Paving the way for a net-win for technology companies, Senate Finance Committee Chairman Orrin Hatch (R-Utah) released a modified chairman’s mark to the Tax Cuts and Jobs Act that brings treatment of equity and performance-based compensation under the Senate Bill in substantial conformity with the bill reported by the House Ways and Means Committee last week. Most importantly, the modified mark alleviates concerns about accelerated taxation of options and restricted stock units (RSUs), and enables certain private company employees to defer taxation on options and RSUs for up to five years.
Adverse Revisions to Deferred Compensation Rules Stricken
Consistent with the status quo, stock options granted at fair market value will not be taxed on vesting. Unless a deferral election is made as described below, any gain received on the exercise of non-qualified stock options will continue to be taxed at ordinary income rates. Incentive stock options will continue to be eligible for preferential treatment that delays taxation at capital gains rates until a sale of the shares acquired on exercise and will benefit from the proposed repeal of the Alternative Minimum Tax.
In a much anticipated step to ease liquidity concerns for start-up employees, the modified Senate Bill, like the House Bill, permits qualifying private company employees to defer taxable income on the exercise of options for up to five years. The Senate Bill goes further to permit eligible employees to defer taxable income otherwise recognized upon settlement of RSUs. Both bills exclude the CEO, CFO, certain highly compensated individuals and 1% stockholders from eligibility to make deferral elections. Read our previous analysis in “Proposed Tax Reform Bill as Amended Stands to Significantly Impact Equity and Performance-Based Compensation.”
Transition Rules Under 162(m) Provide Limited Utility
Both the House and Senate Bills propose to repeal exceptions for qualified performance-based compensation, including options, currently provided under Section 162(m) of the Internal Revenue Code. The Senate Bill adds a limited transition rule that would exempt performance-based compensation in effect as of November 2, 2017, provided that the compensation was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.
Notably, existing Treasury Regulations that provide grandfather rules for newly public companies appear to remain intact. Under these existing rules, newly public companies are generally not subject to the $1 million deduction limitation imposed by 162(m) until the first annual stockholder meeting at which directors are elected occurring three calendars years following the initial public offering.