House Majority Tax Bill Includes Fundamental Changes to Common Executive Compensation Arrangements and Benefits
By Steven Rabitz, Stroock
On November 6, 2017, House Ways and Means Committee Chairman Kevin Brady (R-TX) introduced the Tax Cuts and Jobs Act, the long-awaited Republican-sponsored tax bill (the "House Bill"). The House Bill proposes a significant overhaul to the Internal Revenue Code of 1986, as amended (the "Code").
This bulletin provides a brief overview of the provisions in the House Bill that significantly impact executive compensation and employee benefits, including the following notable changes:
- The effective elimination of the deferral of U.S. Federal income taxation on amounts deferred under many commonly utilized non-qualified deferred compensation arrangements;
- Elimination of the performance-based compensation exception to the Code Section 162(m) deduction limitation for publicly-traded companies;
- Imposition of a 20 percent excise tax on amounts paid over $1,000,000 to certain covered employees and parachute payments to certain covered employees of tax-exempt organizations;
- Eliminations of and/or limitations on certain deductions and income exclusions currently provided on benefits to employees; and
- Technical adjustments to tax-qualified retirement plan provisions.
This Bulletin does not address the many other topics associated with the House Bill. There is considerable uncertainty about the prospects of the House Bill in its currently proposed form, as it is expected that the Senate Republicans will soon offer their own version of tax reform. Further, it is possible that at the end of the day, either no tax reform will be enacted in 2017 or any tax reform enacted will look dramatically different than in the proposal.
Acceleration of Income for Most Compensatory Deferral Arrangements.
Under long established tax principles, service providers, including employees, are not generally taxed on compensation in respect of services they render unless they actually receive it, or are deemed to have constructively received it. For example, if an employer promises to pay an employee $1 million on the third anniversary of the promise, the employee is not generally taxed unless and until the amount is actually received by the employee. An employee may be deemed to constructively receive such amounts if, for example, amounts are set aside specifically for the employee's benefit in a trust (and the trust's assets are not otherwise subject to the claims of creditors of the employer under so-called "rabbi trust" arrangements), or the employee is allowed to access the unpaid amounts for security for a loan. These general principles have applied not only to promises in the form of cash payments, but also equity-based awards, such as restricted stock, restricted stock units and "phantom" units.
In the wake of the Enron bankruptcy, Congress enacted Code Section 409A, which has placed significant restrictions on the timing and form of the promises associated with, and the timing of the actual payments in respect of non-qualified deferred compensation. Separately, Code Sections 457(b) and 457(f) impose additional requirements on the deferral of income under a non-qualified plan sponsored by a governmental or tax-exempt entity and Code Section 457A imposes similar requirements on the deferral of income under non-qualified plans sponsored by tax-indifferent entities (e.g., entities not subject to taxation in the U.S.).
The House Bill would repeal Code Sections 409A, 457(b), 457(f), and 457A and replace them with new Code Section 409B. Pursuant to the proposed Code Section 409B, income deferred under a "non-qualified deferred compensation plan" is includible in income of the person who performed the services when there is no substantial risk of forfeiture of such individual's right to compensation. As drafted, Section 409B would effectively eliminate the ability of an employee to defer taxation of income outside of a qualified plan other than via the short-term deferral exception rule of Section 409A which was retained in Section 409B.
Section 409B defines rights "subject to a substantial risk of forfeiture" as rights to compensation that are "conditioned upon the future performance of substantial services by any person." Specifically excluded from conditions constituting a substantial risk of forfeiture are (i) covenants not to compete and (ii) the occurrence of a condition related to a purpose of the compensation other than the future performance of services. This suggests a very restrictive standard that would eliminate most common vesting conditions from qualifying, including, for example, vesting upon a change in control.
In a formulation reminiscent of, but more restrictive than, the currently effective Section 457A, Code Section 409B expands the definition of "non-qualified deferred compensation plan" to include equity compensation currently excluded from Section 409A coverage, specifically the right to compensation based on the appreciation in value of a specified number of equity units of the service recipient, whether paid in cash or equity, stock appreciation rights and stock options. The Code Section 409B definition of "non-qualified deferred compensation plan" does exclude the "portion of any plan which consists of a transfer of property described in Section 83." The House Bill, however, leaves open the question of how the taxation of equity grants that vest long before payment will be handled. For example, there are open questions as to the treatment of awards that become vested upon an employer-initiated termination other than for "cause" or when an employee terminates after meeting "retirement" age (i.e., has satisfied certain age and service requirements).
While it appears that this provision of the House Bill will not affect fully-vested 2017 year-end compensation awards grants, the impact over the intermediate term is more uncertain. Even those companies that are currently planning multi-year arrangements or staggered grants occurring over multiple years will have to be mindful of developments.
The concept of deferred compensation is not new, and there are many commercial reasons why companies have employed deferred compensation. Many have found deferred compensation an effective retention tool, and many have also found that deferred compensation helps to align the interests of employees and enterprise owners. Like many pay practices, deferred compensation has generated much debate and discussion. One need only look back to two major developments in this century alone to witness how regulatory perceptions have informed the structure of deferred compensation.
First, the Enron bankruptcy promoted an environment in which deferred compensation was regarded as potentially subject to abuse, and thus needing strict regulation. Next, the financial crisis of 2007 and 2o08 appeared to place greater primacy on ensuring that key employees maintained sufficient "skin in the game." Deferral of income and of income tax was perceived as a necessary bulwark against untoward risk and undesirable short-term incentives. Should the House Bill provision pass in its current form, there could be yet another paradigm shift, dramatically altering pay practices.
Elimination of Performance-Based Compensation for Section 162(m)
The House Bill substantially expands the application of the Section 162(m) $1 million limitation on deduction of compensation paid to covered employees under Code Section 162(m) (currently, the CEO, and four other highest paid executive officers, other than the principal financial officer) of publicly-traded companies by eliminating the exception for qualifying performance-based compensation and expanding the universe of people and companies subject to Code Section 162(m). The House Bill applies this elimination of the exception to stock options and stock appreciation rights (although coupled with the current inclusion of stock options and stock appreciation rights as non-qualified deferred compensation, it is questionable whether companies would continue to favor such types of awards or with what features and in what contexts).
If this provision of the House Bill is enacted in its current form, it could be expected to have a significant impact on the compensation structure for executives of public companies, as incentive compensation for such employees is often structured to qualify for the performance-based exception to prevent loss of deduction of payments of compensation to officers in excess of $1 million. More importantly, it likely will have a decidedly greater impact on shareholders of those companies—should those companies choose to pay compensation in excess of $1 million to covered executive officers.
Of lesser impact, the House Bill also (i) expands the definition of covered employees to include any employee who (A) was the "principal executive officer" or "principal financial officer" any time during the taxable year (B) who is required to have his or her income disclosed pursuant to the Securities and Exchange Act of 1934 ("the '34 Act") by virtue of being one of the three most highly compensated officers of the company (other than the principal executive) or (C) was a covered employee of the taxpayer of any previous year starting with 2017 and (ii) expands the definition of a public company to include any corporation which is an issuer that is required to file reports under Section 15(d) of the '34 Act. Thus, under the House Bill, a covered executive would continue to be subject to Code Section 162(m)'s limitations even if no longer considered a "covered employee." In addition, as a result of expanding the definition of "public companies," some companies with registered debt securities, or that are not listed on an exchange but that have a large number of equity holders, would under the proposal become subject to Code Section 162(m), as may foreign private issuers that have traditionally avoided such limitations.
Excise Tax on Tax-Exempt Executive Compensation
In what appears to be an attempt to align compensation paid to executives of tax-exempt organizations with the compensation limits imposed on public company executives, the House Bill imposes a new 20 percent excise tax (payable by the employer) on compensation in excess of $1 million paid to the five highest paid employees for the tax year of an applicable tax-exempt organization. The excise tax also applies to any excess parachute payments paid to such individuals. The definition of excess parachute payment generally follows the definition of Code Section 280G parachute payments, but instead of a parachute payment being defined based on payments contingent on a change in control, parachute payment is defined in reference to a payment contingent on the employee's separation from employment from the employer.
Elimination of Deductibility of Certain Employee Fringe Benefits
The House Bill reduces or eliminates a number of tax benefits for employees and their employers. The income exclusions for Dependent Care Assistance Programs, Adoption Assistance Programs and Qualified Moving Expenses provided by employers are all eliminated in House Bill and a $50,000 limit is imposed on the exclusion of employer-provided housing from income (reduced further for high income individuals and completely eliminated for 5 percent owners).
The House Bill eliminates deductions for entertainment expenses regardless of relation to the taxpayers trade or business and for deductions for certain fringe benefits provided by an employer to an employee and not included in the income of the employee.
A new Code provision is also added under the House Bill for Tax-exempt entities, requiring them to treat the cost of transportation fringe benefits, on-premises gyms and other athletic facilities provided to employees as unrelated business taxable income subject to the corporate tax rate.
Adjustments to Tax Qualified Retirement Plans Provisions
The House Bill also makes a number of technical changes to provisions of the Code governing tax qualified retirement plans, including:
- The elimination of the option to re-characterize a Roth contribution as a traditional IRA contribution;
- Reduction of the minimum age for in service distributions from defined benefit plans and state and local government defined contribution plans from 62 to 59 1/2;
- Relaxation of certain rules regarding hardship distributions and loans from defined contribution plans; and
- Technical changes to rules regarding testing of tax-qualified plans for compliance with nondiscrimination rules.
The proposals in the House Bill raise not only many interpretative and operational issues but also on the design and structure of compensation and benefit arrangements. They may also have knock-on effect for those service providers to such arrangements, including trustees and custodians to IRAs and record-keepers to qualified plans.
In coming days and weeks, we will learn more about whether these proposals will take more definitive form, or be deferred indefinitely.
See, Section 451(a), and Treasury Regulation section 1.451-1(a).
Code Section 409B in the House Bill provides that compensation will not be treated as deferred for purposes of Section 409B if the service provider receives payment of such compensation not later than 2 1/2 months after the end of the taxable year of the service recipient during which the right to payment is no longer subject to a substantial risk of forfeiture.