United States: Thanksgiving Tax Frenzy – New Tax Bill Proposes Executive Compensation Changes That Could Derail Deferred Compensation And Stock Options

Congress has been in a frenzy to try and get new tax legislation passed by Thanksgiving, and members of the House and Senate would presumably rather be enjoying a feast rather than drafting and analyzing additional tax provisions when Turkey day rolls around. This blog addresses the executive compensation related provisions in the proposed new tax legislation which is likely to be voted on in the very near future.

On November 2, 2017, the House released its version of the "Tax Cuts and Jobs Act" bill that would overhaul the current federal income tax regime in the United States. This bill was subsequently amended by the House Committee on Ways and Means on November 6, and on November 9, respectively. And on November 9th, the House Committee on Ways and Means approved the amended bill for subsequent consideration by the full House.

The Senate meanwhile is also working on its own version of a new tax bill, which in certain part follows the House bill, but also deviates from it in many regards. Each has proposed certain changes that would significantly impact the way that executives of companies are compensated and taxed and would likely change the way that most public, private and tax-exempt companies structure their incentive compensation. Below is a brief summary of the current law and the potential changes that could occur because of the new tax bill:

Under current law:

  • Certain employees, usually executives, can generally defer compensation to a later tax year subject to the rules of Section 409A of the Internal Revenue Code ("Code"), and such nonqualified deferred compensation is generally taxed when it is paid in subsequent years.
  • Stock options do not provide for deferral of compensation if the exercise price of the option cannot be less than the fair market value of the underlying shares on the date the option is granted, and if the option does not otherwise include a deferral feature. Such stock options are not taxed until they are exercised.
  • Code Section 162(m) limits the amount a public company may deduct for compensation paid to the CEO and the three highest paid executive officers (other than the CEO or CFO) to $1 million per year, with exceptions for performance-based remuneration which does not count toward the $1 million limit.

Under the Senate's Bill:

  • Any compensation provided under a nonqualified deferred compensation plan will be includible in the service provider's taxable income when there is no substantial risk of forfeiture of the service provider's rights to such compensation, and this would effectively eliminate deferred compensation. This repeals a current tax benefit enjoyed by many executives in many companies and reflects a major change in the law. A covenant not to compete or performance conditions (i.e., any condition related to a purpose of the compensation other than the performance of services in the future) would not constitute by themselves, a substantial risk of forfeiture. In other words, once the service provider has satisfied the underlying service requirement, the service provider would be taxed on the amount of compensation, even if there were other unsatisfied conditions to vesting.
  • Equity compensation awards granted to service providers, including stock options and the like will be considered to be nonqualified deferred compensation and therefore taxable when vested, even if there were performance conditions to vesting, and regardless of how the exercise price compares to the value of the underlying stock on the date the award is granted. This would likely effectively eliminate the usage of non-qualified stock options. However, it appears that incentive stock options ("ISOs") governed by Code Section 422 would continue to be treated as they currently are (i.e., no income tax on exercise, only upon disposition of the underlying shares). The use of ISOs may become particularly beneficial because under both the House and Senate versions of the tax bill, the alternative minimum tax would be repealed, and ISOs would no longer be subject to potential alternative minimum taxation.
  • Note that the House's bill originally had a provision similar to those described in these first two bullets, but in a subsequent amendment, struck these provisions.

Under the House's Bill:

  • Employees of privately held companies may avoid triggering the immediate inclusion of taxable income for stock options if an employee makes an election under Code Section 83. Under this provision, a "qualified employee" can defer income for up to five years after the employee exercises a vested option or has a stock award that becomes vested. Unfortunately, this provision may be quite limited in practice because top executive officers would be precluded from this benefit, and additionally, the tax bill would require a company to provide equity compensation to at least 80% of its employees.

Under both the House and Senate Bills:

  • The performance-based exception to Code Section 162(m) would be eliminated, thereby effectively limiting the amount an employer could deduct to $1 million per year for each covered employee subject to Code Section 162(m). This could represent a significant new tax burden as most publicly-traded companies rely on this performance-based exception to ensure deductibility of compensation paid to such executives. The CFO would also now be subject to the 162(m) deduction in addition to the other four executives and the tax bill would expand the application of the limitation to corporations with publicly-traded debt.
  • Tax-exempt organizations would be subject to a 20% excise tax on compensation paid in excess of $1 million to any of its five highest paid employees for a tax year.

If enacted, these rules would generally apply to tax years beginning after 2017. However, with respect to deferred compensation arrangements in place before 2018, the current laws would generally continue to apply until the last tax year beginning before 2026, at which time such arrangements would become subject to the provisions described herein. It is likely that the current proposals on the table will be modified before any enactment of the legislation. The evolution of the tax bill is very fluid and this blog reflects the state of the tax bills through November 12, 2017.

Companies and executives should carefully monitor the progress of the tax bills and, if desired, may want to weigh in with their legislators to influence the direction and outcome of the tax bill.

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.

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