Effective on January 1, 2013, the tax cuts enacted by the Bush Administration and extended in December 2010 will automatically end, and tax rates will revert to their pre-2001 levels. This means that, absent action by Congress and the Obama Administration, the rates for most tax brackets will rise in 2013. For example, the lowest tax bracket (applying to ordinary income up to $17,900 for married taxpayers filing jointly) would rise from 10% to 15% and the top tax bracket (applying to ordinary income above $398,350 for married taxpayers filing jointly) would rise from 35% to 39.6%. In addition, deduction phaseouts for high-income taxpayers will reappear and the alternative minimum tax exemption amount will drop, ensnaring millions of additional taxpayers.
At this point, it is impossible to accurately predict what will happen to tax rates in 2013 in light of the split control of Congress. One possibility is that no agreement will be reached and taxes will automatically increase as noted above. Alternatively, a compromise may be reached. The only thing that seems certain is that tax liabilities of high earners will increase, either through higher tax rates, limitations on deductions, or a combination of the two. Thus, many employees, especially at the executive level, may want to accelerate compensation income into 2012. This client alert examines some of the alternatives for doing so.
2012 Bonuses. Most employers would pay out 2012 bonuses in the first quarter of 2013 in the normal course. In order to accelerate income to 2012, all or a portion of these bonuses generally could be paid by December 31, 2012. The obvious downside is the risk that the bonuses would be overpaid if company performance is below projections. To address this issue, some of our clients are considering paying out a significant percentage, but less than all, of projected 2012 bonuses, with a "true-up" in 2013. Similarly, it may be possible to accelerate certain signing, retention and other bonuses that are payable in 2013 into 2012. Of course, any public company that decides to pay out bonuses earlier than scheduled will need to consider SEC reporting obligations and possible adverse shareholder reactions.
Stock Option Exercise/Restricted Stock Vesting. Employees can choose to exercise vested stock options in 2012 (and employers can choose to accelerate vesting as necessary). In addition, the vesting of restricted stock could be accelerated into 2012. Similarly, the vesting of most restricted stock units (in general, those that pay out upon vesting) could be accelerated into 2012 and shares issued (or cash paid for cash-settled RSUs) by year-end. These alternatives are likely to be more attractive to privately held companies than to public companies, given the potential SEC disclosure issues.
Deferred Compensation Payments. Unfortunately, section 409A of the Internal Revenue Code places substantial limitations on the ability to accelerate deferred compensation into 2012 without adverse consequences, including a 20% additional income tax. For example, amounts payable as a result of termination of an arrangement subject to section 409A generally cannot be paid until one year after the arrangement is terminated. However, there are at least a few planning opportunities:
- Arrangements generally may be terminated and paid out within one year following a change in control. For plans of an employer that experienced a recent change of control, action could be taken to terminate affected plans in 2012 and immediately pay out benefits.
- Plans that provide for payment to be made during an objectively determinable period not to exceed 90 days following a permissible event (e.g., separation from service) generally may be made at any time during that period as long as the employee is not given an election as to when the payment is made. Thus, for any deferred compensation payments that could be made in the 90-day period crossing January 1, 2013, the employer generally could choose to make the payments in December 2012.
- Employees who were planning on terminating in 2013 and who are to receive distributions in connection with their terminations of employment could instead choose to terminate in 2012. This should generally allow the employer to process the distribution in 2012. Of course, this approach generally will not be available to "specified employees" (generally, officers) of publicly traded companies due to the required six-month delay for payments to these individuals under section 409A.
Tax-Qualified Retirement Plans. In some circumstances, employees may be able to accelerate tax-qualified retirement plan income into 2012. For a defined benefit plan, this would typically require termination of employment (and would only make sense if the plan offers a lump-sum distribution option). There may be more flexibility with "401(k)" and other defined contribution plans. For example, many such plans allow distributions of vested benefits for employees who reach a specified age (often age 59-1/2, because a 10% IRS excise tax usually applies to in-service distributions made before that date). Section 409A does not apply to tax-qualified retirement plans.
Conclusion. Given the likely tax increases, especially for high-income taxpayers, employees, companies and their tax advisors should consider the desirability of accelerating compensation income into 2012. As described above, there are a number of potential opportunities to do so. However, great care should be taken before any income is accelerated. In particular, any acceleration should be analyzed for compliance with section 409A of the Code.