After a flurry of activity in the House and the Senate over the past few weeks, H.R.1, colloquially known as the Tax Cuts and Jobs Act (the “Act”), which represents the first major overhaul of the U.S. tax system in several decades, passed both houses on December 20, 2017. The Act makes certain significant changes in the area of executive compensation, which companies and their advisors should be aware of and evaluate carefully, particularly as companies consider their year-end planning and compensation programs for next year.
While the preliminary versions of the House and Senate bills contained certain provisions that would have drastically altered the rules governing executive compensation arrangements, those provisions did not make their way into the Act.¹ The Act does, however, include notable amendments to Code Section 162(m), as well as new rules regarding the tax treatment of certain stock options and RSUs granted to employees of private companies, and some other provisions which will be the subject of future alerts.
Modifications under Code Section 162(m)
Code Section 162(m) generally limits the deductibility of compensation paid to certain “covered employees” of public companies to $1 million. The Act removes the exclusion from the $1 million deduction limit for commissions and performance-based compensation. Until now, many companies have relied heavily on the exclusion for performance-based compensation (which requires the satisfaction of certain conditions in order to be utilized), opting to provide performance-based compensation to covered employees to assist in maximizing the company’s tax deductions while offering compensation to the extent desired. Companies that currently rely heavily on this exclusion can expect to be slapped with higher tax bills in connection with their compensation practices (assuming they continue to compensate covered employees at the same levels). However, companies also will be free from the conditions previously imposed in order to take advantage of the performance-based compensation exclusion, and may gain a certain level of flexibility in crafting their incentive arrangements when they no longer have an imperative to satisfy those conditions.
The Act also modifies the scope and treatment of “covered employees” for purposes of Code Section 162(m). Under current law and SEC guidance, four employees are considered “covered employees” for a given taxable year (including the CEO and the next three highest compensated employees, other than the CEO and the CFO), and each such individual must meet this qualification on the last day of the taxable year in order to be so designated for that year. The Act expands the definition of “covered employee” to include the CFO, as well. In addition, an individual is a “covered employee” if he or she holds one of the covered positions at any time during the taxable year, and the “covered employee” designation will continue to apply to an individual for all future years, even (1) when he or she is no longer employed by the company or (2) when payments are made to, or includible in the income of, another individual (such as a beneficiary after death, or a former spouse pursuant to a qualified domestic relations order). This continuing designation applies to any individual designated as a covered employee for taxable years beginning in or after 2017. Companies previously used deferred compensation to defer payments otherwise subject to Code Section 162(m) to a year in which the individual no longer was a “covered employee.” This approach no longer will work. Guidance will be needed as to how this continuing designation will apply to covered employees following a company’s acquisition by another company, and how the limit will apply to deferred compensation attributable to different executive positions.
The changes under Code Section 162(m) are generally effective for taxable years beginning in 2018, but there is a grandfather rule for compensation paid pursuant to a written, binding contract that was in effect on November 2, 2017, which was not modified in any material respect on or after that date. It is unclear how many arrangements will be able to take advantage of the grandfather rule as guidance is needed on a number of issues, including what constitutes a written, binding contract, the impact of the ability to use negative discretion and its applicability to evergreen arrangements.
Tax treatment of qualified equity grants in private companies
The Act also includes a provision pursuant to which certain private company employees who receive options or RSUs will be permitted to defer income inclusion of the stock received pursuant these awards for up to five years beyond the date they would be taxable under the current rules by filing an “inclusion deferral election” (similar to a Code Section 83(b) election) no later than 30 days after the award is substantially vested or transferable, whichever is earlier. A host of requirements must be met in order to qualify for this favorable tax treatment, the most significant of which are described below.
Generally, the new rule provides that a “qualified employee” of an “eligible corporation” may be eligible for deferred income inclusion with respect to “qualified stock.”
A “qualified employee” is an employee who agrees, in the inclusion deferral election, to meet the requirements necessary to ensure the withholding requirements of the company with respect to the qualified stock are met, and who is not (i) a 1% owner at any time during the calendar year, and has not been at any time during the 10 prior calendar years, (ii) the CEO or CFO (or an individual acting in either capacity), (iii) a family member of an individual described in (i) or (ii), or (iv) one of the highest compensated officers for the taxable year, and has not been for any of the 10 prior taxable years.
“Qualified stock” generally includes stock received by an employee in connection with the exercise of an option or the settlement of an RSU, where the option or RSU was granted in connection with the performance of services in a year in which the company was an eligible corporation. “Qualified stock” expressly does not include any stock if, at the time it becomes substantially vested, the employee may sell the stock to, or otherwise receive cash in lieu of stock from, the company.
An “eligible corporation” is a private company that has a written plan under which at least 80% of its U.S. employees are granted options or RSUs with the same rights and privileges. The applicable “rights and privileges” will be different for options and RSUs, and an inequality in the number of shares available to employees will not constitute a difference in rights and privileges so long as the number of shares available to each employee is more than de minimis. The 80% rule applies separately to each type of equity award, and accordingly, the requirement cannot be satisfied by granting a combination of options and RSUs in a given year. An inclusion deferral election may not be made if, in the prior calendar year, the company purchased any of its outstanding stock, unless at least 25% of the total dollar amount of the stock purchased is stock with respect to which an inclusion deferral election is in effect (“deferral stock”) and the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis. Companies transferring qualified stock to qualified employees have certain notice, income tax withholding and reporting requirements with respect to such transfers. Failure to provide the required notice may result in a penalty to the company.
These provisions generally apply to options exercised or RSUs settled beginning in 2018. Until further guidance is issued, a company will be treated as complying with the 80% rule and employer notice requirements if it complies with a reasonable good faith interpretation of those requirements.
This new rule offers private company employees the much desired ability to defer income taxation of equity grants, but the numerous requirements for eligibility, in particular the 80% rule, may make the deferral unavailable to many employees.
With respect to the changes under Code Section 162(m), public companies should first evaluate whether they can take advantage of the grandfather rule as well as whether there is any ability to accelerate deductions into 2017 so as to preserve deductibility. Going forward, companies will want to consider how to structure their compensation programs to balance the increased flexibility made possible by the elimination of the Code Section 162(m) restrictions with the desire to have a strong performance-based program.
With respect to the ability to defer taxation of private company equity awards, companies should review their plans to determine the availability of the new rule or whether their plans could be modified to make such deferrals possible.
A copy of the Act can be found here.