United States: Tax Bill: New Opportunity To Defer Tax On Certain Equity Awards And Repeal Of Performance-Based Exception To 162(M)

The Tax Cuts and Job Act of 2017 was recently signed into law creating two important changes in executive compensation, which we outline below.

The Tax Bill Permits Certain Employees to Elect to Defer Taxation of Qualified Equity Grants by Private Companies

The Tax Bill creates a new Section 83(i) of the tax code, which allows certain employees of private companies to defer taxation on the exercise of certain stock options or the settlement of restricted stock units for up to 5 years. Under current law, non-qualified stock options and restricted stock units are generally taxed on exercise (for options) or settlement (for restricted stock units).

The key benefit of Section 83(i) is the opportunity to defer taxation of income attributable to "qualified stock" (defined below) until the earlier of:

  • the date the qualified stock becomes transferrable (including transferable to the employer);
  • the date the stock becomes readily tradeable on an established securities market, such as upon an IPO;
  • the date that is 5 years after the employee's right in the stock is vested;
  • the date the employee becomes an "excluded employee" (defined below); or
  • the date the employee revokes his or her election.

However, not all employees and employers will be able to benefit from the new Section 83(i); specifically:

  • Section 83(i) can only be utilized by "eligible corporations." "Eligible corporations" are private companies that have a written plan under which at least 80% of all US employees (excluding part-time employees) are granted options or restricted stock units, with the same rights and privileges. The number of shares available to all employees need not be equal in amount so long as more than a de-minimis amount is available to each employee. Because Section 83(i) requires that 80% of all US employees to be participants, it is likely that only early stage corporations will be able to utilize this deferral opportunity.
  • Section 83(i) is available for employees who are not "excluded employees" and who make an election to defer (as further described below). An "excluded employee" is a person who:

    • is or has been at any time the corporation's chief executive officer or chief financial officer;
    • is or was one of the 4 highest compensated officers during the preceding 10 taxable years; or
    • is or was a 1% owner during the preceding 10 calendar years.

Employees who are family members of the CEO or CFO are also excluded.

Only the taxation of "qualified stock" is eligible for deferral under Section 83(i). "Qualified stock" means: (a) stock received in connection with the exercise of an option or settlement of a restricted stock unit; and (b) the option or restricted stock unit was granted by an employer in connection with the performance of services during a calendar year in which the employer was an "eligible corporation." However, qualified stock does not include any stock if, at the time of vesting, the employee may sell the stock to, or otherwise receive cash in lieu of stock from, the corporation. Further, no election is permissible if the employer purchased any of its outstanding stock in the preceding calendar year, unless (a) at least 25% of the total dollar amount of stock purchased is stock under which there is an active deferral election (i.e., "deferral stock"), and (b) the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis.

In order to take advantage of the deferral opportunity, the employee must make a Section 83(i) election no later than 30 days after the employee's rights in the qualified stock are transferrable or vested. If the election is made, the amount of income required to be included at the end of the deferral period will be based on the value of the stock at the time the stock becomes transferrable or vested, regardless of whether the stock value decreases during the deferral period. No election may be made under Section 83(i) if the employee has already made an election under Section 83(b) with respect to the qualified stock. In addition, if an election is made under new Section 83(i), an option granted as an incentive stock option, will no longer be eligible for the favorable tax treatment available to incentive stock options.

Section 83(i) also imposes notice and reporting requirements, which are as follows:

  • The employer is required to provide notice to the qualified employee at the time the right to the qualified stock becomes transferable or vested. The notice must: (a) certify that the stock is qualified stock; (b) notify the employee that the employee may be eligible to make an election to defer under Section 83(i); and (c) inform the employee of the tax consequences of the election. A failure to satisfy the notice requirements may result in the imposition of a penalty ($100 per failure, maximum of $50,000 per year).
  • The employer must report on Form W-2: (a) the amount of income covered by the deferral election for both the year of deferral and the year income is recognized by the employee; and (b) the aggregate amount of income which is deferred pursuant to Section 83(i) elections, determined as of the close of the calendar year.
  • Any employer with outstanding deferral stock as of the beginning of a calendar year which purchases any stock during such year is required to include on its tax return the total dollar amount of its outstanding stock purchased during the year.

Generally, the new Section 83(i) will apply to stock attributable to options exercised or restricted stock units settled after December 31, 2017.

The Tax Bill Repeals the Performance-Based Compensation Exception Under Section 162(m) and Expands Who is Covered by Section 162(m)

Under current law, Section 162(m) places a $1 million limit on the ability of "publicly held corporations" to deduct, for federal income tax purposes, compensation paid to "covered employees." Prior to the Tax Bill, compensation that was "performance-based" did not count against the $1 million limit.

The Tax Bill eliminates this performance-based exception, meaning that all compensation paid to a "covered employee" that is above $1 million will not be deductible by employer corporation. There will no longer be an exemption available for stock options and performance-based stock awards.

The Tax Bill also broadens the applicability of Section 162(m) in two key ways. First, the definition of "covered employee" has been expanded. Under current law, "covered employees" only includes the chief executive officer and the next 3 highest compensated officers (excluding the chief financial officer) who served in those roles at the end of the year. The definition of "covered employee" will be expanded to include the chief financial officer of the employer, and now applies to anyone who met the criteria at any time during the taxable year. In addition, beginning for covered employees in 2017, once an employee is a covered employee, they will remain subject to Section 162(m) for as long as they are employed by the corporation and beyond. This means corporations will no longer be able to defer compensation to an employee into a year when the employee is no longer a "covered employee."

Second, the definition of "publicly held corporation" is expanded beyond all publicly traded corporations (currently subject to Section 162(m)) to include corporations required to file under Section 15(d) of the Securities Exchange Act of 1934 (i.e., corporations with publicly traded debt).

The amendments to Section 162(m) will apply to taxable years beginning after December 31, 2017, except that the amendments will not apply to compensation provided pursuant to a binding contract that was in effect on November 2, 2017, and which was not modified in any material respect on or after that date. The impact of the grandfathering provision is still unclear. However, deductions in 2018 for performance-based awards granted in previous years may still be allowed. Compensation pursuant to an employment agreement with the chief financial officer entered into prior to November 2, 2017 may also still qualify for the deduction.

Takeaways

The creation of Section 83(i) potentially makes the equity component of executive compensation packages much more valuable. However, due to the limited scope and applicability of Section 83(i), it remains to be seen how many companies will elect to utilize this new opportunity.

Companies subject to Section 162(m) will likely modify their compensation philosophies to be more cash-based and more definitive in light of the repeal of the performance-based exception. In fact, some large public companies have recently announced a move to higher salaries in light of the changes to Section 162(m).

For more coverage of the new tax bill's impact on the workplace click here.

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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Authors
Pamela B. Greene
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