The House and Senate have voted to enact a final tax reform bill (H.R.1, the Tax Cuts and Jobs Act), which includes several provisions that impact executive compensation programs. It is expected that President Trump will sign the legislation, which means many of the law’s provisions will apply for taxable years beginning after December 31, 2017.
Here’s a brief summary of these provisions:
Changes to 162(m)
The final bill removes the performance-based compensation exception to the $1 million pay cap under current Code section 162(m) and expands the definition of a “covered employee” to cover anyone who holds the CEO or CFO position at any time during the tax year (not just those in the job at year-end) and the three highest paid officers during the year. An employee who was a “covered employee” during any year (starting with the 2017 tax year) would continue to be a “covered employee” as to any compensation paid by the company in future years, including after retirement, to the individual or their beneficiaries. Thus, $1 million would become a hard cap on deductible compensation, and it would apply to a larger group of employees.
Code section 162(m)(2) will be expanded to provide that “publicly-held corporation” means any corporation issuing any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 and companies that are required to file reports under section 15(d) of the Securities Exchange Act of 1934. The most consequential effect of this expansion is that certain foreign companies that are publicly traded through an American Depository Receipt (ADRs) may now be subject to 162(m).
These changes would be applicable to taxable years beginning after December 31, 2017. The legislation includes a transition rule that would allow companies to deduct compensation paid under a written binding contract in effect on November 2, 2017, if the terms of the contract are not modified in any material way after that date. Please view “Making sense of the tax reform bill’s confounding 162(m) transition rule – is action by year-end necessary to preserve deductions?” Executive Pay Matters, December 20, 2017.
Changes to compensation programs for tax-exempt organizations
Under the tax reform legislation, tax-exempt organizations would be subject to a 21% excise tax (increased from 20% in the earlier versions of the legislation) on any remuneration paid to “covered employees” in excess of $1 million. The legislation clarifies that remuneration is treated as “paid” for purposes of the excise tax when the rights to the remuneration are no longer subject to a substantial risk of forfeiture (within the meaning of section 457(f)(3)(B)). A “covered employee” will include any current or former employee who is one of the five highest compensated employees during the current tax year or for any preceding taxable year beginning after 2016. Remuneration is defined broadly, to include all wages paid to the employee during the year. However, it does not include the portion of any remuneration paid to a licensed medical professional (i.e. doctors, nurses and veterinarians) that is for the performance of medical or veterinary services.
Additionally, tax-exempt organizations would be subject to a “golden parachute” regime, imposing a 21% excise tax that is triggered when amounts in excess of three times a covered employee’s base amount is paid upon separation from service. For this purpose, payments to a licensed medical professional for the performance of medical or veterinary services and amounts paid to employees who are not highly compensated employees as defined in section 414(q) are excluded. These provisions would apply to taxable years beginning after December 31, 2017.
Provisions in the House bill that would have eliminated deferred compensation for tax-exempt employees under Code section 457 and would have prevented tax-exempt employers from sponsoring 457(b) plans were stricken from the Senate bill and are not part of the final legislation. Additionally, provisions that would have changed the existing regime for determining when, and if, an excess benefit transaction excise tax applied, and would have eliminated protections provided to organization managers for reliance on professional advice, were also excluded.
Private company equity grants
The legislation includes new Code section 83(i), which would delay for up to five years the taxation of compensation paid to employees of “eligible corporations” in the form of “qualified stock.” An “eligible corporation” is one with stock that is not readily tradable on an established securities market and that has a written plan in place to grant stock options or restricted stock units (RSUs) to at least 80% of all full-time, U.S.-based employees. “Qualified stock” is:
- Received in connection with the exercise of options or settlement of RSUs
- Provided for an employee’s performance of services during a calendar year in which the corporation was an eligible corporation
Stock would not be considered “qualified stock” if the shares can be liquidated by permitting the employee to transfer the stock back to the corporation for cash once it first becomes transferable or not subject to a substantial risk of forfeiture.
Employees must make an affirmative election within 30 days of the date of an equity grant to defer income taxes on qualified stock, or be taxed, similar to an 83(b) election under current law. Once this election is made, income taxes on qualified stock would be due upon the earliest of the following:
- The date the stock is transferrable, including to the employer
- The date the employee first becomes an “excluded employee” (i.e., CEO, CFO or a 1% owner or one of the top four highest-paid employees for any of the 10 preceding taxable years, determined on the basis of the Securities and Exchange Commission disclosure rules for compensation, as if such rules applied to such a corporation).
- The first date any stock of the employer becomes readily tradable on an established securities market
- The date five years after the date the employee’s right to the stock is not subject to a substantial risk of forfeiture
- The date on which the employee revokes a deferral election
For employees to be eligible to make an 83(i) election, an eligible corporation would need to grant at least 80% of all full-time, U.S.-based employees stock options or RSUs that have the same rights and privileges (determined under the rules for Employee Stock Purchase Plans in Code section 423(b)(5)). To meet this standard, employees may receive different amounts of stock, but each participant must get more than a de minimis amount and employees cannot be granted a combination of stock options and RSUs during a year (i.e., they must be granted stock options or RSUs for the year).
Employees that have made 83(b) elections with respect to any stock options are not eligible to make elections under Code section 83(i). Additionally, the deferral election is generally not available if the corporation has bought back any outstanding stock in the preceding calendar year, unless at least 25% of the total dollar amount the company bought back is stock to which a Code section 83(i) deferral election is in effect and the determination of which individuals from whom such stock is purchased is made on a reasonable basis. In applying this requirement, stock subject to the longest deferral election under Code section 83(i) must be purchased first.
The employer would be subject to reporting requirements regarding stock on which employees have deferred income tax. The employer would also be required to provide notice to employees about their right to defer income tax on the stock as well as the consequences of the deferral. Employees who make the election would pay tax on the share value at vesting, which could decline over the deferral period.
Finally, qualified stock under 83(i) would not be treated as deferred compensation for purposes of Code section 409A.
Other employee compensation provisions
For the most part, the proposals in the House bill to repeal a number of provisions that permit employees to exclude employer-provided benefits from income did not appear in the final legislation. The two that remain would tax the reimbursement of qualified moving expenses and certain employee achievement awards. There are other provisions in the tax reform legislation that would deny a deduction for certain reimbursements. Here is a brief listing of those provisions, each of which is effective starting in tax year beginning in 2018:
- Moving Expenses: Companies will no longer be able to deduct most reimbursements provided to employees, nor can employees exclude those amounts from income if reimbursed by their employers.
- Employee Achievement Awards: Only certain employee achievement awards that are considered “tangible personal property” will be deductible to the employer and excludible from employee income. These will not include cash, cash equivalents, gift cards, gift coupons or cash-based gift certificates, or vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, or other securities.
- Other Benefits: Deductions are curtailed or eliminated for (1) entertainment, amusement or recreation; (2) club dues for business, pleasure, recreation or other social purposes; (3) a facility used in connection with any of the above items; (4) providing any qualified transportation fringe and most commuting expenses. Employers can still deduct the expenses for certain on-premises eating facilities.
Puneet Arora, Steve Seelig and William Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email firstname.lastname@example.org, email@example.com, William.firstname.lastname@example.org or email@example.com.