New Tax Law Affects Exec Comp Deduction, Other Provisions
While the new tax law avoided making major changes to the existing retirement tax provisions, the same cannot be said for the tax treatment of executive compensation and related provisions.
In the event you’ve been avoiding the news for the past two weeks, President Trump signed the Tax Cuts and Jobs Act
(TCJA) into law (H.R. 1/P.L. 115-97) on Dec. 22, delivering a nearly $1.5 trillion net tax cut over the 10-year period 2018-2027. The new law affects every segment of the tax code, including corporations, pass-through entities, individual files and estates. However, in order to comply with the budget requirements, the new law includes several revenue raisers to help offset the cost of the changes, including several compensation and benefit changes.
Following are highlights of the key compensation changes, which include:
1. modifying the deductibility of so-called excessive employee remuneration;
2. extending an excise tax on “excess tax-exempt organization executive compensation”;
3. modifying the treatment of qualified equity grants;
4. changing the holding period for so-called carried interest; and
5. increasing the excise tax for stock compensation of insiders in expatriated corporations.
Expansion of Code Section 162(m)
One revenue raiser to help offset the cost of the law is a provision to modify the current limitation on so-called “excessive” employee remuneration under Code Section 162(m). Under the provision, the $1 million yearly limit on the deduction for compensation with respect to a “covered employee” of a publicly traded corporation under Section 162(m) is expanded to include the principal executive officer, the principal financial officer and the next three highest paid employees — conforming the definition of “covered employee” with the current SEC reporting rules.
In addition, the current exceptions for commissions and performance-based compensation is repealed, such that the $1 million deduction limit applies to stock options, stock appreciation rights, performance stock units and performance shares. In addition, for a tax year beginning after 2016, once an employee qualifies as a covered employee, the deduction limitation applies to that person so long as the corporation pays remuneration to that person (or to any beneficiaries) – the so-called “once a covered employee, always a covered employee” provision.
The TCJA also extends the Section 162(m) limit to include all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs), or which are otherwise treated as reporting companies under Section 15(d) of the Securities Exchange Act.
The provision applies to tax years beginning after Dec. 31, 2017. The law includes a transition rule specifying that the changes do not apply to any remuneration under a written binding contract in effect on Nov. 2, 2017, and that is not modified in any material respect. For purposes of this rule, any contract that is entered into on or before Nov. 2, 2017, and that is renewed after such date is treated as a new contract entered into on the day the renewal takes effect.
Excise Tax on Tax-Exempt Organization Exec Comp
The TCJA imposes an excise tax of 21% on compensation in excess of $1 million paid to any of the five highest-paid employees of a tax-exempt organization (or any person who was such an employee in any preceding tax year beginning after 2016). The tax applies to the value of all remuneration paid for services, including cash and the cash-value of most benefits.
Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration. In addition, the definition of remuneration for this purpose includes amounts required to be included in gross income under Section 457(f). The conference agreement clarifies that substantial risk of forfeiture is based on the definition under section 457(f)(3)(B) which applies to ineligible deferred compensation subject to Section 457(f).
Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested (and any increases in such value or vested remuneration) under this definition, even if it is not yet received.
The excise tax also applies to excess “parachute payments,” or payments in the nature of compensation that are contingent on an employee’s separation and, in present value, are at least three times the employee’s base compensation. The base amount would be the average annualized compensation includible in the covered employee’s gross income for the five tax years ending before the date of the employee’s separation from employment.
Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity or an eligible deferred compensation plan of a state or local government employer. The conference agreement also exempts compensation paid to employees who are not highly compensated employees (within the meaning of Section 414(q)) from the definition of parachute payment, and also exempts compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment.
The provision is effective for tax years beginning after 2017.
Treatment of Qualified Equity Grants
While not a so-called revenue raiser (as described above), the new law includes a provision permitting private companies to allow employees to elect to defer recognition of income attributable to stock received on exercise of an option or settlement of a restricted stock unit (RSU) until an opportunity to sell some of the stock arises. Qualified employees are permitted to defer recognition for up to five years from the date the employee’s right to the stock becomes substantially vested.
If an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the tax year that includes the earliest of:
1. the first date the qualified stock becomes transferable;
2. the date the employee first becomes an excluded employee;
3. the first date on which any stock of the employer becomes readily tradable on an established securities market;
4. the date five years after the first date the employee’s right to the stock becomes substantially vested; or
5. the date on which the employee revokes their inclusion deferral election.
Elections apply only to stock of the employee’s employer and the options or RSUs would have to be granted in connection with the performance of services by the employee. A written plan must provide that at least 80% of the employees of the company would be granted stock options or RSUs with the same rights and privileges. The conference agreement clarifies that the 80% requirement cannot be satisfied in a taxable year by granting a combination of stock options and RSUs, and instead all such employees must either be granted stock options or RSUs for that year.
In addition, certain employees are not permitted to make the election, including:
1. a 1% owner during the current year or any of the 10 preceding calendar years;
2. anyone who is or has been the CEO or CFO;
3. a family member of a 1% owner or a CEO or CFO; or
4. one of the four highest compensated officers in any of the 10 preceding taxable years.
RSUs are not eligible for a Code Section 83(b) election and receipt of qualified stock would not be treated as a nonqualified deferred compensation plan for purposes of Section 409A (the exception applies solely with respect to an employee who may receive qualified stock).
The provision applies to stock attributable to options exercised, or RSUs settled, after 2017, subject to a transition rule.
The TCJA includes a provision stipulating that certain partnership interests received in connection with the performance of services are subject to a three-year holding period in order to qualify for long-term capital gain treatment.
Transfers of applicable partnership interests held for less than three years are treated as short-term capital gain. This treatment affects partnership in connection with the performance of substantial services to businesses which consist of engaging in capital market transactions or other specified investments.
The conference agreement clarifies the interaction of Section 83 with the provision’s three-year holding requirement. Under the provision, the fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest or may have made a Section 83(b) election with respect to an applicable partnership interest does not change the three-year holding period requirement for long-term capital gain treatment.
Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.
The provision applies to tax years beginning after 2017.
Increase Excise Tax for Stock Compensation of Insiders in Expatriated Corporations
Under previous law, certain holders of stock options and other stock-based compensation are subject to an excise tax upon certain transactions that result in an expatriated corporation. An excise tax at the rate of 15% was imposed on the value of specified stock compensation paid to certain officers, directors and 10% owners of an expatriated corporation.
The TCJA increases the 15% rate of excise tax to 20%, effective for corporations first becoming expatriated corporations after the date of enactment (Dec. 22, 2017).
Descriptions and analyses of the key retirement, compensation and other benefits changes in the new law include: