The Tax Cuts and Jobs Act is an interesting beast. As mentioned in my prior post, publicly-traded companies are being forced to reevaluate executive pay in light of the loss of 162(m) tax deductibility. Private companies, on the other hand, are tasked with evaluating their approach to equity compensation with the advent of changes to Alternative Minimum Tax (AMT) and the addition of a new tax deferral possibility. On the surface, both sound great, but each requires a bit of soul (or compensation philosophy) searching.
AMT keeps on ticking
Some thought Incentive Stock Options would be removed as a tax preference item. Many believed AMT might be abolished altogether. Spoiler alert! AMT still exists, and ISOs are still a factor. On the bright side, changes to the exemption and phased-out levels mean that fewer individuals are likely to get cornered by pernicious AMT obligations due to holding on to shares from ISO exercises. The summary below is not tax advice and should be relied on as guidance. It is provided merely as a starting point between you and your tax professionals.
- Single Heads of Household will see their exemption move from $54,300 to $70,300. The start of the phase-out level has moved from income of $120,700 to an impressive $500,000.
- Married couples filing jointly will see their exemption move from $84,500 to $109,500. The start of the phase-out level has moved from income of $160,900 to a whopping $1,000,000.
- Married people filing separately will see their exemption move from $42,2500 to $54,700. The start of the phase-out level has moved from income of $80,450 to $500,000.
These changes give new life to ISOs and especially to early-exercise (exercise prior to vest) features. It seems unlikely that mid-level staff members will be trapped by AMT as often as in the past. Of course, as pre-IPO valuations continued to rise, it will become more likely that smaller grants will be worth even more. Before you jump in and change your programs, make sure you complete a thorough analysis.
New Section IRC 83(i) – Deferral of Income from Private Company Equity
This rule is a modification of a proposal that has been floating around for a few years. It is designed to allow individuals who exercise stock options, or vest in RSUs to delay recognizing the income and associated taxes. The theory is that this will allow people to become owners at a lower initial cost and catch up when there is some liquidity in the stock. BUT…
- The company must be “eligible.” This means no stock has been readily traded during the prior calendar year. (Tough for companies “going private.”) There must be a written plan (no big deal.) And, the company must grant to at least 80% of their staff (at a more than nominal level) and must allow all grantees to participate in potential deferrals equally. This last rule will be a deal breaker for many companies.
But wait, there’s more!
- Employees must be “qualified.” The following cannot participate:
- CEO and their family members
- CFO and their family members
- Anyone who has held more than 1% of the company’s stock in the prior 10 years
- Anyone who has been one of the top 4 highest paid officers in the prior 10 years
- The deferral election must be made within 30 days of vesting.
If all of the above have been satisfied:
- A qualified employee can elect to defer for 5 years, Income Taxation (but not FICA and Medicare), of amounts received as a result of a stock option exercise or restricted stock unit (RSU) settlement that meet certain conditions.
- The taxable amount is the value taxable as of the eligible transaction, regardless of the post-transaction rise or fall of company stock price.
- Deferral ends on the earlier of:
- The first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer.
- The first date on which the employee is no longer a qualified employee.
- The first date on which any stock of the employer becomes readily tradable on an established securities market.
- The date five years after the first date the employee’s right to the stock becomes substantially vested.
- The date on which the employee revokes the inclusion deferral election.
That is a ton of ifs, ands, AND buts! The election is not without individual risk. The eligibility requires many companies to reevaluate how and why they use equity. It is likely the end result will be similar to most other tax planning tools (ISO capital gains treatment, 83(b) elections, etc.) A small percentage of individuals will take advantage of the deferral unless the company spends real time and money educating their employees.
While these provisions are both better than the prior tax regime, they are unlikely to create material changes in the way most companies utilize equity prior to IPO. The details are still be reviewed, and perhaps we will find new angles in the nooks and crannies of these rules. I’d love to hear your thoughts.
Dan Walter, CECP, CEP is the President and CEO of Performensation. He is passionately committed to aligning pay with company strategy and culture and considered a leading expert on equity compensation issues. Dan has written several industry resources including an issue brief on Performance-Based Equity Compensation. He has co-authored ”Everything You Do In Compensation is Communication”, “The Decision Makers Guide to Equity Compensation”, “Equity Alternatives” and other books. Connect with Dan on LinkedIn. Or, follow him on Twitter at @Performensation.