The tax reform bill released by House Republicans on November 2, 2017, would dramatically change the executive compensation landscape. Under a proposed new rule (section 409B), compensation would generally be taxed as it “vests” regardless of when it is earned. This new treatment would apply to many types of deferred compensation that are commonly used to incentivize employees to grow the value of a business, including stock options, stock appreciation rights, and change of control bonuses. If enacted, this new rule would likely have the harshest impact on private companies, which often rely on “liquidity events,” such as a change of control or IPO, to reward employees. It would also unleash a host of drafting issues for current employee benefit arrangements, contracts, grants, and plans.
The tax reform bill would eliminate the performance-based pay exception to section 162(m), with the result that compensation paid by publicly traded companies to certain executive officers would not be deductible to the extent in excess of $1 million in a particular year.
New Section 409B
Under new section 409B, deferred compensation would be taxed as it “vests,” regardless of when it is actually paid. For this purpose, compensation would be considered unvested only if it is conditioned on the future performance of substantial services by the service provider. Compensation that does not depend on future performance of services, but for example, is dependent on the employer meeting a particular goal (such as attainment of earnings or IPO), would be considered vested.
Importantly, section 409B would apply to equity-based compensation, including stock options, stock appreciation rights, and other rights to compensation based on the value or appreciation in value of equity of the employer. Presumably service providers would be taxed on appreciation in value of vested equity awards, without regard to exercise. Unless incentive stock options (ISOs) are carved out in regulatory guidance, this rule would eliminate the special tax treatment available for ISOs.
There are very limited exceptions to the definition of “deferred compensation,” including certain tax qualified employer plans; certain vacation or sick leave, compensatory time, disability pay, or death benefit plan; and compensation payable by March 15 of the year following the year in which it vests.
The proposed section 409B provides transition rules for existing deferred compensation, which would have to be included in income by 2025. Current section 409A would be eliminated, and the Treasury and IRS are directed to issue guidance allowing companies to change the payment date of compensation deferred under current plans to align with the date that the compensation would be taxed under section 409B.
Since section 409A was enacted in 2004, companies have carefully structured employment agreements, separation agreements, equity grants, and compensation plans to be exempt from or comply with section 409A. If section 409B is enacted, companies will need to review and likely amend those plans.
Section 409B may have the biggest impact on privately held companies, which frequently use equity-based awards to incentivize employees and for which there is generally no liquidity until a change of control or IPO. These employees often wait until a liquidity event to exercise options. A tax imposed on the appreciation in value of unexercised options would severely decrease the attractiveness of options as a compensation vehicle.
Elimination of Section 162(m) Performance Based Compensation Exception
Under current section 162(m), compensation paid by publicly traded companies to certain executive officers is not deductible to the extent it exceeds $1 million in a particular year. There is an exception, however, for performance-based compensation, which is deductible even if it exceeds $1 million. Many publicly traded corporations have structured at least a portion of their executive compensation packages to comply with the performance-based compensation exception. The proposed tax reform bill would eliminate the exception and, in effect, increase the cost of certain executive compensation. The bill also specifies that a company’s chief financial officer would be a specified officer for this purpose (along with the chief executive officer and the next three most highly compensated executives).
Bottom line, the proposed revisions to sections 409A and 162(m) represent a significant departure from long-standing executive compensation rules that are well-embedded in industry practice. Compliance with the new rules and transitions, if passed, will require careful review of existing agreements and practices.