Category: Tax and Financial News

Equity compensation is becoming more mainstream and is not just for executives anymore. Grants of restricted stock or restricted stock units (RSUs) are getting to be more common than stock options – and the rules are different, as is the tax planning. Below we will look at some of the particulars of how restricted stock and RSUs operate, how to understand a grant, planning for the tax consequences, and what to do after the shares vest.

How Restricted Stock and RSUs Work

At their core, restricted stock and RSU company shares that vest according to a schedule can be awarded as compensation. The vesting schedule can be tied to length of employment, meeting certain performance criteria, or a combination of both. Upon vesting, the employee owns the shares themselves and can do what they wish with them – from holding, selling, gifting, etc. While this might sound simple, the devil is in the details.

Understanding Your Grant

First, it is important to understand that restricted stock or RSUs are similar to stock options but have important tax and financial planning differences.

There are important facts you need to determine. First, how does the vesting schedule work; what amount of shares vest and when? Is the vesting simply tied to length of service or are there performance or even liquidity event triggers? Second, what are your tax-withholding choices?

From there, you can determine or at least estimate key factors such as how much the award will be worth both pre-tax and post-tax.

Tax Planning – Section 83(b) Election

Taxation can be tricky with restricted stock and RSUs. One strategy is to use a Section 83(b) election for restricted stock.

Typically, a person is taxed when the restricted stock vests regardless of whether the shares are sold. The Section 83(b) election allows the taxpayer to be taxed on the share value at the grant date instead. This election can be made within 30 days from the grant date of the restricted stock and is not an option for RSUs.

Why would you want to consider a Section 83(b) election? Remember that regardless of the election or not, you are taxed as ordinary income for the share value regardless of whether you hold or sell the shares. The advantages are that if you think the stock price will rise between the grant and vesting, then you will pay less ordinary income tax and have lower cash outflows. Second, after the initial taxation of the grant, the change in value after this point is capital gains.

Tax Planning – Withholding

The other issue to consider is not withholding enough taxes. The IRS rules say that your company is required to withhold 22 percent for restricted stock and RSUs (37 percent for income over $1 million during the same year).

The problem is that there is a good chance your margin tax bracket is higher than 22 percent if you are receiving these kinds of equity compensation awards. As a result, you will need to make some estimated payments to cover the difference. Unless you have enough cash from other sources, you may need to consider liquidating some of your shares to cover the tax bill.

The conundrum here is that if you do not see the shares immediately and the price falls, then you will be selling shares at a lower value than what you are being taxed on. It is best to consider your holistic tax scenario and work with your tax advisor to come up with a plan.

Game Plan for After Vesting

Aside from the tax consequences, you need to consider the impact on your overall financial planning. One of the biggest risks taxpayers can face is that they become heavily concentrated in the company stock. You will need to look at your overall portfolio and consider if you need to diversify depending on how much of your net worth is tied up in a single stock now.

Some financial planners recommend looking at the situation this way in an example with your shares worth $150,000 at vesting. If you had $150,000 in cash to invest, pay down debt, etc., would you use all of that to buy the company stock? If the answer is no, then why would you hold it? In other words, do not let tax implications lead your financial planning decisions.

Conclusion

More and more companies are issuing compensation in equity forms such as restricted stock grants or RSUs. Make sure you understand your vesting schedule and conditions so you can plan for the tax implications as well as your overall financial picture.

President Biden presented his $1.8 trillion American Families Plan, which focuses on expanding benefits for education, children and childcare. The Biden administration intends to pay for the plan with a series of tax hikes on certain individual taxpayers. Depending on your income and source of wealth, there are some clear winners and losers of this proposal, so let’s look at each and start with those who lose.

Losers Under the Plan

High Earners: The proposed plan would increase the highest individual tax rate from 37 percent up to 39.6 percent. Currently, this tax bracket starts with those earning more than $523,000 for singles and $628,000 for taxpayers who are married filing jointly. While the percentage increase may appear small, this change is projected to raise more than $111 billion over the next 10 years.

Heirs of Large Estates: The plan proposes eliminating the “step-up” in basis on assets received when an estate is passed on. The step-up in basis means that the heir now has a basis in the inherited asset equal to the fair market value at the date of death. This essentially eliminates the payment of capital gains taxes.

The plan allows for the initial $1 million in transferred gains to remain tax-protected, so this would only impact larger estates.

Wealthy Investors: A change to the long-term capital gains and qualified dividends taxation is proposed for taxpayers earning more than $1 million per year.

Currently, long-term capital gains (on assets held for more than one year) and qualified dividends are taxed at a flat 20 percent. The plan taxes long-term capital gains and qualified dividends as ordinary income, raising the rate to 39.6 percent for the taxpayer affected.

Hedge Funds and Private Equity: The Biden plan looks to eliminate the carried interest tax break, which allows partners in the funds to treat a large portion of their compensation as long-term capital gains instead of ordinary income.

Real estate investors: Currently, the tax law allows for what are called section 1031 like-kind exchanges. A 1031 exchange allows the proceeds from the sale of real estate to be reinvested in another similar or “like-kind” asset, and defer the capital gains taxes as a result.

The proposed plan would eliminate section 1031 like-kind exchanges for all sales where there are gains of $500,000 or more.

Winners

Low and Middle-Income Families with Children: The Biden tax plan calls for a five-year extension of the expanded Child Tax Credit (CTC) created in the American Rescue Plan. The CTC gives a credit of $3,000 for every child age 6 to 17 and $3,600 for children 5 and younger for single taxpayers earning $75,000 or less and married filers earning $150,000 or less. The plan would also make the existing $2,000 CTC permanently refundable.

Low-Income Individuals Without Children: The plan proposes a permanent enlargement of the Earned Income Tax Credit. The American Rescue Plan increased the maximum benefit for filers without children from $534 to $1,502 and broadened the eligibility criteria to include those under and over 65.

Working Parents: The American Rescue Plan also included a temporary enhancement of the Child and Dependent Care Tax Credit. This credit would give qualifying families a tax credit of up to $4,000 for one child or $8,000 for more than one child to compensate for childcare costs while they work, including after-school programs. The new tax plan would make this credit permanent for those making $125,000 per year or less.

Conclusion

The benefits of the Biden tax plan for its winners are nothing new or novel. Essentially, it calls for making permanent several the provisions originally passed in the American Rescue Plan and increases taxes on wealthier taxpayers to pay for it.

The Child Tax Credit as we know it originated during the Clinton administration, but the recently enacted American Rescue Plan created a new version. The updated version of this tax credit could have a beneficial impact on Americans struggling through the COVID-19 pandemic. There are changes to many aspects of the credit, so let’s look at each one below.

Monthly Payments Versus Once-a-Year Credit

First, the new version of the Child Tax Credit applies only to the year 2021. If a family qualifies, the credits are $3,600 for each child under age 6 and $3,000 for those ages 6 to 17.

The major difference is not the limits, but that in 2021 half of the credit will be paid on a monthly basis in the second half of the year. From July through December, the credit will be paid out at a rate of $300 for each child under age 6 and $250 for each child ages 6 to 17. In prior years, the tax credit was available only when filing an annual tax return. The other half of the credit in 2021 will be reconciled on 2021 income tax returns.

Income Limits and Phase-Outs

Similar to the stimulus checks, the tax credit is based on adjusted gross income. To receive 100 percent of the credit, the AGI limits are $75,000 for single filers, $112,500 for heads of household and $150,000 for those married filing jointly.

The phase-outs start once a taxpayer exceeds these AGI thresholds. Every $1,000 in AGI over the limit reduces the credit by $50 (per dependent child). For example, if a couple filing jointly earned an AGI of $165,000, their credit will be reduced by $750 per child.

Qualification for the Credit

While the tax credit is ultimately based on 2021 income, to facilitate the monthly payments, the new Child Tax Credit will use 2020 income tax returns. For those who haven’t filed yet, the look-back will be to 2019. The monthly payments will be based on these already filed tax returns and then the balance of the credit be reconciled based on 2021 income.

If a taxpayer receives more interim monthly payments on the tax credit than their 2021 AGI entitles them to, they will need to pay back the unqualified portion of the credit.

Unique Situations

In the scenario where a child crosses age thresholds mid-year in 2021, the age for determining the credit will be based on how old the child is on Dec. 31, 2021. For example, a child who turns 6 before the end of the year will qualify for the lower $3,000 credit and not the $3,600 for those under 6.

Existing Child Tax Credit is Still Available

One of the unique features of the new Child Tax Credit is that the old version is still available. This version established under the Tax Cuts and Jobs Act of 2017 has significantly higher AGI thresholds: single taxpayers with an AGI of $200,000 and married filing jointly at $400,000. As a result, many taxpayers will still qualify for this version with its lower credit of $2,000 per child and no monthly payments.

Conclusion – There’s More to Come

As the July 1, 2021 start date approaches, the IRS will release more details on the new Child Tax Credit and what taxpayers can do to take advantage of the changes.

The recently passed American Rescue Plan (ARP) Act of 2021 includes a provision making nearly all student loan forgiveness tax-free, at least temporarily. Before the ARP, student loan forgiveness was tax-free only under special programs. Before we look at the changes to come under the ARP, let’s look back at what the previous law provided.

The Old Rules

Under the earlier measure, student loan forgiveness was tax-free under certain circumstances. These special programs included working in certain public sectors, some types of teachers as well as some programs for nurses, doctors, veterinarians, etc. Essentially, you had to work in a specific field under certain conditions for a minimum length of time and some or all your student loans would be forgiven or discharged. There are also other technical qualifications, such as death and disability, closed school, or false certification discharges, but these aren’t widely applicable.

Because student loans are not dischargeable in bankruptcy, income-driven repayment plans were the other main type of program that could result in forgiveness or discharge. Typically, borrowers repaid an amount indexed to their income over a 20-to 25-year period; whatever was leftover at the end was discharged. The forgiven loan amounts under income-driven repayment programs were considered a discharge of indebtedness and tax as ordinary income (although there are exclusions for insolvent taxpayers).

The New Rules

Under the new law in the ARP, the forgiveness of all federal student and parent loans are tax-free. This includes Direct Loans, Family Federal Education Loans (FFEL), Perkins Loans, and federal consolidation loans. Additionally, non-federal loans such as state education loans, institutional loans direct from colleges and universities, and even private student loans also qualify.

The essential criteria for the loan discharge to qualify for tax-free treatment is that it must have been made expressly for post-secondary educational expenses and be insured or guaranteed by the federal government (this includes federal agencies).

This all means that the debt discharged under income-driven forgiveness programs will now be tax-free as well, but there’s a catch. The discharge of student loan debt needs to happen within the next five years because the provision expires at the end of 2025. There could be an extension, but that’s uncertain now.

Why this Change May Really Matter

The change in rules making income-driven student loan forgiveness tax-free isn’t a huge deal for most people. The new law really matters because it sets the stage for broader student loan forgiveness. The program currently being floated by President Biden to forgive $10,000 in student loan debt or the even larger $50,000 proposal by some Senate Democrats will qualify for tax-free treatment.

Good tax professionals ask the right questions to ensure they understand your situation and can help you to the best extent the law allows. Given the host of pandemic-related tax changes for 2020, it’s good to keep these four questions below in mind. If your tax preparer doesn’t ask these questions in your tax organizer or during a meeting, raise them yourself.

1. Did you receive your stimulus payment?

Not everyone received all the stimulus they were entitled to. As a result, the amount of your stimulus payments needs to be reconciled on your 2020 tax return to calculate if you qualify for the Recovery Rebate Credit.

The way the Recovery Rebate Credit works is that if you qualified for stimulus payments but didn’t receive them, then you’ll receive a credit on your 2020 tax return. On the other hand, if you received too much, there is no impact to your refund or balance due. You can’t lose here, so make sure you discuss your stimulus payments.

2. Did you work remotely? If so, when and where?

As a result of the pandemic, a lot of people worked from home for all or part of the year. If you lived in the same state you worked in, then there’s no cause for concern or further investigation. In situations where workers lived and therefore worked remotely in a different state than they normally would have commuted to when going into the office, then there could be an issue.

If you worked from another state for any part of the year, make sure you ask your tax preparer about this so you can understand the filing requirements in each state and any nexus issues. Just remember that if you are a W-2 employee, it doesn’t matter if you worked from your home, there is no home office deduction unless you’re self-employed.

3. Did you take any distributions from your retirement accounts in 2020 due to COVID-related circumstances?

Typically, early distributions from tax-advantaged retirement accounts such as 401(k) and IRAs are subject to a 10 percent penalty. There are provisions in the law that allowed penalty-free distributions in 2020 under certain circumstances related to COVID-19. Also, the income from distributions is spread over three years, which can further reduce the overall tax rate (unless you elected to tax it all in the year of distribution).

If you took distributions from a retirement account and were impacted by COVID-19, make sure your tax professional is aware of these exceptions; and ask the right questions to see if you qualify for any of the preferential treatment.

4. Are you self-employed and missed work because you were sick with the coronavirus or needed to care for someone who was ill with it?

Under the Families First Coronavirus Response Act (FFCRA), those who are self-employed can be eligible for sick and family leave credits if they or a family member had coronavirus and couldn’t work between April 1 and Dec. 31, 2020, as a result. If eligible, your tax preparer will file Form 7202 with your Form 1040 to make the claim.

Conclusion

Doing the best as a tax preparer means knowing your client’s situation and circumstances. There’s a good chance your tax professional is already on top of the COVID-19 changes, but it’s good to keep the questions above in mind just in case.