Tax increases may be looming. If you have stock options, restricted stock units, or company shares, now’s the time to analyze whether President Biden’s proposed tax changes could impact your financial planning, whether directly or indirectly.
Some of the potential tax increases, such as a major hike in the top rate of capital gains tax, may require you to take action before any new tax legislation is adopted.
The proposed tax provisions to follow are in the American Jobs Plan and the American Families Plan. The US Treasury’s General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals, known informally as the “Green Book,” provides a summary and rationale of the tax changes.
Don’t have time to read Congressional legislation or a book written by the US Treasury? No problem. I read that stuff so that you don’t have to, along with related commentaries from law firms and other expert observers. Below is what to know about the potential impact of Biden’s tax proposals on stock compensation and company shares that you hold. For investors, this provides an opportunity to assess the possible changes and the impact on decisions involving stock options, restricted stock, ESPPs, and company stockholdings.
I. Top Tax Rate
Currently, the flat supplemental wage withholding rate, which applies to income such as stock compensation and cash bonuses, is 22% for yearly amounts up to $1 million and 37% for yearly amounts in excess of $1 million. That higher withholding rate is tied to the top tax bracket.
Under Biden’s plan, the highest ordinary tax bracket rate would go from 37% to 39.6% starting January 1, 2022. That would therefore increase the higher rate of supplemental wage withholding to 39.6%. This rate would also apply to short-term capital gains for anyone in the top tax bracket.
When you decide to exercise nonqualified stock options (NQSOs), you control when you will realize the taxable income at exercise, including federal tax. If you’re in the top tax bracket or will be from your option exercise, analyze whether for tax reasons it makes sense to exercise the options in 2021 instead of in 2022, when that bracket rate may be higher.
While most financial advisors would not suggest you make stock option exercise decisions solely for a 2.6% tax savings, this potential tax hike is worth evaluating as a factor for options close to expiration. For options not close to expiration, remember that NQSOs offer substantial leverage and upside, all of which ends as soon as you exercise the options.
II. Capital Gains Tax Rate
Long-term capital gains, such as from company stock sales, currently have a top tax rate of 20% (plus the 3.8% Medicare surtax). Biden’s tax plan would raise the top rate on long-term capital gains and on qualified dividends to the highest rate of ordinary income tax for households with over $1 million in adjusted gross income ($500,000 for married filing separately).
The rate change would be retroactive to the date it was announced, considered to be April 28, 2021, when President Biden issued a Fact Sheet on the American Families Plan. The change for taxes for capital gains realized at death and with gifts, discussed below, would start January 1, 2022.
With incentive stock options (ISOs) taxation, when you hold the shares more than two years from grant and one year from exercise, the full gain at sale over the exercise price is capital gain. While the tax treatment for NQSOs is fixed at exercise, for ISOs when you sell the stock without meeting the holding periods the tax treatment changes to essentially follow the ordinary income rates. Anyone with annual income of more than $1 million will want to evaluate whether to risk holding ISO shares for the long-term capital gains rate when that rate would actually, under Biden’s plan, match their ordinary income rate.
Similar thinking applies to the decision with restricted stock about whether to make a Section 83(b) election to be taxed at grant instead of vesting. One big advantage of the election is to get an early start on the holding period for long-term capital gains. But under the proposed change, the tax rates on long-term and short-term capital gains for people in the top tax bracket may become the same anyway.
According to some experts, it remains unclear whether this higher capital gains rate would apply to all capital gains income or to only some portion of it. Among the many other issues are how this change would impact the 0% rate on qualified small business stock (QSBS). The potential impact for individuals with stock by this proposed change, including the range of open issues and when to recognize capital gains income, are aspects which have not been detailed as of this writing.
III. Capital Gains Realized Upon Death or At Gifting of Stock
Biden’s tax plan would dramatically change the capital gains treatment via gifting or upon death for transfers of appreciated property, such as company stock. For example, the ability to eliminate capital gains at death by a step-up in the basis on the shares, which allows heirs to then pay tax only on the appreciation after death, would no longer apply to gains over $1 million per person ($2 million per couple).
Death itself triggers the recognition of capital gains tax on these amounts as if the stock was sold!
Similarly, any gifts made over these amounts would be taxable at that time to the gifter. Currently the receiver just carries forward the basis, and the giver would owe gift tax only if they did not have any of their lifetime gift/estate exemption amount remaining. Exceptions would apply, such as with transfers to a spouse, a charity, or heirs of small businesses and farms that continue to run those businesses. Donations of highly appreciated stock to charities would still avoid the capital gains tax, making it an even more popular strategy.
The Biden administration’s proposals so far do not yet include lowering the estate tax exemption from the current $11.7 million per person ($23.4 million for married couples), which was discussed during the campaign and may be forthcoming. However, that amount does automatically go down to $5.49million per person (adjusted for inflation) at the start of 2026, when the provision sunsets at the end of 2025 under the Tax Cuts & Jobs Act (TCJA).
Whether any of these proposals will get adopted in their current form, and with the proposed effective dates, remains uncertain. Doubts about what will happen are raised by experts quoted in articles in Investment news and in Political commentaries. However, with a split Congress and the tie-breaker in the form of the Vice-President, all bets are off.
For more information or advisory on tax planning, please contact our office or email@example.com.