It’s early days yet for the Tax Cuts and Jobs Act released last week by the House Ways and Means Committee, but one thing is clear: Congressional tax writers are scouring the landscape to find a combination of more revenue and accelerated revenue from various sources in order to pay for the substantial cuts in income taxes promised by the House Bill. House Republicans wisely decided against the “Rothification” of 401(k) plans, which would have generated revenue by reducing or limiting opportunities for pre-tax deferrals under the most prevalent retirement savings vehicle maintained by employers and would also have generated consternation from most industry and employee groups. But a variety of other tax-favored benefit programs and benefit plan features are being scrutinized for curtailment, including deferred compensation arrangements. In fact, the proposals contained in the House Bill regarding deferred compensation and executive compensation are nothing short of earthshaking. Specifically, the House Bill would sweep away the elaborate framework of rules that currently govern various types of deferred compensation arrangements and would also make significant changes to the rules relating to the deduction of executive compensation by public companies.
Sweeping Changes to Deferred Compensation Rules
The House Bill would replace Section 409A of the Internal Revenue Code with a simple rule that would tax nonqualified deferred compensation in the year in which the service provider’s right to receive the compensation ceases to be subject to a substantial risk of forfeiture (i.e., becomes vested). The new rule, codified under a new Code Section 409B, purports to apply to nonqualified deferred compensation earned with respect to services performed on or after January 1, 2018. (More on this potentially unrealistic effective date below.) Fortunately, the House Bill includes a fairly lengthy transition period for the treatment of benefits already earned under existing deferred compensation plans. Under the proposed rule, nonqualified deferred compensation attributable to services performed through the end of 2017 would be taxed in the later of the last taxable year of the service provider beginning before 2026 – which would be 2025 for individuals – or the taxable year in which such amounts are no longer subject to a substantial risk of forfeiture.
The definition of “nonqualified deferred compensation” is quite broad. It includes all cash-based forms of deferred compensation, as well as stock options, stock appreciation rights, phantom stock, and similar equity-based arrangements. (Restricted stock subject to taxation under Code Section 83 would not be covered by the new rule.) The bill would preserve the short-term deferral exception under Code Section 409A, which excludes from the scope of deferred compensation amounts that are paid within 2½ months following the end of a taxable year in which a service provider obtains a vested right to receive the compensation.
Tax exempt employers should take note that the House Bill, in its current form, would effectively eliminate the special treatment of deferred compensation arrangements under Code Section 457. So Section 457(b) plans would no longer be available to tax exempt employers and the more restrictive rules of Code Section 457(f) – which already provides for the taxation of deferred compensation when it becomes vested – would no longer be necessary. (Code Section 457 would continue to apply to the deferred compensation arrangements of state and local governments.)
The House Bill also includes a narrow definition of “substantial risk of forfeiture” which requires a service provider to provide substantial services in the future in order to achieve a deferral of compensation. This definition is consistent with meaning of substantial risk of forfeiture currently provided under Section 409A, but is narrower than the definition given in the proposed regulations under Code Section 457(f) released last year, which would allow a bona fide non-compete to create a substantial risk of forfeiture. Accelerated vesting and payment would be allowed, however, in the event of death, disability, and termination of employment without cause.
The Joint Committee on Taxation estimates that these changes in the law governing nonqualified deferred compensation would generate approximately $16 billion dollars of revenue for the federal government between 2018 and 2027.
Narrower Restrictions on Compensation Deductions under Code Section 162(m)
The House Bill would also make substantial changes to the limitations that apply to the deduction of executive compensation payments by public companies under Code Section 162(m). Most significantly the House Bill would eliminate the exception for performance-based compensation, which would require the value of stock options, stock appreciation rights, and other performance based pay to be counted toward the $1 million annual deduction limit. In addition, the definition of "covered employee" under Code Section 162(m) would be modified to include the chief executive officer, the chief financial officer, and the three highest compensated employees at the close of the tax year, which would align the term with the definition that applies under federal securities law. Finally, in an attempt to apply Section 162(m) concepts to tax exempt employers, the House Bill would enact a 20% excise tax on the payment of compensation in excess of $1 million by a tax exempt organization to any of its five most highly compensated employees during any tax year.
What Employers Should Do Now
Much more will be said and written about the House Bill as it progresses through the legislative process. The bill has already been modified by the mark up released yesterday by the House Ways and Means Committee and it remains to be seen what the Senate Finance Committee produces in the way of potential tax legislation. Given the transition period that will apply to deferred compensation benefits earned before January 1, 2018, there is no need for employers to take action with respect to their existing deferred compensation plans now. But employers – and employees who wish to defer compensation for the coming year – are left in a difficult position.
It seems unlikely that the January 1, 2018 effective date for new Code Section 409B will survive, but employers may wish consider delaying 2018 deferral elections or accepting them subject to suspension depending on the final terms of tax reform legislation. Similarly, employers may wish to delay or suspend contributions to be made in 2018 (other than contributions attributable to services provided before January 1, 2018) until the tax reform legislation is finalized. In any event, employers should continue to pay close attention to the benefits and compensation aspects of the tax reform legislation and fasten their seatbelts for what could be a bumpy ride.