A recent Supreme Court ruling provides potential tax savings for railroad employees. Wisconsin Central Ltd. v. United States holds that stock-based compensation provided to railroad employees is exempt from federal employment taxes. According to the 5-4 ruling, for employees of railroad companies such as Union Pacific and BNSF, stock option income is not considered money remuneration under the Railroad Retirement Act (RRTA) and, therefore, not subject to payroll taxes.
What amount of savings can railroad employees expect?
Thanks to this ruling, a tax savings of 7.65% applies for railroad employees who exercise non-qualified stock options and make less than the Social Security wage cap of $128,400. While higher income railroad employees won’t save as much, they’ll still avoid the 1.45% Medicare tax equivalent within their Tier 1 withholding (which applies to all wages). For individuals earning over $200,000 and married taxpayers earning more than $250,000, there are also savings from avoiding the additional 0.9% Medicare tax enacted on high-income individuals under the ACA.
What are non-qualified stock options?
While there are two types of stock options, this tax savings applies only to non-qualified stock options. It helps to understand the different types of stock options and how they are taxed.
For Non-Qualified stock options (NQSO), income taxes are due for the year you exercise the option. The difference between the grant price and the market price at the time of exercise is considered earned income (whether you decide to sell the stock or hold on to it). Earned income is normally subject to both ordinary tax rates and payroll taxes, meaning you would pay your ordinary tax rate plus additional FICA taxes of 7.65% for Social Security and Medicare, unless you are a railroad employee.
Incentive stock options (ISOs) are subject to special requirements and holding periods, but their advantage is that they are not considered earned income and are not subject to payroll taxes. You don’t pay taxes on these options until you sell the stock. Depending on the holding period between the time you exercise the option and the time of sale, you will either pay ordinary tax rates or capital gains rates on the difference between the grant price and the market price at the time of sale.
Why are railroad employees treated differently?
Most U.S. workers are covered under the Federal Insurance Contributions Act (FICA) and have Social Security and Medicare taxes withheld from their paychecks. Railroad employees are not covered under FICA. Instead, they are covered under the Railroad Retirement Act (RRTA) which pre-dates FICA. Tier 1 RRTA withholding is the equivalent to FICA withholding, and railroad retirees receive benefits from the Railroad Retirement Board (RRB) rather than the Social Security Administration.
What is the difference between FICA and RRTA?
FICA applies to “all remuneration for employment, including the cash value of all remuneration (including benefits) paid in any medium other than cash,“ which is why non-qualified stock options are subject to FICA taxes. However, the RRTA applies to “any form of money remuneration.” In Wisconsin Central Ltd. v. United States the court has ruled that stock options, even non-qualified stock options, are not money and therefore not subject to RRTA taxes.
Author: Rebecca A. Barnes, CFP®, EA
Rebecca is a tax and financial planning practitioner with Callahan Financial Planning Company, serving clients in San Francisco, Mill Valley, and San Rafael, CA, Omaha and Lincoln, NE and Denver, CO.