Between the American Taxpayer Relief Act of 2012, enacted on Jan. 1, 2013 to avert the fiscal cliff, and the phase-in of new rules from the Patient Protection and Affordable Care Act, a number of new tax rules may affect executive compensation in 2013.
The new higher tax bracket of 39.6% is for very high earners and applies to withholding from supplemental wages in excess of $1 million. Supplemental wages such as bonuses and income from equity awards are subject to special withholding. The employer can elect to combine supplemental wages with regular wages and withhold based on the total, or can elect to withhold at a flat rate of 25% (unchanged from 2012) on the supplemental wages. For supplemental wages in excess of $1 million paid in 2013, however, the employer must withhold at a flat rate of 39.6%. The IRS recently ruled that the withholding cannot exceed the 39.6%. If the employee expects to owe more than the amounts withheld, he or she must either arrange for more withholding from regular wages or make estimated tax payments.
In addition to higher withholding on supplemental wages, when an executive's wages exceed $200,000, the employer must withhold the additional 0.9% Medicare tax on the wages above $200,000. While the additional Medicare tax applies to the executive only if the adjusted gross income of the executive and his or her spouse exceeds $250,000 for married executives and $200,000 for unmarried executives, the withholding obligation is based on the employer's pay to the executive.
Just as for all employees, the FICA tax reduction to 4.2% is history for executives. For 2013, the FICA tax is 6.2% of the first $113,700 in wages paid by an employer. While this is not a major tax increase, because it is only $2,274 in additional taxes, it does need to be considered.
For 2013, taxes on investment income are increased. First, the basic rate on dividends and capital gains has risen to 20% for higher-income taxpayers. In addition, the new 3.8% tax rate on investment earnings for high-income taxpayers applies. Thus, capital gains are now taxed at 23.8% versus the prior rate of 15%, roughly a 59% increase. So, executives who are contemplating selling company stock or recognizing capital gains in 2013 must contend with higher taxes.
The alternative minimum tax (AMT) was permanently "patched" as part of the fiscal cliff legislation. There are a number of issues for high-income taxpayers, however. While the patch helps taxpayers at the bottom edge of the "higher income" group, the patch will be phased out for those with much higher incomes. While many of these individuals have not paid AMT in the past, they need to be aware that the AMT is computed and compared to the regular tax liability. The 3.8% tax on investment income will be added to tax liability after the minimum tax has been computed. Thus, for those taxpayers who have paid minimum tax in the past, there is no relief from the additional 3.8% tax on investment income, because it will be added to the greater of the regular tax liability or the minimum tax liability.
Dealing with restricted property, health benefits
The IRS in 2012 provided a model election under Section 83(b) of the Internal Revenue Code. When an employee or independent contractor is awarded restricted property in exchange for services, he or she can elect to accelerate the taxation of the restricted property received. The general rule is that property subject to restrictions is taxed to the service provider at the time the restrictions lapse and is taxed on the value of the property at the time the restrictions lapse, less any amount paid for the property. For example, if an employee is awarded a share of restricted stock when the stock is worth $10, but the stock is valued at $25 when the restrictions lapse, the employee is taxed based on the $25 value. With an election under Section 83(b), the employee can elect to be taxed on the $10 value on the date of grant, even though the stock could end up being forfeited.
There are numerous technical requirements for making the election under Section 83(b), and an executive should consult his or her tax adviser before making the election. However, the IRS form should enable the executive to make the election without fear of the IRS's rejection for an incomplete election.
Many executive employment contracts call for the executive to receive employer-paid medical benefits for some period of time after the executive terminates employment. These benefits typically are provided if the executive is terminated without cause or there has been a change in control of the employer. The Patient Protection and Affordable Care Act provided penalties for discrimination in the provision of health benefits to highly compensated employees. There have long been rules about discriminatory health coverage for self-insured plans, but the rules now apply to insured plans. The rules became effective in 2012, but the IRS has stayed the effective date pending the issuance of final regulations.
Under the old rules, discrimination in self-insured plans resulted in the executive's being taxed on the extra benefits. The rules for insured plans provide that the employer is assessed a substantial penalty based on the number of employees discriminated against. Thus, for a large company, providing one executive with postemployment medical coverage may result in very large penalties against the employer.
While the IRS has yet to provide final regulations, employers and executives should be prepared to amend existing employment agreements when the IRS does issue them, to prevent penalties against the employer.
For public companies, executive compensation should continue to be transparent. Pressure to align executive rewards with company performance will continue. While the proxy monitoring services are not perfect in their analysis and recommendations, they influence executive compensation design considerably. It's more important than ever to tell your compensation "story" in the discussion and analysis. Aligning executive compensation programs with shareholder interests is not easy, but relying on a program that is "the same as last year" will no longer be sufficient. When designing or approving executive compensation programs, compensation committees need to think about how a program looks, as well as how it works.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
