Tax Withholding Rates
Tax withholding rates for federal income tax purposes are based on the marginal income tax rates so when those rates increase, so do the withholding rates that apply to compensation.
There are two rates that apply to supplemental payments (which include NQSO exercises and vesting/payout events for awards):
If all the current tax rates are allowed to expire, the optional flat rate that can be applied to supplemental payments will increase from 25% to 28% (some of you may remember that this is what the rate used to be, nine years or so ago).
The mandatory rate that applies to supplemental payments to individuals that have already received more than $1,000,000 in supplemental payments during the year is the maximum individual tax rate–which is expected to increase to 39.6%.
For companies that allow share withholding on restricted stock and unit awards (most of you that grant these awards), these expected changes could have implications at the corporate level, not just the individual level, since the amount of cash the company will need to make available to cover the tax payments will increase.
More to Come?
And this is just the beginning. Additional tax rate increases will go into effect in 2013 to fund President Obama’s health care reform package.
Planning for the Tax Increases
Just as with the UK increases I blogged about in February, advance planning and employee communication is key. Employees that have accrued considerable appreciation in NQSOs may want to exercise this year, while tax rates are lower. Employees that hold stock that has appreciated significantly in value may want to consider selling–although here the decision is complicated by the different tax rates that may apply depending on how long the shares have been held (i.e., short-term vs. long-term capital gains rates).
The good news is that the NASPP has scheduled a webcast to review the impending tax rate changes and planning considerations–be sure to tune in next Tuesday, July 27, for “How Upcoming Tax Rate Changes Impact Your Stock Plans” with Bill Dunn and Sheryl Eighner from PricewaterhouseCoopers.
18th Annual NASPP Conference Hear about all the latest tax developments impacting stock and executive compensation–straight from the IRS and Treasury–at the 18th Annual NASPP Conference. The Conference will be held from September 20-23 in Chicago; register today.
NASPP New Member Referral Program Refer new members to the NASPP and your NASPP Conference registration could be free. You can save $150 off your registration for each new member you refer, up to the full cost of registration. You’ll also be entered into a raffle for an Apple iPad and the new members you refer save 50% on their membership–it’s a win-win!
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
The recently passed Emergency Economic Stabilization Act of 2008 (EESA) includes several programs that will change executive compensation and taxation for participating companies as well as changes to offshore non-qualified deferred compensation, and AMT on ISO exercises.
Troubled Asset Relief Program (TARP)
This program allows financial institutions to sell “troubled assets” to the Treasury by either direct purchase or by auction. The direct purchase program is called Capital Purchase Program (CPP), which includes $250 billion of the bailout fund, and the auction process is called Trouble Asset Auction Program (TAAP). Companies who participate in any of the TARP programs will be subject to certain pre-conditions once the company exceeds $300 million received through one or both (cumulatively) of the programs.
Companies who sell troubled assets to the Treasury directly through the CPP will be subject to the following restrictions as a condition of participation:
•IRC 280G(e): Senior executives’ severance benefits must be limited to less than three times the executive’s trailing five-year average annual taxable compensation.
•162(m): Participating companies must limit the federal income tax deduction for annual compensation paid to each of its senior executives to $500,000 and may not claim an exemption for performance-based compensation during the covered period (as long as the Treasury holds equity or debt in the participating company).
•Incentive compensation: Participating companies must adopt measures to avoid incentive compensation that might encourage senior executives to take risks that could negatively impact the value of the company.
•Clawback: Participating companies must include clawback provisions for any bonus or incentive compensation paid out on the basis of financial statements or performance metrics later determined to be materially inaccurate during the covered period.
Companies participating in the TAAP will be subject to the CCP provisions plus:
•Severance benefits: New arrangements with senior executives will also be limited to less than three times the executive’s trailing five-year average annual taxable compensation. If an existing arrangement allows the executive to receive more than this amount, any amount that is in excess of the executive’s average annual income will be non-deductible by the company and subject to a 20% excise tax payable by the executive.
IRC 457A: Taxation of Offshore Deferred Compensation
In addition to the pre-conditions for companies participating in the TARP, the EESA adds section 457A to the IRC. Section 457A applies to non-qualified deferred compensation plans for any foreign corporation that has little or no taxable income in the United States and it not subject to a comprehensive foreign income tax as well as any partnership where less than “substantially all” of its income goes to persons not subject to U.S. income tax nor a comprehensive foreign income tax. Under 547A, non-qualified deferred compensation will be taxable when it vests (or when the income amount can be determined) rather than when it is paid. So, this change may impact only a small number of companies and compensation structures, but will certainly complicate taxation for situations that are covered.
There has been an effort to help alleviate the burden of AMT for many taxpayers (see the NASPP Legislative update “IRS to Suspend Collection Action for AMT on ISO Exercises). Well, the EESA slipped in a little light at the end of the tunnel for individuals struggling with AMT consequences, as Barbara brought to our attention in Tuesday’s blog entry. Division C of the EESA does the following for AMT:
•Allowable AMT exemption increased to $46,200 for individuals and to $69,950 for married individuals filing jointly.
•Personal credits can be credited against AMT Income for the 2008 tax year. •Accelerates (reduces) the AMT tax credit recovery period depending on the individual’s particular situation
•Eliminates the phase-out provision of AMT, which reduced the amount of the taxpayer’s AMT refundable credit by a percentage commiserate with the individual’s excess adjusted gross income.
•Abates any underpayment of tax outstanding as of 10/3/2008 related to AMT from ISO exercises, including interest and penalties.
For full details, see our newly created Economic Stimulus Legislation portal where you can find the actual legislation, memos detailing the impact of the EESA, and sample documents for companies participating in the TARP Capital Purchase Program.