Lists abound at this time of year. This list covers year-end planning ideas for executive compensation matters. A combination of the expiration of the "Bush-era" tax cuts and the additional Medicare taxes required by implementation of the Affordable Care Act suggest consideration of a number of executive compensation items of year-end tax planning, in addition to normal year-end items.
First, a summary of the changes taking effect in 2013 that most directly affect executive compensation, assuming no Congressional action to change the results:
- There will be an increase in maximum federal income tax rates. The highest rate (absent Congressional action) will increase from 35% to 39.6%.
- The highest rate on long term capital gains will increase from 15% to 20%.
- There will be an increase in Medicare taxes on wages over $200,000 (single) or $250,000 (married filing jointly) of .9% (an increase from 1.45% to 2.35%).
- There will be a new Medicare tax of 3.8% on the lower of (1) modified adjusted gross income over $200,000 (single) or $250,000 (married filing jointly) or (2) the sum of investment income (interest (other than municipal bond interest), short-term and long-term capital gains, and the taxable portion of annuity payments, but not distributions from tax-qualified retirement plans).
The "top ten" items that follow are divided into three broad categories: (A) items that should be on a regular year-end checklist, and are unaffected by tax rates, (B) items that are not unique to 2012, but that deserve a renewed examination in light of possible increases in various tax rates, (C) uniquely 2012 items that are keyed to potential changes in income taxes, employment taxes and capital gains rates.
Executive Compensation Regular Year-End Checklist
1. 409A Documentary Errors
What if a 409A deferred compensation plan contains a documentary error, but the amount at issue is still subject to a substantial risk of forfeiture? For example, what if a severance plan provides for non-exempt installment payments on involuntary separation from service but lump sum payments on involuntary separation from service within 2 years after a change in control, and the definition of change in control is not 409A-compliant? This is an impermissible double toggle and violates Section 409A on its face.
The 409A income inclusion proposed regulations make it clear that only deferred amounts as to which the substantial risk of forfeiture has (or would have) lapsed on or before December 31, are subject to income inclusion if the plan fails to meet the requirements of Section 409A. See Prop. Treas. Reg. Section 1.409A-4(a)(2).
Thus, if the document is corrected (e.g. by making the CIC definition 409A compliant) before the risk of forfeiture lapses (here, before an involuntary separation) and the risk of forfeiture does not lapse on or before December 31, the documentary error is corrected. There is no 409A penalty, and (apparently) no need to file under the documentary correction program. The preamble to the proposed regulations clarifies that this is the intent. See Preamble to Prop. Treas. Reg. Section 1.409A-4, at Section II: "In the subsequent taxable year in which the service provider becomes vested in the deferred amount, the plan might comply with section 409A(a) in form and operation, so that under the general rule no income inclusion would be required and no additional taxes would be due for that year…"
Not surprisingly, the proposed 409A income inclusion regulations also contain an anti-abuse rule, Prop. Treas. Reg. Section 1.409A-4(a)(1)(ii)(B) that allows the IRS to ignore vesting terms if there is a pattern or practice of permitting otherwise impermissible changes in the time or form of payment of unvested deferred amounts.
Now is a good time to re-check documents, especially if they were brought into compliance with Section 409A early, as many interpretations and understandings have evolved. Sometimes changes innocently made to forms of documents trip disastrous Section 409A consequences. Double-toggles, for example, can be inadvertently created by special vesting rules for retirement (which can cause a loss of the short-term deferral exemption) or by payment events that are not a permitted 409A trigger (such as an IPO) or departure of the CEO.
2. 409A Again (Release Timing)
If payment of a deferred amount subject to Section 409A is contingent on the service provider's (employee's) taking an employment-related action (most often, execution and non-revocation of a release and waiver of claims), the employer has until December 31, 2012 to be sure the plan documents do not permit the service provider to "choose" the year of payment by manipulating the date of signing the release. See IRS Notice 2010-6. Two alternative approaches are permitted:
- Provide in the documents that post-separation payments will be made on a specified date (e.g. 60 days) after separation provided the release has been signed and not revoked. This requires a 60-day delay in payment post-termination (for anyone not subject to the 6-month delay). Such a delay may be inconvenient for the recipient, especially if salary continuation (and related COBRA deductions) is involved, but is has the virtue of treating all recipients the same.
- Provide in the documents that if the post-separation period for executing a release commences in one year and ends in the subsequent year, the payment will not be made (or commence) until the subsequent year, regardless of in which year the revocation period ends. Under this approach only persons who separate late in the year (typically November or December) will potentially be affected by a delay in payment (not counting the 6-month delay applicable to specified employees). However, not all recipients will be treated the same.
An informal review of documentary provisions shows widespread use of both options.
3. Don't forget shareholder re-approval under Code Section 162(m)
Where an incentive plan is designed to meet the performance-based compensation exception under Code Section 162(m), the plan may list several (or numerous) performance measures from which the compensation committee may choose in setting goals. These performance measures must be approved by shareholders. If the incentive formula is not locked into the plan (i.e., if the committee may re-set the formula each year and may choose among permitted performance measures) the performance measures must re-approved by shareholders every five years. Treas. Reg. §1.162-27(e)(4)(vi). Thus, if the list of performance measures was last approved in 2008, it would have to be re-approved no later than the first shareholder meeting in 2013. Many companies are already working on drafts of 2013 proxy statements, and this item should be on the checklist. Too often it gets added at the last minute or gets overlooked.
Year-End Checklist Items Worth a Closer Look than Usual Because of Possible Tax Increases
4. Be sure to take first required minimum distribution in 2012
For terminated individuals reaching 70-1/2 in 2012, the first required minimum distribution under Section 401(a)(9) of the Code ("RMD") is due for 2012, although the regulations permit it to be paid as late as April 1, 2013. (In that case, two RMDs are due in 2013.) By taking the first RMD in 2012 (for those eligible), the higher marginal income tax rates can be avoided.
5. To Roth or not to Roth?
The decision whether to convert a substantial amount (e.g. an existing rollover IRA or a 401(k) plan account balance where an in-service distribution is available) to a Roth rollover account is complicated, as it has always been. It's a longer-term financial decision, and a conversion in 2012 could adversely affect the individual's marginal tax rates and whether AMT applies. On the other hand, Roth IRAs are not subject to required minimum distributions under Code Section 401(a)(9). And with tax rates set to increase, it may be worth another look, even if the executive previously considered and rejected a Roth conversion.
2012 Executive Compensation Ideas Uniquely Tied to Possible Tax Increases.
6. Accelerate vesting on account-balance-type non-qualified deferred compensation
For account-balance-type non-qualified deferred compensation, employment taxes (Social Security and Medicare taxes) are due in the year the deferred amount is no longer subject to a substantial risk of forfeiture. Treas. Reg. § 1.3121(v)-1(e). By accelerating vesting of deferred amounts, some savings on employment taxes may be achievable. Where a tax-exempt organization is involved and the account is subject to full immediate taxation on vesting under Code Section 457(f), acceleration would have additional implications, including an adverse cash flow for the organization.
7. Consider early inclusion of defined-benefit-type non-qualified deferred compensation for employment taxes
Generally, accrued benefits under a non-account-balance deferred compensation plan are not required to be taken into account for employment taxes until the date the amount ultimately payable is "reasonably ascertainable." That is, the amount, form of payment, and commencement date are all known and the only actuarial assumptions required are interest and mortality. Treas. Reg. § 1.3121(v)(2)-1(e)(4)(i).
However, the employer may choose to take the benefit amount into account on any earlier date (but not earlier than the vesting date). Treas. Reg. §1.3121(v)(2)-1(e)(4)(ii). (In that case, there is a true up when amounts are actually determinable.) Of course, where the tax payments serve to reduce the benefits, the employee cannot have a choice without risking triggering constructive receipt. If the employee is required to pay the employment taxes out-of-pocket, an employee choice should be permissible. Also, if a tax-exempt organization is involved and the arrangement is subject to Section 457(f), accelerating the vesting date would also trigger full taxation and may not be desirable.
Acceleration of payment of employment taxes in this case should not be an impermissible acceleration under Section 409A because the Section 409A anti-acceleration rules have an exception for payment of employment taxes (and any income taxes on the amount deemed distributed to cover employment taxes). Treas. Reg. §1.409A-3(j)(4)(vi).
Acceleration of employment taxes on a defined-benefit amount of $1 million (assuming the maximum rates would be applicable) would result in a savings of $47,000 (.9% + 3.8% x $1 million) if the employment taxes are paid in 2012 instead of 2013 (assuming no Congressional action to change this result). For very large SERPs, the savings could be even more substantial.
8. Accelerate annual bonuses into 2012
Many companies with a calendar year fiscal year pay annual bonuses early in the year following the performance year (e.g., in 2013 for 2012 performance) although the company takes the deduction in the earlier year.
It is now close enough to the end of the year that, in many cases, performance against a stated goal can be determined or closely estimated. In such a case, by accelerating payment of bonuses for 2012 performance into 2012, the employer can allow employees to save not only the income tax increase but also the employment tax increases. Some plans may need to be amended to permit this, but others provide the employer or the compensation committee enough flexibility to accelerate the payment without amending the plan.
Several cautions are in order here. First, not all employees will be in the highest marginal tax brackets and may not gain a significant tax savings from the accelerated payment. Those who are not in high brackets may not appreciate paying 2012 taxes on amounts that otherwise would not be taxable until 2013, although since most taxes are paid through withholding, there may be no practical difference whether the amount is paid in 2012 or 2013 for these lower-bracket employees.
Second, for those four individuals at a public company whose compensation is subject to the Code Section 162 (m) limit, pre-payment of an incentive in 2012 based on 2012 performance will not qualify as performance-based compensation because the performance period will not have ended. However, most companies will know by this point in the year which executives will be subject to Section 162(m) and therefore the Section 162(m) impact can be controlled by not pre-paying bonuses to those individuals until 2013, after the performance period ends and the performance can be certified. Caution should be used if the executive has made an election during the performance period (but at least 6 months prior to the end of the performance period) to defer payment of the bonus. If the bonus is accelerated by, in effect, truncating the performance period, the deferral election timing may not satisfy Section 409A requirements. The 409A effect will be governed by the documents and the timing of the election and should be examined carefully.
Finally, for companies whose annual bonus operates as a plan-within-a plan (a plan with a readily-triggered performance condition tempered by a heavy does of negative discretion in the plan-within-a plan), accelerating payment into 2012 is probably not advisable. This is because with this type of plan the company's deduction is taken in the year after the performance year, once the negative discretion has been exercised and the "all events test" has been met. Thus, accelerating payment of the bonus would not only wreak havoc with the normal bonus determinations, but would also cause a doubling up of the company's deduction in 2012 and result in no deduction for 2013 if the company goes back to the post-performance-year payment scheme.
9. Exercise vested options
For those fortunate enough to hold stock options that are in the money, exercising them in 2012 instead of 2013 could result in significant tax savings by avoiding the higher income tax and employment tax rates on the income realized on exercise.
10. Sell vested restricted stock
"Vested restricted stock" is really just unencumbered "stock" held by the executive. After the 1-year capital gains holding period is satisfied, the gain on the sale of that stock would be taxable at long-term capital gains rates. By selling the stock held long term in 2012, the 15% maximum capital gain rate can be locked in. If longer term appreciation is expected, the stock can be repurchased with a new higher basis. The tax savings would have to exceed the transaction costs for this to be worthwhile. Those individuals subject to Section 16(b) of the Securities Exchange Act of 1934 must take care not to have purchases and sales of the stock within a 6-month period unless an exemption is available under Rule 16b-3 to prevent matching the purchase and sale, triggering liability. Also, executives subject to stock retention requirements will need to be sure not to run afoul of them.