Tax Reform Proposals Threaten Major Changes to Executive Compensation
The tax reform proposals under consideration in both houses of Congress threaten to upend longstanding executive compensation practices. The Senate's proposal relating to deferred compensation would bring many customary compensation practices to a halt and affect top executives as well as many employees at lower levels. Both chambers' proposals include new limitations on executive compensation at both publicly held companies as well as at non-profit employers. All employers should monitor the tax reform process as executive compensation changes may become effective as early as January 1, 2018, leaving very little time to prepare. Certain key aspects of the proposals are outlined below. At the time this was written, the Joint Committee on Taxation had issued a Description of the Chairman's Mark (dated November 9, 2017) summarizing the yet to be released Senate bill.
Senate Proposal Ends Deferred Compensation for Services After December 31, 2017
- Taxation Upon Vesting; Only Service-Based Vesting Allowed. Under the Senate's proposal (as well as under a substantially similar provision that was eliminated from the House proposal in committee), essentially all nonqualified deferred compensation, including, surprisingly, nonqualified stock options and severance pay, would be includible in income when the compensation is no longer subject to a service-based substantial risk of forfeiture (subject to a limited short-term deferral exception). By apparently repealing existing Sections 409A, 457A and 457(f), the Senate's proposal effectively eliminates, among other things, executive SERPs, the ability to pay severance over time, the ability to use any performance-based vesting triggers that are not coupled with a continued service requirement, and the economic utility of nonqualified stock options.
- No Change in the Rules on Restricted Stock and Statutory Options. The Senate's proposal preserves the existing treatment under Section 83 of property transfers (e.g., restricted stock). Statutory stock options (e.g., ISOs) under Sections 422 and 423 are preserved as well.
- Murky Transition. It is unclear how transition rules would apply to existing deferrals and stock options. Under the Senate proposal, existing deferrals must be included in income by the later of 2026 or when the compensation is no longer subject to a service-based substantial risk of forfeiture.
Public Companies: Elimination of the Broad Exception to Section 162(m) $1 Million Compensation Limitation
- Performance Based Compensation Exception Repealed. Historically, performance-based compensation, such as stock option income or compensation paid only on the attainment of performance goals, has been excepted from the $1 million deduction limitation. The House and Senate proposals repeal the performance-based compensation exception.
- CFOs Again Subject to Section 162(m). The proposals correct an unintended gap that had resulted in CFOs generally not being subject to Section 162(m) since 2007 due to changes in the SEC's executive compensation disclosure rules.
- Once Covered, Always Covered. The proposals provide that once an executive is subject to Section 162(m), he or she remains covered for all future periods, including after termination of employment. This would eliminate the ability to deduct, for example, large payments, such as severance, made after termination of an executive's employment.
- Expansion of Covered Companies. The House proposal expands the definition of a publicly held corporations subject to Section 162(m) to include any corporation "that is required to file reports under section 15(d) of [the Securities Exchange Act of 1934]." One impact of this change appears to be to subject private corporations with public debt that triggers Section 15(d) reporting to the $1 million deduction limitation.
Excise Taxes on "Excess" Non-Profit Executive Compensation
- Excise Tax on Compensation over $1 Million. In general, annual compensation in excess of $1 million paid to any of the top five most highly paid executives at a non-profit would, under the proposals, result in an excise tax on the employer in the amount of 20 percent of the compensation that exceeds $1 million.
- Excise Taxes on Large Termination Payments. The proposals seek to limit severance at non-profits by imposing a 20 percent excise tax. In general, under the proposals, a non-profit is liable for the excise tax if payments made in connection with a termination of employment to any of its top five most highly compensated executives equal or exceed three times the executive's average compensation over the preceding five years.
For more information about how the executive compensation provisions in the tax reform proposals may impact you, please contact Ed Bintz, Jeff London, Doug Pelley, or Kathleen Wechter.
© 2017 Arnold & Porter Kaye Scholer LLP. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.