© 2017 The Texas Lawbook.
By Gail Stewart and David Schiller of Baker Botts
Nonqualified Deferred Compensation Changes
Current law
- Taxation now occurs at payment. Amounts deferred under a nonqualified deferred compensation plan, or deferred compensation, that comply with applicable statutory rules generally are not taxable until such amounts are actually or constructively received (generally at payment).
- Certain types of arrangements are not considered a deferral of compensation. Therefore, they are not considered subject to the rules regulating nonqualified deferred compensation. These arrangements include short-term deferrals and stock options or stock appreciation rights (SARs).
- A payment is considered a short-term deferral if the terms of the plan do not provide for a deferred payment and require that payments be made to the employee within the “short-term deferral period.” The short-term deferral period begins at vesting and ends 2.5 months after the close of the tax year when vesting occurs.
- A stock option or SAR does not provide for the deferral of compensation if the exercise price of the stock option or SAR is not less than the fair market value of the underlying stock on the date of grant and the stock right does not otherwise provide for a deferral of compensation.
Proposed rules
- The changes, if implemented, would result in taxation at vesting for amounts attributable to services performed after Dec. 31, 2017. Deferred compensation would be taxable at the time when there is no substantial risk of forfeiture (at vesting) rather than at payment, unless paid out within the short-term deferral period described above. Deferred compensation will be treated as subject to a substantial risk of forfeiture only to the extent that the right to payment is conditioned on the employee’s future performance of services. (Only service-based vesting will be recognized. Performance-based vesting is disregarded, and a covenant not to compete will not create a substantial risk of forfeiture.)
- The implementation of these changes will have a major impact on many common arrangements because taxation will now occur immediately upon vesting and not at a later payout. Here are some likely consequences:
- Stock options and SARs will become obsolete in their current form in the public sector because taxation could be imposed before exercise (under the House Bill, rules would allow up to 5 years of deferral on broad-based private company stock options and RSUs issued to employees who are not NEOs);
- Multiyear severance arrangements would be deemed vested and taxable before payment. This would likely result in severance being paid in an immediate lump sum. Moreover, this is also likely to have an adverse effect on an employer’s ability to enforce any post-termination restrictive covenants to which the executive is subject since their enforceability has historically been bolstered by structuring severance payments over an extended period of time.
- Restricted stock unit arrangements with retirement features – or other deferred payment features, such as payable only upon an initial public offering – will no longer be viable because such retirement or other deferred payment features would no longer constitute a substantial risk of forfeiture (they are not conditioned on the future performance of substantial services by the employee). Thus amounts would be taxable in many cases well in advance of the time of payment.
- Traditional deferred compensation arrangements – such as excess benefit plans, SERPs and salary or bonus deferral programs – will be severely curtailed because accruals and deferrals would be taxable immediately upon vesting.
- Voluntary early retirement windows presumably would no longer permit tax deferral on multiyear payments, unless part of a tax-qualified plan.
- Presumably, these changes would result in a reversion back to using traditional restricted stock subject to IRC Section 83 as the preferred form of equity compensation. Restricted stock (including performance-based restricted stock) appears to be exempt from these new rules.
- These changes, together with the elimination of the alternative minimum tax and lowering of the corporate tax rate, will also renew interest in incentive stock options (ISOs), which maintain their tax-qualified status.
- Deferred compensation amounts attributable to services performed before Jan. 1, 2018, would become taxable in full by the end of 2026 (or, if later, at the time of service-based vesting).
These deferred compensation changes would be implemented pursuant to a new section of the Internal Revenue Code (Section 409B) and the elimination of Sections 409A and 457A. As referenced above, these changes would apply differently depending on whether the deferred compensation is attributable to services occurring after Dec. 31, 2017, or before Jan. 1, 2018.
Internal Revenue Code Section 162(m)
Current law
Employers generally may deduct reasonable compensation for personal services as an ordinary and necessary business expense. But Section 162(m) provides a $1 million per year limit on the deductibility of compensation expenses with respect to a covered employee of a publicly held corporation. Nonetheless, remuneration payable solely on account of the attainment of one or more pre-established performance goals is not subject to the deduction limit if certain outside director and shareholder approval requirements are met. Section 162(m) defines a covered employee as the CEO as of the close of the taxable year and the three most highly compensated officers for the taxable year (other than the CEO).
Proposed rules
After Dec. 31, 2017, the “performance-based compensation” and commission exceptions to the $1 million annual deduction limitation in Section 162(m) would be eliminated. This could also affect existing performance-based awards, stock options and SARs 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. This expansion to cover former employees would arguably subject severance pay to Section 162(m) as well. 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.
New Internal Revenue Code Section 4960 for Tax-Exempt and Government Employers
Current law
Employers are generally allowed a deduction for reasonable compensation expenses, subject to a $1 million deduction limit in the case of a publicly held corporation. That limit generally does not apply to tax exempt organizations.
Proposed rules
Tax exempt organizations would be subject to a 20 percent excise tax on compensation in excess of $1 million paid to their top five executives. This excise tax would also apply to severance paid to such executives exceeding three times the executive’s five-year average base amount.
Open Questions
The net effect of these rules would be far-reaching, and many questions will need to be answered by regulations and other guidance implementing the rules. For example:
- What methodology will be used to tax stock options and SARs at vesting? Will it be based on the option or SAR spread at vesting or on the Black-Scholes model?
- How will a performance-based restricted stock unit be valued if it will be taxed before the applicable performance conditions have occurred and performance will not be measurable at such time?
- Will “qualified performance-based awards” granted prior to 2018 but vest after 2018 remain eligible for deduction under Section 162(m)?
The above changes to the executive compensation tax laws are complex, and may change throughout the legislative process. It remains to be seen if the Senate and House bills will stand up to political scrutiny.
Baker Botts lawyers Eric Winwood, Mark Bodron, Rob Fowler and Marian Fielding also contributed to this article.
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