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Looming 2013 Capital Gains, Dividend and Medicare Tax Increases: Key Considerations for Executives, Directors and Companies

July 2012

Background

Tax efficiency has long been a central tenet of equity compensation planning. Companies “market” equity compensation grants to their executives and directors based not only upon business considerations (e.g., the importance of aligning long-term performance with pay), but also upon federal income tax advantages. Executives and directors seeking equity awards, as opposed to cash awards (e.g., long-term incentive bonuses), frequently do so because cash-settled awards are subject to a maximum federal income tax rate of 35% (to increase to 39.6% in 2013), whereas stock-settled awards can qualify for a mix of the 35% ordinary income tax rate and the 15% long-term capital gains rate.

In fact, much tax planning in the world of equity compensation revolves around the goal of having the compensation qualify, to the maximum extent possible, for the 15% long-term capital gains rate. Combine this rate with the maximum ordinary income rate on dividends of 15% and equity compensation begins to look much more tax-efficient than cash-based compensation.

Executives, directors and companies rarely consider Social Security and Medicare taxes in deciding whether to seek equity awards or cash awards. Currently, the tax rates and the timing of these taxes generally are the same for equity awards and cash awards – the most notable exception is an incentive stock option, which is not subject to Social Security and Medicare taxes.

Change is in the Air

This favorable tax regime (or tax-indifferent regime in the case of Social Security and Medicare taxes) for equity awards will become materially less favorable in 2013. In particular, the maximum long-term capital gains and dividends rates will increase by 59% and 189%, respectively. Medicare taxes (employee portion) due upon the vesting of restricted stock or the exercise of a nonqualified stock option (as well as a cash award constituting wages) will increase by 62%. The chart below documents these changes. (Not shown are the effects of limitations in itemized deductions scheduled to take effect in 2013 due to the expiration of the Bush tax cuts or the scheduled expiration of the 2% Social Security tax "holiday.")

 

Type of Tax
2012 Rate
Increase Due to Bush Tax Cuts Expiring
Increase Due to Health Care Reform
Total 2013 Rate
Percentage
Increase over 2012 Rate
Capital Gains (Long-Term)
15%
5%
3.8%
23.8%
59%
Dividend (Highest Rate)
15%
24.6%
3.8%
43.4%
189%
Medicare
1.45
0%
.9%
2.35%
62%

 

The increases in these federal taxes, which take effect on January 1, 2013, apply only if an executive’s or director’s adjusted gross income (“AGI”) exceeds the applicable “high earner” threshold: (i) $200,000 for an unmarried individual; (ii) $250,000 for a married joint-filer; and (iii) $125,000 for a married person filing separately from his or her spouse. In the case of the capital gains and dividend tax increases due to Health Care Reform, the taxes apply to the lesser of an executive’s or director’s net investment income or the amount of AGI that exceeds the applicable threshold. (The idea is to tax “unearned income,” as opposed to wages.) In the case of the Medicare tax increase due to Health Care Reform, the tax applies to the full extent of any excess AGI over the applicable threshold. (This tax applies to a director only if the director is an employee.)

 

Key Considerations for Executives, Directors and Companies

Given the magnitude of these increases, should an executive or director holding restricted stock or options sell the stock and/or exercise the options in 2012 and demand greater amounts of cash-based or cash-settled awards in 2013 and beyond? Should a company sponsoring an equity compensation plan place a greater emphasis on cash-settled or cash-based awards in 2013 and beyond?

The answers to these questions depend upon a number of factors, some of the most important of which are explored below.

 

Executives and Directors

Securities Laws

The threshold question for an executive or director holding vested shares of restricted stock or an option that can be exercised for vested shares, and who wants to sell such shares in 2012, is whether the shares can be sold without violating the federal or the applicable state’s securities laws. If the shares are private company shares, such shares generally constitute “restricted securities” that cannot be sold absent registration with the Securities and Exchange Commission (“SEC”) and the analogous state agency, or an exemption from such registration.

If the shares are public company shares, the restricted securities limitation will not apply if the plan has been registered (e.g., through an SEC Form S-8 filed with the SEC). Under certain circumstances, however, restricted securities that constitute “control securities” can face a tougher hurdle for a legal sale.

Also, in the public company context, the federal short swing profit rule (Rule 16b-3 under the Securities Exchange Act of 1934) may prevent a sale that follows a purchase within a six month period. Certain exemptions from this rule do exist, however.

An executive or director looking to sell securities should consider seeking independent legal advice regarding the securities law requirements associated with any such sale. Reliance on company counsel for advice carries with it many legal risks for such an executive and director – company counsel represents the company, which may require, for instance, an indemnification from the executive or director in the event of any securities law violation.

Balancing of Tax Rates

The top marginal ordinary income tax rate will increase from 35% to 39.6% in 2013. This means that any cash-based or cash-settled award will be taxed – such tax to apply only upon vesting or payment, as applicable – at 39.6%. Social Security and Medicare taxes also apply at the time of vesting.

In contrast, restricted stock and stock options generally are subject to tax at vesting and exercise, respectively, and also upon sale of the stock. Upon vesting of restricted stock, the ordinary income tax will apply, in many instances at the top rate of 39.6%. This is the same result for an exercise of a nonqualified stock option. An exercise of an incentive stock option may trigger alternative minimum tax at a rate of 28%.

Social Security and Medicare taxes apply to restricted stock and nonqualified stock options. In the case of the Medicare tax, the rate will be 2.35% instead of the 1.45% applicable to cash-based or cash-settled awards. Incentive stock options are not subject to Social Security or Medicare taxes.

Upon the sale of the stock, long term capital gains treatment may apply and, if so, tax will be capped at the 23.8% capital gains rate – considerably higher than the 2012 rate of 15%, but also considerably lower than the top ordinary income tax rate of 39.6%.

All else being equal, the tax consequences suggest that, in the case of an equity-based award, even greater emphasis will be placed upon converting as much of the top ordinary income tax rate of 39.6% to the top capital gains rate of 23.8% as possible. The spread, 15.8 percentage points (39.6 – 23.8), although less than the current spread of 20 percentage points (35 – 15), is still quite significant.

Anticipated Growth in Stock Value

An executive or director may believe that the value of the shares will appreciate materially over the years. If so, the executive or director may wish to sell the shares in 2012 (if able to do so) as a means of “locking in” his or her tax exposure. This argument works so long as the marginal ordinary income tax rate does not approach 100%, as it did prior to the 1980s.

 

Companies

Share Ownership Requirements

A company may impose share ownership requirements on executives and directors. This so-called “skin in the game” approach has gained popularity in recent years as a means of aligning the executives’ and directors’ interests more precisely with the interests of the company.

Timing of Tax Deductions

This can be a material issue for a company that grants nonqualified stock options. Such a company cannot take a deduction of wages paid unless and until the executive or director exercises the option. In contrast, a cash-based or cash-settled award can be deducted earlier, at vesting or payment, as applicable.

Cash Flow

Shifting to cash-based or cash-settled awards can adversely affect a company’s cash flow. Unless stock awards are sold back to the company, or the company institutes a share buy-back plan, cash flow generally is not an issue for equity grants.

Financial Accounting

Cash-based or cash-settled awards may trigger adverse financial accounting consequences for a company. Any company considering a material shift towards cash-based or cash-settled awards should consider obtaining the advice of its accountant as to such financial accounting effects.

Please contact your Wolff & Samson attorney or Adam B. Cantor, Chair of the firm’s Employee Benefits and Executive Compensation Group, or Farah N. Ansari, an associate in this Group, for assistance in determining the appropriate steps to take in light of the increased taxes that will take effect on January 1, 2013.