Executive Compensation Legislative Whiplash

by Orrick, Herrington & Sutcliffe LLP
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Orrick, Herrington & Sutcliffe LLP

As we reported last week, the tax reform bill released by House Republicans (the "House Bill") would eliminate deferred compensation and stock options, and then on Tuesday, November 7, the House Bill was amended to restore current law.   But then on Friday, November 10, the Senate and the Joint Committee on Taxation (the "Senate Bill") eliminated deferred compensation and stock options (but not incentive stock options). Both bills eliminate the performance-based compensation exception to the $1M deduction limit under Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code").  See the below side-by-side chart.  Now, more than ever, it is important you make your views known on these issues.

 

House Bill

Senate Bill

Deferred Compensation

A critical update to our previous alert is that the House Bill, as amended, no longer proposes to accelerate the taxation of deferred compensation and equity awards to the date of vesting. 

Under this amended House Bill, nonqualified deferred compensation packages and equity awards—including stock options and restricted stock units—will continue to follow current law in Code Section 409A.

The amended House Bill also provides a deferral feature for certain employees of private companies who receive stock options or restricted stock units as compensation for their services to defer the recognition of income for up to five years.

The Senate Bill proposes rules that are largely the same as the rules summarized in our previous alert and reproduced below, as originally proposed in the House Bill, except the Senate Bill clarifies that it does not intend to subject incentive stock options (ISOs) to the new rules. 

New rules: Deferred compensation and equity awards of publicly traded companies, including restricted stock units and non-qualified stock options, will be subject to income tax as soon as there is no longer a substantial risk of forfeiture (i.e. when the compensation or award vests regardless of whether or not exercised). Generally only service-based vesting can be used to defer taxation. The new rules are not intended to apply to ISOs.

Deferred compensation, restricted stock units, stock options and equity awards paid or granted for services after December 31, 2017 would be subject to the new tax rules. Deferred compensation, restricted stock units, stock options and equity awards earned or vested for services performed before January 1, 2018 must be includable in gross income by the last taxable year before 2027.

Assuming the Act goes into effect, new guidance will be issued within 120 days after the effective date, allowing deferred compensation arrangements to be amended to conform the date of payment, settlement or exercise to the date that the amounts are required to be included in income.

Performance-Based Exception to Code Section 162(m)

The amended House Bill did not revise the proposed new rules for Code Section 162(m), which are summarized in our previous alert and reproduced below.

New Rules: The performance-based exception is repealed and more executive officers, including the principal financial officer, are subject to the $1 million deduction limitation. In addition, once an employee qualifies as a covered person, the deduction limitation will continue to apply even following termination of employment. These tax rules would be effective for tax years beginning after December 31, 2017.

Impact: While corporations will no longer receive a tax deduction for stock options, SARs or performance-based cash incentives and equity awards over the $1 million deduction limitation, institutional shareholders will likely continue to push corporations to adopt such performance-based awards to ensure that compensation is tied to performance. Without the need to meet the performance-based exception, corporations will have more discretion in how performance formulas are structured and awards are paid out.

The Senate Bill proposes the same new rules for Code Section 162(m) as the House Bill.

 

What You Should Do Now

Companies and individuals should voice their concerns to congressional representatives and industry associations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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