Last week, we posted on the tax legislation bill proposed that day by House Republicans (see Holy Cow! Proposed Tax Bill Would Turn Executive Compensation on Its Head). Now that we have had an opportunity to fully digest it, we find that the proposed changes are even worse than we thought. Below is a slightly more comprehensive summary of the two big changes affecting executive compensation.
Modifications to the $1 Million Deduction Limit of Code Section 162(m)
The Bill modifies and expands Code Section 162(m) in four important ways:
- The Bill would eliminate the performance-based compensation exclusion from Section 162(m)—and the exclusion for commission-based compensation. Obviously this would have a dramatic impact on the tax cost of compensating covered employees. Estimates indicate that a covered employee’s compensation consists of 50% - 75% in performance-based compensation, which generally is intended to be deductible under Section 162(m), without regard to a cap.
- The Bill would explicitly extend Section 162(m) to the CFO. Not surprising.
- The Bill would provide that any individual who is treated as a “covered employee” under Section 162(m) for any taxable year beginning after December 31, 2016, would continue to be considered a “covered employee” with respect to that company so long as the company continues to provide remuneration to the individual. This includes persons who terminate or otherwise cease to be an NEO in a year (e.g., due a reduction in roles).
- Finally, the Bill would apply the limits of Section 162(m) to any company that files SEC reports, including those that issue debt securities to the public, but not stock.
Limitations on Nonqualified Deferred Compensation
The Bill would essentially end the deferral of compensation, supplemental executive retirement plans, and excess plans, as we know them by replacing Code Sections 409A and 457A with a new Code Section 409B, effective for services performed after December 31, 2017.
- Under the Bill, an employee would be taxed on compensation as soon as it is no longer a subject to a substantial risk of forfeiture, and the Bill defines “substantial risk of forfeiture” narrowly, as it is under Code Section 457(f), as only if the person’s rights to such compensation are conditioned upon the future performance of substantial services [by any person].
- The risk of forfeiture due to the employer’s insolvency is not good enough.
- Neither is the risk of forfeiture due to a covenant not to compete, or other restrictive covenant, or the occurrence of a condition related to a purpose of the compensation other than the future performance of services good enough.
- And financial performance conditions would not alone, constitute a substantial risk of forfeiture.
- Under new Section 409B, nonqualified deferred compensation would specifically include phantom stock, stock options, stock appreciation rights (SARs), certain restricted stock units (RSUs), and other similar equity instruments. Only forms of equity compensation that are subject to Code Section 83, such as restricted stock, would be excluded.
- The exception for short-term deferrals would continue to apply.
- Stock options and SARs would be taxed when vested, as opposed to when exercised.
- The Transition rules provide that all deferred compensation amounts and accrued benefits as of December 31, 2017 will be grandfathered under the rules of 409A until 2025. In 2025, those amounts when the will recognized as income, unless they remain subject to a substantial risk of forfeiture.
- IRS would be required to publish regulations that allow employers to amend or terminate their deferred comp plans to provide for distributions in or prior to 2026.
Supposedly another version of the Tax Bill is expected this week, so everything in here may be superseded. Stay tuned. A complete summary of the executive compensation and employee benefits provisions can be found here.