On November 16, the House of Representatives passed its version of the Tax Cuts and Jobs Act, and the Senate passed its version of the bill on December 2. Although the House and Senate must first reconcile their respective versions before the bill can be enacted into law, we are highlighting three significant executive compensation changes that are part of both the current House and Senate versions of the bill (collectively referred to as the “tax reform bill”).
1. New opportunity to defer taxation of non-publicly traded company options and restricted stock unit awards.
Currently, non-qualified stock options are taxed upon exercise and restricted stock unit (RSU) awards are generally taxed at the time they are vested and settled. The tax reform bill would allow qualifying employees of privately-held companies to elect to defer income tax on income from illiquid stock acquired in connection with the exercise of stock options or the settlement of RSU awards for up to five years after the employee exercises a vested option or an RSU becomes vested. This election would be available with respect to options that are exercised or RSUs that are vested and settled after December 31, 2017. One condition for such “qualified equity grants” is that the employer must implement a broad-based equity incentive program that grants stock options or RSUs to at least 80 percent of its employees in a calendar year. The deferral election would not be available to certain employees of the companies issuing the awards—i.e., individuals who are current or former chief executive officers, chief financial officers, certain other highly compensated employees or 1 percent owners do not qualify for the extra deferral election.
2. Commission-based and performance-based compensation exclusions eliminated for compensation subject to Code Section 162(m) deduction limit.
Tax Code Section 162(m) currently limits public companies from deducting compensation over $1 million paid in one year to certain executive officers. This limitation does not apply to certain commission-based and performance-based compensation. The tax reform bill proposes to eliminate these exclusions. Also, the scope of the Section 162(m) limit would be expanded to include the chief financial officer and individuals who at any time were “covered employees” of the public company, so long as the company continues to provide remuneration to such individuals. These changes would result in the loss of some of the tax advantages of performance-based compensation and may cause some employers to re-evaluate their executive compensation programs. However, we expect that many companies would continue to maintain performance-based compensation programs for their other benefits, including linking the compensation of executives to company performance.
3. New tax on executive compensation for tax-exempt organizations.
Under the tax reform bill, tax-exempt organizations would be subject to a 20 percent excise tax on:
- Compensation over $1 million paid to its current or former five highest-paid employees, plus
- Payments to such employees that are contingent on the employee’s separation of employment and exceed the individual’s annual taxable compensation in the five years preceding the date of termination, if the aggregate amount of such contingent payments is at least three times the individual’s average historical compensation amount.
In addition to these significant changes, the House version of the bill would repeal the alternative minimum tax, which currently limits the tax benefits that are otherwise available for incentive stock options (or ISOs). The Senate version would increase the amounts that are exempt from the alternative minimum tax, but would not entirely repeal the tax. To the extent that this tax is eliminated or applies to fewer individuals, this should increase the attractiveness of ISOs, although they would be subject to the same limits and holding period rules that currently exist.
The original versions of both the House and Senate bills included significant changes to the current tax treatment of nonqualified deferred compensation, including Code Section 409A, however, those changes have been deleted from the tax reform bill. Had these changes remained part of the bill, companies would have been required to restructure their deferred compensation arrangements, including equity and equity-based awards, nonqualified supplemental retirement plans and severance programs.
We will provide updates on tax reform provisions that affect executive compensation as more information becomes known through the legislative process.