A radical transformation is in store for executive compensation if last week’s tax reform bill (the House Ways & Means Committee’s Tax Cuts and Jobs Act) becomes law. If passed as written, every employer will need to quickly re-examine and re-think their approach to their equity, incentive, severance and deferred compensation arrangements. The changes, if implemented, would result in:
- Taxation at Vesting for Amounts Attributable to Services Performed After December 31, 2017. Deferred compensation would be taxable at the time of vesting rather than payment. Only continued performance of services will qualify as a vesting condition for this purpose — no performance-based condition will delay vesting. The implementation of these changes will have a major impact on many common arrangements, including:
- Non-qualified stock options and stock appreciation rights for public companies, which will become obsolete in their current form because taxation could be imposed before exercise;
- Severance arrangements, which may be deemed vested and taxable before payment;
- Restricted stock unit arrangements with retirement features, because amounts would be taxable (in many cases) well in advance of the time of payment (traditional restricted stock would not be impacted); and
- Traditional deferred compensation arrangements (such as excess benefit plans, SERPs and salary/bonus deferral programs), because accruals and deferrals would be taxable immediately or at the time of vesting.
- Year 2025 Income Inclusion for Existing Deferrals. Deferred compensation amounts attributable to services performed before January 1, 2018 would become taxable in full by the end of 2025 (or, if later, at the time of vesting).
- Tightening of the $1 Million Annual Deduction Limit in Section 162(m). Beginning after December 31, 2017, the "performance-based compensation" exception to the $1 million annual deduction limitation in Section 162(m) would be eliminated. This could affect existing performance-based awards, stock options, SARS and severance amounts that pay out after 2017. Moreover, the covered employees subject to the $1 million deduction limit under Section 162(m) would be expanded to include CFOs, former covered employees and their beneficiaries. Finally, the corporations subject to Section 162(m) would be expanded to include companies that file SEC reports solely due to public debt, such as many private equity portfolio companies.
The net effect of these rules would be far-reaching, with numerous questions that will need to be answered by regulations and other guidance implementing the rules. It remains to be seen if the House bill will stand up to political scrutiny. In addition, the Senate is expected to release its tax bill on Thursday, November 9th, and may take a different approach than the House.
The above changes to the executive compensation tax laws are complex, and may change throughout the legislative process. Baker Botts will be tracking the legislation and ready to answer your questions as tax reform develops.