The final tax reform bill signed by President Trump on December 21, 2017 makes substantial changes to executive compensation paid by private and public companies and non-profit organizations. But it could have been worse. Significant restrictions on nonqualified deferred compensation plans were removed from the final bill. This article briefly summarizes the major changes:
Private Companies: Employee Deferral of Stock Option Gains
The law adds a new Section 83(i) to the Tax Code that, subject to a number of conditions, allows employees to elect to defer the inclusion of income arising from the exercise of stock options and the payment of restricted stock units (RSUs) in stock for up to five years. Key conditions and requirements include the following:
Eligible Company Requirements. The company must be privately held and at least 80% of the company’s employees must receive stock options or RSUs. The 80% requirement is intended to incentivize companies to broaden the employee group that receives stock.
Eligible Employee Requirements. To be eligible to defer tax recognition, the employee must not be the CEO or CFO or a family member of the CEO or CFO, a 1% owner of the company within the past 10 years, or one of the four most highly compensated officers in any of the past 10 years.
Deferral Requirements. Eligible employees may elect to defer the recognition of stock option or RSU income until the earliest of (a) five years after the date the stock is first vested; (b) the date the stock becomes transferable or publicly traded; or (c) the date on which the employee is no longer eligible for the deferral or revokes the deferral election.
Notice Requirement. Effective January 1, 2018, the company must provide a written to notice to employees of their rights to defer. Failure to provide this notice results in IRS penalties on the employer of $100 for each missed notice, up to an annual cap of $50,000.
Effect of Election to Defer. When income is included at the end of the deferral period, the amount included is based on the value of the stock at the time of exercise or settlement, rather than at the time of income inclusion. This rule applies even if the value of the stock has declined during the deferral period.
Bottom Line: These rules apply to stock options exercised, and RSUs settled, after 2017. As a result, privately held corporations will need to determine if they can and want to apply the new rules to outstanding option and RSU awards and, if so, be ready to satisfy the notice requirements. This legislation is intended to allow employees of private companies which do not have access to public markets to readily sell their shares to cover taxes arising on the exercise of stock options and RSUs to delay the tax event for up to five years. The restrictive conditions imposed in order for the income deferral election to apply may hinder its use by private companies.
Public Companies: Expansion of $1 Million Compensation Limit
Performance-Based Compensation Exception Repealed. Under Section 162(m) of the Tax Code, compensation over $1 million to certain public company executive officers is not deductible by the company. Historically, performance-based compensation paid only on the attainment of performance goals, has not been subject to the $1 million deduction limitation. This exception is repealed by the new law.
CFOs Subject to Section 162(m). The legislation amends Section 162(m) to specifically include a public company’s principal financial officer as a “covered employee” subject to the $1 million compensation limit. This corrects an unintended gap that left CFOs generally not being subject to Section 162(m) due to changes in the SEC’s executive compensation disclosure rules.
Once Covered, Always Covered. If an executive is a “covered employee” for 162(m) purposes in 2017 or any later year, the new law provides that he or she remains a covered employee for all future periods, including after termination of employment for any reason (including death). This eliminates the ability to deduct severance payments made after termination of an executive’s employment to the extent that the severance results in compensation in excess of the limit.
Expansion of Covered Companies. The definition of a public company subject to Section 162(m) is expanded by the new law to include any corporation that is required to file reports under Section 15(d) of the Securities Exchange Act of 1934. This change would subject private companies with public debt that triggers Section 15(d) reporting to the $1 million deduction limitation.
Limited Grandfathering Rule. The new law grandfathers compensation provided pursuant to a written binding contract in effect on November 2, 2017, so long as it is not materially modified after November 2, 2017.
Bottom Line: The changes could result in a significant loss of deductions to companies, but the corporate tax rate reductions would mitigate some of the impact. In addition, given the expansion of employees covered, it could result in many more companies subject to the $1 million pay limit.
Non-Profits: Excise Taxes on “Excess” Compensation
Excise Tax on Compensation Over a $1 Million. In general, annual compensation in excess of $1 million paid to any of the top five most highly paid persons at a non-profit employer results in 21% excise tax on the employer for compensation paid that exceeds $1 million.
Excise Taxes on Large Termination Payments. A 21% excise tax is also imposed on separation payments that exceed a specified level. This excise tax, payable by the non-profit, is imposed if severance payments to any of its top five most highly compensated persons equal or exceed three times the person’s average compensation over the preceding five years.
Bottom Line: This legislation, along with the proposed changes to the intermediate sanctions rules, may materially impact executive pay at tax-exempt organizations. Many large tax-exempt organizations compete with for-profit organizations for senior executive talent, and these changes would likely put tax-exempt organizations at a substantial cost disadvantage relative to similar for-profit companies. In addition, by placing downward pressure on tax-exempt executive compensation levels, the changes could jeopardize the ability of some tax-exempt organizations to achieve their missions due to the inability to pay competitive compensation packages to qualified executives.