Tax Cuts and Jobs Act Proposes Sweeping Changes in Compensation and Benefit Taxation

by Wilson Sonsini Goodrich & Rosati
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On November 2, 2017, Congressman Kevin Brady of Texas, Chairman of the House Ways and Means Committee, introduced the Tax Cuts and Jobs Act (the "Proposed Bill") in the U.S. House of Representatives. The Proposed Bill proposes sweeping changes that would significantly impact how employers provide compensation and benefits to their employees, particularly equity compensation. 

As originally introduced, the Proposed Bill:

  • Eliminates much of the benefit of stock options, stock appreciation rights (SARs) and other deferred compensation arrangements under a new proposed Section 409B that taxes compensation (including equity awards) as it "vests," regardless of when it is actually earned, paid or, in the case of stock options or SARs, exercised.
  • Revises Internal Revenue Code Section 162(m) to eliminate the "performance-based" compensation exception and expands the $1 million annual tax deduction limitation to include a publicly traded company's chief financial officer.

The effective date of the Proposed Bill is January 1, 2018, which would provide a short window for employers to react if it is passed as currently proposed, a task made more difficult by the lack of details in the Proposed Bill. 

Recent Amendment to Proposed Bill: On November 6, 2017, Congressman Brady introduced an amendment to the Proposed Bill (the "Proposed Amendment") that proposes changes for private companies by excluding stock options and certain other equity awards, including RSUs, granted by private companies to their non-executive employees from Section 409B, and instead allowing income deferral of these awards under a newly proposed Internal Revenue Code Section 83(i) for a prescribed period (of not more than five years) following the date these awards are transferrable or, if earlier, are no longer subject to a "substantial risk of forfeiture," that is, once it vests. These changes may be welcome for certain private companies, however, the scope of coverage of, and compliance with, Section 83(i) still presents significant challenges to providing equity-based compensation to private company employees compared to current law.

While we expect that the Proposed Bill will evolve, we cannot predict with certainty which provisions of the Proposed Bill will change, and employers would be advised to begin considering the impact of the Proposed Bill and any of its proposed amendments on their compensation arrangements.

This alert briefly summarizes the key provisions of the Proposed Bill relating to compensation and benefits matters, and provides an initial overview of how those provisions would be impacted if amended as proposed in the Proposed Amendment.  For an analysis of the other provisions of the Proposed Bill, please refer to our other WSGR Alert.

Deferred Compensation Arrangements Would Be Taxable at Vesting

Background: Since the adoption of Internal Revenue Code Section 409A in 2004, employers have carefully structured compensation arrangements that provide for the deferral of compensation in a manner that is exempt from or in compliance with Section 409A, in order to avoid these amounts being currently includable in gross income and subject to an additional 20 percent federal penalty (plus additional penalty taxes in certain states, including an additional 5 percent in California).

Proposed Bill: The Proposed Bill dismantles Section 409A in its entirety with respect to compensation earned for performance of services on or after January 1, 2018, and replaces it with a new Section 409B that eliminates the ability to defer compensation once the compensation "vests," regardless of when it is actually earned or paid. 

General Effect:

The new Section 409B:

  • Prohibits the deferral of compensation beyond the date that it "vests," which occurs once the compensation is no longer conditioned on the future performance of substantial services by the person eligible for the compensation. Compensation that does not depend on future performance of substantial services, but, for example, is dependent on the employer meeting a particular performance goal (such as attainment of revenue, change in control or an initial public offering), would be considered vested, which is a major departure from current law.
  • Applies to stock options, SARs, and other rights to compensation based on the value or appreciation in value of equity of the employer (e.g., restricted stock units (RSUs)) as deferred compensation rights. As a result, stock options, SARs, RSUs, and other similar equity rights will be subject to income inclusion on the date the award "vests" regardless of when the equity right is exercised or settled. 
  • Excludes the following limited arrangements from the "deferred compensation" definition: certain tax qualified employer plans; certain vacation or sick leave, compensatory time, disability pay, or death benefit plans; restricted stock awards and other awards (but not stock options) subject to Internal Revenue Code Section 83; and compensation payable within two and a half months following the end of the service recipient's (generally meaning the employer's) tax year in which it vests (for an employer with a calendar year fiscal year, this deadline will be March 15 of the year following the year of vesting). 
  • As initially proposed, covers many types of equity awards and does not specifically exclude incentive stock options or options granted under employee stock purchase plans, which are currently entitled to favorable tax treatment.  As discussed in greater detail below, the Proposed Amendment proposes changes that would exempt certain private company equity awards from Section 409B.
  • With respect to currently outstanding arrangements, limits the applicability of Section 409B to those that provide for compensation that "vests" after 2017. Compensation that vested before 2018 generally will be taxed under Section 409A or other applicable tax law, except that the available deferral period generally will end in 2026. The Proposed Bill requires the U.S. treasury department to provide guidance within 120 days of the Proposed Bill's enactment to assist employers with accelerating payments under existing vested deferred compensation arrangements to align the date of distribution with the date that the compensation would be taxed under Section 409B without violating Section 409A.
  • Prescribes that amounts under currently outstanding arrangements that provide compensation that "vests" in 2018 or later are subject to Section 409B, regardless of the date of the deferred compensation arrangement. 

Proposed Amendment

The Proposed Amendment, which imports much of the framework of the previously proposed Empowering Employees Through Stock Ownership Act:

  • Excludes from coverage under proposed Section 409B those arrangements under which an employee may receive "qualified stock." Qualified stock generally is defined as stock issued pursuant to the exercise of an option or settlement of an RSU that was granted by an employer whose stock is not readily tradable on an established securities market to one of its employees who is not otherwise excluded under Section 83(i) and under a plan that broadly offers equity awards to its employees, all in accordance with the proposed Section 83(i): 
  •  
    • Under the newly proposed Section 83(i), an employee is excluded under Section 83(i) if he or she: (i) has been a 1 percent owner at any time in the ten preceding calendar years; (ii) is or has been at any time the chief executive officer or chief financial officer, or an individual acting in such a capacity; (iii) is a close family member (spouse, children, grandchildren, and parents) of anyone described in clause (i) or (ii); or (iv) has been among the top four highest compensated officers during any of the ten preceding tax years;
    • In order to broadly offer awards to employees, at least 80 percent of U.S. employees must be granted options or RSUs, as applicable, in the applicable year, and the grants must have the same rights and privileges (determined in a manner similar to the employee stock purchase plan rules).
  • Defers the income tax event of any "qualified stock" for which a timely election is made with the Internal Revenue Service under Section 83(i) until the earlier of: (i) the date such qualified stock become transferable (including to the employer); (ii) the date the employee becomes an excluded employee; (iii) the date the employer's stock becomes readily tradeable on an established securities market; (iv) the 5-year anniversary of the date the rights of the employee in such stock is transferable or not subject to a substantial risk of forfeiture, whichever occurs first; or (v) the date the employee revokes such election.

Practical Considerations – Equity Awards:

  • Under the Proposed Bill, many equity compensation programs would have to be substantially overhauled under Section 409B to avoid negative tax consequences for equity-based awards that "vest" based on services performed on or after January 1, 2018.
    • Private companies in particular, which commonly use stock options to compensate their employees, would be significantly impacted by Section 409B, as it would result in many holders of their equity-based awards recognizing income on these awards before the options are exercised and before there is a liquidity event (e.g., a change in control or IPO). As a result, stock options, particularly those that vest on a time-based vesting schedule, might become largely unusable for many private companies in the context of employee retention if Section 409B is implemented without the Proposed Amendment. 
    • RSUs and performance shares or units that are settled at the time or shortly after any service-based vesting requirements are satisfied will continue to be a viable compensation vehicle for employers that can settle such equity awards in cash, with publicly tradeable shares, or on a net exercise basis.
    • Any equity awards that vest upon the satisfaction of performance conditions (e.g., a private company RSU that vests upon the satisfaction of both a service-based condition and a liquidity-event condition) will be taxed once the service-based vesting condition is met, even if the performance condition has not yet occurred, rendering such types of equity awards largely unusable for many companies, including many private companies, if Section 409B is implemented without the Proposed Amendment.
    • With respect to existing stock options that, by their existing terms, will be unvested as of January 1, 2018, employers may explore creative solutions to minimize the tax burden on employees if the proposed Section 409B becomes law, including one or more of the following: amending stock options to be exercisable on a cashless basis, accelerating the vesting of stock options before the end of 2017 but preserving or extending the existing exercise schedule, and adding contractual performance-based vesting conditions (e.g., stock price attainment or liquidity event) to provide additional retention incentives. 
    • With respect to future equity awards, employers may develop various approaches to maximize the retention and incentive value of their equity compensation programs including, granting stock options that are "vested" on the grant date (when there is no spread) but including a contractual forfeiture provision if a performance-based condition (e.g., a stock price attainment, a liquidity event, or a financial metric) is not achieved.  Employers may also wish to grant more equity awards in the form of restricted stock, which are exempt from the proposed Section 409B, and/or impose robust stock ownership guidelines.  However, it remains to be seen whether these approaches will ultimately be respected under proposed Section 409B.
  • Under the Proposed Amendment, many stock options and other equity awards granted by private companies may receive relief from the adverse effects of proposed Section 409B by having the opportunity to delay the tax event following the date the stock purchased or received under the award is transferable or no longer subject to a "substantial risk of forfeiture," that is, once it "vests." However, the rules under the Proposed Amendment for taking advantage of this tax deferral opportunity are fairly restrictive and may make it difficult for many private companies to provide equity compensation to their employees that fully benefits from this relief.
  • The Proposed Amendment also leaves many unanswered questions, including how the U.S. treasury department may interpret what it means to be "transferrable" or "readily tradable on established securities market." It remains to be seen whether this Proposed Amendment (or other amendments) will be included in any final bill.

Practical Considerations – Generally:

  • Some employers may seek to reduce or eliminate in-service cash and equity incentive compensation programs, and instead provide more enhanced severance benefits as a means of deferring taxation.
  • Existing severance arrangements may have to be revised as severance would, in the best case scenario, be taxed upon termination of employment, even if it is paid over time and/or conditioned on compliance with a noncompetition covenant. It remains to be seen whether "involuntary terminations" such as terminations without cause or resignations for good reason will, similar to current rules under Section 409A, be considered to constitute a "substantial risk of forfeiture," such that the severance payments are not considered "vested" until the actual date of termination. In addition, it remains to be seen how severance arrangements that provide for payment upon a voluntary resignation or a "walk-away" right will be taxed under Section 409B, including whether the severance will be considered "vested" and taxable as soon as the arrangement is entered into, rather than upon the termination or payment date.
  • Incentive compensation would be taxed once it "vests" even where the payment is deferred for corporate governance or other reasons. The Proposed Bill did not address how incentive compensation that is not determinable on the date it "vests" will be taxed under Section 409B.
  • It remains to be seen how states that have a tax framework similar to Section 409A, such as California, may adjust to the proposed Section 409B.

Additional Limitations on Deductibility of Compensation under Section 162(m)

Background: Internal Revenue CodeSection 162(m) limits the annual tax deduction to $1 million for compensation paid to each of a publicly traded company's chief executive officer and three highest compensated officers (other than the chief financial officer) (each, a "covered employee"), except with respect to qualified performance-based compensation, commissions, or to certain compensation paid by a company that recently became publicly traded. Publicly traded companies commonly structure executive compensation programs so that a portion of the executive's compensation is intended to comply with the performance-based compensation exception.

Proposed Bill: The Proposed Bill:

  • Eliminates the "performance-based" exception so that any compensation over $1 million is not deductible.
  • Expands the "covered employee" definition to include a publicly traded company's chief financial officer as of the end of the company's taxable year, which aligns the scope of the "covered employee" group with its original definition as adopted in 1993.
  • Expands a publicly traded company's annual tax deduction limitation to include any employee who has ever been a covered employee with respect to that publicly traded company.

Practical Considerations:

  • The proposed amendments to Section 162(m) would eliminate a publicly traded company's ability to deduct compensation above $1 million that it pays in any year to any covered employees, which likely increases the cost of executive compensation for many publicly traded companies.
  • There are not any "grandfathering" rules for any existing arrangements that are designed to comply with the "performance-based" exception, which may result in the loss of tax deductibility with respect to annual multi-year performance awards for which the performance period ends after January 1, 2018.
  • While institutional shareholders and their advisors continue to strongly support a focus on pay-for-performance, it remains to be seen whether this Proposed Bill (if approved) would cause more publicly traded companies to provide a higher percentage of an executive compensation in fixed compensation (e.g., base salary) instead of performance-based compensation as a result of performance-based compensation no longer providing tax advantages.

Additional Limitations on Deductibility of Entertainment, Fringe Benefit, and Other Business Expenses

Background: Employers currently can deduct certain expenses related to entertainment, amusement or recreation activity or facility expense, certain fringe benefits provided to employees (e.g., employee discounts, working condition, and transportation fringe benefits), and expenses for goods, services, and facilities.

Proposed Bill: The proposed law:

  • Eliminates many of these deductions for expenses incurred or paid after 2017, including deductions relating to entertainment, amusement or recreation activities or facilities (including membership dues relating to such activities or facilities) related to the employer's trade or business; and deductions related to transportation fringe benefits, on premises gyms and other amenities not directly related to a trade or business (subject to certain exceptions such as certain benefits that are included in the taxable compensation of the recipient); and
  • Limits the current 50 percent deduction so that it applies solely to expenses for food or beverages and qualifying business meals, subject to current exceptions. 

Practical Considerations:

  • Many employers would be limited in taking tax deductions for tax-free benefits they commonly provide to employees (e.g., transportation fringe benefits, gym and other athletic facilities and other amenities primarily of a personal nature).

Amendment of Certain Provisions Applicable to Retirement and Welfare Plans

Proposed Bill: The Proposed Bill:

  • Repeals the ability of employees to recharacterize or undo a conversion from a traditional IRA to a Roth IRA.
  • Permits in-service distributions from certain tax qualified retirement plans beginning at age 59½, lowering the age from 62 (or 70 ½, in some cases). 
  • Relaxes the requirements for in-service hardship distributions and extends the rollover period for plan loans.
  • Limits the exclusion from an employee's income for employer-provided housing.
  • Repeals the exclusion from an employee's income of employee achievement awards, dependent care assistance programs, reimbursement of qualified moving expenses, adoption assistance programs, and educational assistance programs. Under the Proposed Amendment, the dependent care assistance program repeal would not occur until January 1, 2023.

Practical Considerations:

  • Most of the retirement plan proposals (if implemented) likely are to be welcome changes for employers and employees alike.
  • We expect that the elimination of tax exemptions offered under popular employee welfare programs, such as for dependent care assistance and qualified moving expenses, will be disfavored by employees as well as many employers.

Next Steps

Prior to its enactment, the Proposed Bill is likely to continue to change, perhaps significantly. We will continue to monitor the status of the Proposed Bill and expect to provide updates as the legislative process moves forward.

 

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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