The Tax Cuts and Jobs Act (the “Act”) enacted and signed into law in December 2017, included significant changes to the tax laws regarding executive compensation. Regulations and the Joint Committee report, which will add details, are expected over the next 12-18 months.
$1,000,000 Deduction Limit. The Act changes section 162(m) of the Code. Prior to the Act, Section 162(m) set an annual limit of $1,000,000 for the tax deduction that may be taken by a public company (i.e., a company that has a class of stock required to be registered under Section 12 of the Securities Exchange Act) for compensation paid to the CEO or one of the four other executives whose compensation must be reported on the proxy statement because they are in the top-paid group. However, section 162(m) included the following exemptions and exceptions, which provided significant opportunities for avoiding the 162(m) limits:
- Compensation that met the requirements to be considered “qualified performance based compensation” was fully deductible.
- Commissions were fully deductible.
- Compensation paid to former employees and current employees who were formerly top-five executives was fully deductible.
- Compensation paid to the CFO was fully deductible.
Thus, prior to the Act, section 162(m) favored deferred compensation over current compensation, performance bonuses over salary and stock options over direct equity grants.
The Act eliminates all of the exemptions and exceptions. Therefore, effective 2018 and forward, all compensation in excess of $1,000,000 paid to any employee or former employee who is or was the CEO, the CFO, or one of the other top three executives whose compensation is required to be reported on the proxy statement, is not deductible by the company in computing its federal taxable income.
The changes eliminate the section 162(m) biases for deferred compensation, performance bonuses and stock option. We expect that companies will react to this by reevaluating the mix of stock options vs. restricted stock, salary vs bonuses and current compensation vs. deferred compensation payable to senior executives. Proxy statements will have to reflect the non-deductibility of amounts that were previously described as deductible under one of the exemptions.
Compensation payable pursuant to a legally binding agreement (such as a stock option agreement) that was in place prior to November 2, 2017 continues to be subject to section 162(m) as it was in effect prior to the Act, including all of the exemptions and exceptions discussed above.
Expansion of $1,000,000 Deduction Limit. The Act expands section 162(m) coverage (see above) to include private companies that are required to file reports under section 15(d) of the Securities Exchange Act. This includes, for example, private companies that have publicly issued debt.
Easing of Tax Burdens for Broad-Based equity Grants. The general rule for taxability of equity grants is that they are taxed at the later of grant or vesting. An employee may elect to be taxed at grant. One of the big concerns in respect of equity grants to employees of private companies is that the employees cannot sell the stock in order to raise the funds to pay the taxes. The Act permits non-executive employees who receive stock (as outright grants or pursuant to the exercise of stock options) to elect to defer income recognition for up to five years after vesting. In many cases a liquidity event (such as a sale of the company or an IPO) is the strategic goal. Therefore, in many cases it would be expected that within five years the stock would become liquid. The election is only available if the company makes non - de minimis grants to at least 80 percent of the U.S. workforce. The employer must notify employees of the ability to defer. An employee’s deferral would also defer the tax deduction for the employer.
The deferral opportunity may be especially attractive for start-ups that have only a few employees. A written plan is necessary.
The Act imposes an excise tax on tax-exempt organizations for compensation paid in any year to any of the top-five executives in excess of $1,000,000. The excise tax is equal to the corporate tax rate (currently 21 percent) multiplied by the amount of compensation paid to the executive in excess of $1,000,000. For example, if the CEO is paid $1.2 million, the employer would be subject to an excise tax of $42,000 (21 percent of $200,000). The excise tax is payable by the employer.