United States: Tax Law Changes To Executive Compensation

The tax law signed by the President on December 22, 2017 makes a number of changes to the executive compensation rules for public and private companies as well as for non-profit employers. This Advisory briefly summarizes certain of the key changes.

Broad Expansion of Section 162(m) $1 Million Compensation Limitation

  • Performance-Based Compensation Exception Repealed. Historically, performance-based compensation, such as stock option income and compensation paid only on the attainment of performance goals, has been excepted from the $1 million deduction limitation. The performance-based compensation exception is repealed by the new law.
  • CFOs Again Subject to Section 162(m). The legislation amends Section 162(m) to specifically include a publicly held corporation's principal financial officer as a "covered employee" subject to Section 162(m). This corrects an unintended gap that, since 2007, left CFOs generally not being subject to Section 162(m) (due to changes in the SEC's executive compensation disclosure rules).
  • Once Covered, Always Covered. If an executive is a "covered employee" subject to Section 162(m) in 2017 or any later year, the new law provides that he or she remains a covered employee for all future periods, including after termination of employment for any reason (including death). This eliminates the ability to deduct, for example, severance payments made after termination of an executive's employment to the extent that the severance results in compensation in excess of the limit.
  • Expansion of Covered Companies. The definition of a publicly held corporation subject to Section 162(m) is expanded by the new law to include any corporation "that is required to file reports under section 15(d) of [the Securities Exchange Act of 1934]." This change would subject private corporations with public debt that triggers Section 15(d) reporting to the $1 million deduction limitation.
  • Limited Grandfathering Rule. The new law grandfathers compensation provided pursuant to a written binding contract in effect on November 2, 2017, so long as it is not modified in any material respect on or after November 2, 2017.

Deferral of Stock Option and RSU Income Inclusion by Employees of Privately Held Corporations

The law adds a new Section 83(i) to the Internal Revenue Code that, subject to a range of detailed conditions, allows most employees of privately held corporations to elect to defer the inclusion of income arising from the exercise of stock options and the payment of restricted stock units (RSUs) in stock for up to five years. Key conditions and requirements imposed under Section 83(i) include the following:

  • Eligible Corporation Requirements. The corporation issuing the stock options or RSUs must not be a public company (or ever have been a public company) and must maintain a written plan under which at least 80% of the company's US employees (excluding certain top executives and part-time employees) received options or RSUs covering more than a de mimimis number of shares with the same rights and privileges in that year. (As a practical matter, this 80% requirement will likely exclude many corporations from being eligible for this rule.) In addition, the corporation must not have repurchased stock in the immediately preceding year unless 25% or more of the shares repurchased were option or RSU deferral stock. For purposes of applying these eligibility rules, all persons treated as a single employer under the controlled group rules are treated as one corporation.
  • Eligible Employee Requirements. To be eligible to defer tax recognition, the employee must not be (or ever have been) the chief executive officer or chief financial officer (or a family member of the CEO or CFO), a 1% owner of the corporation within the past 10 years, or one of the four most highly compensated officers in any of the past 10 years.
  • Deferral Requirements. Eligible employees may elect to defer the recognition of stock option or RSU income until the earliest of (a) five years after the date the stock is first vested (or can be transferred free of vesting conditions), or (b) the date the stock becomes transferable (including to the employer) or publicly traded, or (c) the date on which the employee is no longer eligible for the deferral or revokes the deferral election.
  • Notice Requirement. Effective January 1, 2018, the corporation must comply with requirements to notify employees of their rights to defer and is subject to penalties to the IRS (of $100 for each missed notice, up to an annual cap of $50,000) for failure to provide notification.
  • Effect of Election to Defer. When income is included at the end of the deferral period, the amount included is based on the value of the stock at the time of exercise or settlement, rather than at the time of income inclusion. This rule applies even if the value of the stock has declined during the deferral period.

New Section 83(i) applies to stock options exercised, and RSUs settled, after December 31, 2017. As a result, privately held corporations will want to determine if Section 83(i) may apply to outstanding option and RSU awards and, if applicable, be ready to satisfy Section 83(i)'s notice requirements. Because of the restrictive conditions imposed in order for Section 83(i) to apply, we expect that its use by privately held corporations will be limited.

Non-Profits: Excise Taxes on "Excess" Compensation

  • Excise Tax on Compensation Over $1 Million. In general, annual compensation in excess of $1 million paid to any of the top five most highly paid persons at a non-profit results in an excise tax on the employer in the amount of 21% of the compensation that exceeds $1 million.
  • Excise Taxes on Large Termination Payments. A 21% excise tax is imposed on separation payments that exceed a specified level. This excise tax, payable by the non-profit, is imposed if severance payments to any of its top five most highly compensated persons equal or exceed three times the person's average compensation over the preceding five years.

Certain Exceptions and Special Rules

  • For purposes of calculating the amount of compensation paid under these excise tax rules, compensation is deemed to be paid when it is no longer subject to a substantial risk of forfeiture.
  • Payments for the performance of medical or veterinary services made to a licensed medical professional are excluded from these excise taxes.

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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