This alert has been updated with the Chairman’s Amendment*
The House Ways and Means Committee on November 2, 2017, released the proposed Tax Cuts and Jobs Act, which may have significant impact on the taxation of equity and performance-based compensation for both private and public companies. The 400-plus-page draft bill was revised on November 3, 2017, and remains subject to further revision by the House, Senate and members of the White House Administration, including the Treasury Department in the coming days. If enacted in its current form, the bill would become effective January 1, 2018.
Changes to Deferred Compensation Rules Could Accelerate Taxation
The proposed bill effectively repeals Section 409A of the Internal Revenue Code (the Code), which currently sets forth a complex set of procedures allowing employees and other service providers to defer compensation earned in one year to future years in order to delay taxation. With the addition of a new section 409B, the proposed bill nearly eliminates the ability to defer compensation and instead imposes taxation (including income inclusion, wage withholding and W-2 reporting obligations) at the time any payment or award ceases to be subject to “future performance of substantial services.” The implementation of 409B as written would require companies to fully re-examine existing deferred compensation arrangements, including cash incentive plans and severance agreements. In particular, however, 409B would significantly alter the way companies utilize equity and performance-based compensation.
- General Taxation of Equity Awards on Vesting. 409B would result in taxation of non-qualified stock options and other equity awards upon vesting. This would create substantial liquidity concerns for employees and could put pressure on employers to facilitate net exercise and net settlement scenarios, or to implement design changes to their equity compensation practices. Notably, 409B does not appear to impact the taxation of incentive stock options (ISOs), which in conjunction with the repeal of the alternative minimum tax, would make ISOs more valuable (see below for more details). The bill does not clarify how vested equity awards will be valued for the purposes of taxation. However, because ISOs must be granted at fair market value, we presume “409A valuations” would remain applicable.
- Incentive Stock Options May Become More Attractive with Repeal of AMT, But Have Significant Limitations. The proposed bill leaves Section 422 of the Code, governing the taxation of ISOs, untouched, apparently exempting it from new Section 409B. As a result, ISOs may continue to offer employees eligibility to receive favorable tax treatment by deferring taxation until sale with the added benefit of capital gains treatment not available for non-qualified stock options. The bill’s proposal to repeal the alternative minimum tax, which currently has the effect of eliminating the tax benefits otherwise available to ISOs, may further make ISOs a more attractive benefit. However, ISOs remain subject to substantial restrictions that may limit their utility under the proposed tax regime. In particular, under the current tax rules, the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year may not exceed $100,000. ISOs that fail to comply with this provision are treated as non-qualified stock options. Companies with higher valuations would easily hit this threshold for executives and highly-paid employees and therefore would have limited reprieve from 409B.
- Potential Relief for Private Companies. On June 27, 2017, the House introduced H.R. 3084, a proposed bill that would permit certain private company employees to defer income upon the exercise of options and other equity awards for up to seven years.
The Tax Bill has been amended (the Amendment) by adding H.R. 3084, which was introduced on June 27, 2017 (the “Empowering Employees through Stock Ownership Act”).
The Amendment works to avoid triggering the immediate inclusion of taxable income under proposed Section 409B for stock options and restricted stock units of private companies if an employee makes an election. Under the Amendment, a deferral election is available for “qualified employees” and allows for an “income deferral period” of up to five years after such an employee exercises a vested option or a restricted stock unit becomes vested (the original text of H.R. 3084 proposes a seven-year period). Employees specifically excluded from deferral eligibility include 1% owners, the chief executive officer, the chief financial officer, and for any of the last 10 years, has been one of the four highest compensated officers, as determined by SEC proxy disclosure rules (each an Excluded Employee). The income deferral period would end upon the happening of specified events, such as (i) the stock of the company becoming readily tradable on an established securities market, (ii) the first date the stock becomes transferable (including transferable to the employer), presumably upon a merger with a public company, (iii) the employee revoking the election or (iv) an employee becoming an Excluded Employee.
To further incentivize shared ownership in private companies, the Amendment requires that, effective January 1, 2018, corporations provide stock compensation to at least 80% of its employees with the same rights and privileges to receive qualified stock.
The Amendment has numerous issues that must be resolved including (i) how you define Excluded Employees with reference to an SEC public company standard, (ii) whether a deferral election may be made with respect to vested options that have not been exercised, (iii) how becoming an Excluded Employee after making a deferral election would apply (including the lack of any control that employees would have in this situation) and (iv) how the equal rights and privileges concept would be applied in the context of determining the 80% limit and the applicability of severance and change of control protection that may exist with respect to some employees.
Notwithstanding the forgoing concerns, the Amendment is a step in the right direction for avoiding a severely problematic impact on equity compensation for private companies. However, there is still more needed to alleviate concerns relating to private companies as well as the concerns relating to how Section 409B will be applied to public companies.
- Special Consideration for PSUs and Event-Based Triggers. Because the proposed rules appear to rely only on service-based vesting conditions and exclude performance and event-based triggers, some equity awards could become taxable even before vesting. For example, performance-based restricted stock units would be taxable on grant unless, and only to the extent that, they include a service-based vesting component. Similarly, awards with vesting triggers based on exit events such as an initial public offering or change-in-control would be taxable on grant unless they require the recipient to be employed through the liquidity date.
- Impact on Merger Consideration. The accelerated taxation of equity would also place immense pressure on buyers, particularly in the private company context, to cash-out rather than assume equity awards in order to alleviate liquidity concerns for the equity holders and the company alike. Moreover, the proposed rules suggest that deferred or contingent merger proceeds payable to optionees and carve-out plan participants could be taxable at closing of the transaction, rather than upon receipt, absent provisions requiring continued employment through the payment date.
- Grandfathering of Compensation Earned Prior to 2018. The new deferred compensation rules would apply to compensation earned after December 31, 2017, and allow existing deferred compensation arrangements to remain in place provided that they are paid out by 2026. The bill also permits a one-time acceleration of existing deferred arrangements without penalty taxes. For example, if an employee earned a bonus in 2016 that pays out in 2020 pursuant to the terms of a bonus plan, the payment could be accelerated and subjected to immediate tax without incurring the 20% penalty tax that would otherwise be applicable under 409A.
Repeal of Deduction Exceptions for Performance-Based Compensation
Currently, Section 162(m) of the Code limits the tax deduction public companies may take for compensation paid to certain executive officers in excess of $1 million. The proposed bill will repeal exceptions to this limitation currently offered for qualified performance-based compensation, including non-qualified stock options. Although many companies currently structure their executive compensation to maximize applicable deductions for compensation expense, the value of such deductions and the corresponding impact of the repeal of Section 162(m) performance exceptions may be become less meaningful if corporate tax rates are reduced to the proposed 20%.