The GOP tax reform framework may contain few details, but it has introduced uncertainty for those who receive stock options. Primary considerations include when to exercise those options and how to maximize value for estate planning. Several key reform issues could impact planning for stock options as the framework currently stands.

Income Tax Planning Impact

The tax reform framework proposes compressing the currently existing seven-tier income tax rate system into a system with only three tax brackets (12%, 25% and 35%). Capital gains taxes, which are currently tied to income tax brackets, are not mentioned—leading to the assumption that the current rates (0%, 15% and 20%) will remain untouched. The 3.8% investment income tax is also not mentioned in the framework, but could be impacted or repealed by health reform efforts separate from tax reform. The framework also calls for eliminating the alternative minimum tax (AMT) entirely.

A client who holds stock options will likely be influenced by his or her anticipated income tax rate in determining when to exercise those options (the type of option is also important). When a stock option is exercised, the client will generally be taxed at his or her ordinary income tax rate, assuming the option is a nonqualified stock option. If the option is an incentive stock option (ISO), the exercise will not trigger regular taxes, but could trigger the AMT. The tax is imposed on the difference between the grant price and the exercise price (i.e., the difference between the stock value and the amount the client must pay at exercise to actually buy the stock).

Nonqualified options and ISOs are taxed at long-term capital gains rates when the underlying stock is later sold, as long as the relevant holding period requirements are met (long-term capital gain treatment typically requires a one-year holding period, but ISOs are subject to a subject to a special two-year holding period requirement for long-term capital gain treatment).

As a result of these complex tax rules, the potential for AMT treatment can deter clients from exercising the option in a year when his or her other income and deductions could make application of the AMT more burdensome. If the AMT is eliminated, so is this issue.

Clients with nonqualified stock options may wish to wait to exercise those shares if they think they will be in a lower income tax bracket at some point in the future (which could also lower their eventual capital gains tax on sale of the underlying stock). However, these clients should also be aware that the framework leaves open the possibility of creating a fourth, higher income tax bracket for wealthy individuals—which would likely impact those executives who receive stock options.

Further, clients who are planning for stock options should be aware that the actual income thresholds for determining who is taxed at which rate have not been released. This means that it is possible that clients could actually see higher tax rates after reform is passed (i.e., clients in the current 28% rate bracket could find themselves in the 35% bracket post-reform).  If this is the case, waiting to exercise and even eventually sell the stock could potentially lead to higher taxes.

Estate Planning Issues

Stock options (or the underlying stock) have typically been good candidates for inclusion in estate planning strategies designed to minimize the transfer taxes imposed on the appreciated value of the assets (for example, through the use of grantor retained annuity trusts, or GRATs).

Complete elimination of the estate and generation skipping transfer taxes may make it necessary for clients to rethink these strategies—bearing in mind that it is possible that some sort of sunset provision may be built into the eventual legislation to revive the estate tax at a future date. 

Further, clients should be aware that the framework does not mention the gift tax, leading to the assumption that it will remain in its current form.  A trust strategy such as a GRAT can allow the client to transfer stock gift-tax free to his or her beneficiaries, and, as such, may continue to be useful.

For added flexibility, clients may wish to draft a GRAT (or other trust) so that it contains a provision that allows the client to replace GRAT assets with a different set of equally valued assets (often consisting of cash, promissory notes or even other appreciable stock).

Conclusion

The impact of tax reform is far from clear, but many clients have been assuming that lower tax rates are a given. All clients—and especially clients who are planning for stock options—should be advised that the outcome is still uncertain, making flexibility in planning key.

Check out previous coverage of the treatment of employer stock in 401(k)s in Advisor’s Journal.

For in-depth analysis of stock options generally, see Advisor’s Main Library.  

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