The House tax reform bill released yesterday (as revised today) effectively shuts down nonqualified deferred compensation and penalizes compensation paid to top earners at public companies and tax-exempt organizations. If enacted in its current form, the bill is likely to have a significant impact on how companies and tax-exempt organizations pay their executives and key employees.
Nonqualified Deferred Compensation. Current law permits employees and other service providers to defer compensation, subject to compliance with Section 409A (e.g., timely elections, payments made only on specified dates or permissible events). The bill effectively repeals Section 409A and adds Section 409B, which all but eliminates the ability to defer compensation, and which significantly expands how deferred compensation is defined. The bill’s restrictions apply to compensation for services performed after December 31, 2017. Existing deferred compensation amounts are grandfathered but must be paid out before 2026.
Accelerated Inclusion of Income. Under the bill, compensation is includible in income when it is no longer subject to a substantial risk of forfeiture (“SROF”)—effectively on vesting—even if not payable until a future year. There is an exception for compensation paid by March 15 of the year after the year in which the compensation vests.
Compensation is considered subject to a SROF only if conditioned on the future performance of substantial services (neither a performance condition nor a non-compete qualifies as a SROF). In other words, the only SROF that can delay inclusion is a risk of loss of the compensation by a voluntary termination of employment.
Treatment of Stock Options. Stock options are specifically included in the bill’s definition of nonqualified deferred compensation. Read literally, this means that all stock options (including ISOs and ESPP options) are taxable when they vest (even if not yet exercised), unless by their terms the options are required to be exercised by March 15 of the year after the year in which they vest.
It is not clear if the bill intends to so dramatically restrict stock options or whether it is intended only to restrict options that contain certain features (e.g., a discount exercise price). This provision is not referenced in the summary of the bill prepared by the Ways and Means Committee Majority Tax Staff, and the bill does not include amendments to the various tax code provisions that currently address options, as would be expected if the elimination of the current provisions regarding options were intended to be part of the bill.
There are reports that another version of the legislation being considered would provide for deferred taxation of stock option gains in closely held companies but no such provision is included in the version of the bill released yesterday or in the Chairman’s mark of the bill released today.
Limit on Executive Compensation Paid by Public Companies. Section 162(m) currently imposes an annual limit of $1 million on the deductibility of compensation paid by a public company to each of its covered employees (the CEO and the three other highest paid executive officers, other than the CFO), with a similar but separate rule for emerging growth companies, unless an exception applies. The bill amends Section 162(m) as follows:
- The exceptions for performance-based compensation (including stock options) and commissions are repealed. Most public companies currently rely on the exception for performance-based compensation to preserve the deductibility of compensation paid to their covered employees.
- The list of covered employees is expanded to include the CFO. Accordingly, the $1 million deduction limit applies to the CEO, CFO and next three most highly compensated executives of a public company (including emerging growth companies, even if they have only three named executive officers).
- Also, any employee who is covered in one year remains covered so long as the employee receives compensation from the company (including after termination of employment). The deduction limit currently only applies on an annual basis, capturing only the CEO and the three other most highly compensated executives (other than the CFO) employed at the end of each year, and only compensation paid to those executives in that year. Under the bill, once the compensation of an executive is subject to the limit in one year, all compensation paid to that executive for services to the company in future years will also be subject to the limit, even if the executive ceases active service with the company.
- Section 162(m) currently covers any corporation issuing equity securities required to be registered under Section 12 of the Securities Exchange Act. The bill expands the deduction limit to any corporation that is an issuer of any securities that are required to be registered under Section 12, or that is required to file reports under Section 15(d), of the Securities Exchange Act. As a result, some companies with registered debt securities or that are not listed on an exchange but that have a large number of equity holders are covered. Foreign private issuers may also be covered.
- The amendment applies to taxable years beginning after December 31, 2017.
Limits on Compensation Paid by Tax-Exempt Organizations. Under current law, tax-exempt organizations (such as many hospitals and universities) are not subject to limits on compensation (other than the limitation on private inurement). The bill adds a new Section 4960, which imposes a 20% excise tax on “excessive” compensation paid by tax-exempt organizations.
- The excise tax, payable by the organization, applies to compensation above $1 million paid in any year to any of the organization’s five highest paid employees. Once an employee is covered by the limit, the employee remains covered so long as the employee receives compensation from the organization.
- The excise tax also applies to severance and other termination-related payments to any of these employees, if the payments have an aggregate present value of at least three times the employee’s annual base compensation.
- The excise tax applies to taxable years beginning after December 31, 2017.
To help companies prepare for potential changes to executive compensation rules, Davis Polk has put out a memorandum with tips for planning ahead in light of compensation-related proposals in the bill. The memorandum is available here.