How the Tax Cuts and Jobs Act Will Radically Alter Executive Compensation

Comp & Benefits Alert | November.06.2017

On November 2, 2017, House Republicans released their much anticipated tax reform proposal, entitled the Tax Cuts and Jobs Act (the "Act").  If enacted, the Act would have a significant impact on the taxation of executive compensation.

Deferred Compensation is Phased Out

Current rules: Deferred compensation and restricted stock units (whether or not deferred) are not subject to income tax until payment or settlement, even if vested.  Stock options and SARs, which also have the potential to defer compensation, are generally not subject to income tax until exercise (possibly later in the case of "incentive stock options," or ISOs).

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. It is not clear whether the new rules apply to ISOs and how the new rules will affect certain 1% owners and executives of private companies.

Deferred compensation, restricted stock units, stock options and equity awards paid or granted for services after 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 would continue to be subject to the current tax rules until the last tax year beginning before 2026.

The Act was recently amended to exempt equity awards of private companies held by certain non-executive service providers from the new rules requiring income tax upon each vesting date. In addition, such private company service providers may elect to defer recognition of income for up to five years. 

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.

Impact: Moving forward, most employers will have little reason to adopt traditional deferred compensation arrangements or grant deferred restricted stock units, stock options and SARs since the award holder will not be able defer taxation until settlement or exercise (other than for private companies). For public companies, performance-based restricted stock units will likely continue to be granted (see below).

Performance-Based Exception to 162(m) Repealed

Current Rules: For a publicly held corporation, compensation paid to certain executive officers in excess of $1 million is not deductible unless such compensation falls within certain excluded categories.  Performance-based cash and equity awards are exempt from the deduction limitation, subject to the satisfaction of certain conditions.

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, institutional shareholders will likely continue to push corporations to adopt such performance-based awards to ensure that compensation is tied to performance. However, 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.

What You Should Do Now

Companies and individuals should voice their concerns to congressional representatives and industry associations. Please reach out to us if you need help.

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