Tax Bill Would Fundamentally Alter Executive Compensation

Yesterday, the House of Representatives released its long-awaited tax bill, which if signed into law, would be titled the Tax Cuts and Jobs Act of 2017 (the “Bill”). While many of the broad concepts to be addressed by the Bill have been discussed for months in the media and otherwise, the Bill itself contains provisions not previously made public that would fundamentally alter the tax treatment, and therefore the design, of executive compensation.

Specifically, the Bill contains two provisions, Sections 3801 and 3802, that would dramatically change the way that executives are paid. The first would generally make all executive compensation taxable when no longer subject to “a substantial risk of forfeiture.” For this purpose, a substantial risk of forfeiture is defined as the requirement to provide substantial services, and would not include agreeing not to compete or satisfying performance goals related to the job.  The effect is that compensation would become taxable as soon as an executive has performed the services to which the compensation relates, regardless of when the compensation is paid or whether it is subject to a subsequent performance condition.  The second provision would eliminate the “performance-based compensation” exception to the $1 million compensation deduction limitation of Section 162(m) of the Internal Revenue Code, such that all compensation paid to the CEO and certain other highly compensated executives of public companies would be non-deductible to the extent that it exceeds $1 million for any year, regardless of whether the compensation is subject to the achievement of performance goals.  The definition of who is a “covered employee” (i.e., those subject to the deduction limitation) would be expanded to include (1) a company’s CFO, reversing the current exclusion of the CFO from coverage due to a quirk in the interplay between the statute and the securities regulations; (2) a person who is at any time a CEO or CFO during a fiscal year, even if they are not CEO or CFO on the last day of the fiscal year; and (3) anyone who was a covered employee in any year after December 31, 2016, even for fiscal years in which they would otherwise not be a covered employee.

If ultimately signed into law, we anticipate the following effects from the Bill:

  • Given that compensatory stock options and stock appreciation rights would be taxed when they vest (instead of when exercised as under current law), stock options and stock appreciation rights would be used much less frequently;
  • Given that RSUs would be taxed when they vest (instead of when settled in cash or stock as is the case under current law), deferred settlement of RSUs would be eliminated;
  • Given that cash compensation would be taxed when earned regardless of whether a deferral election is in place, elective deferred compensation plans would be eliminated;
  • Given that taxation of compensation would only be delayed through vesting schedules, longer vesting schedules may become more common; and
  • Given that performance-based vesting would no longer be relevant to ensure tax deductibility and would no longer constitute a substantial risk of forfeiture, the use of performance-based compensation structures may decline at the margins.

The proposed changes would be particularly problematic for private companies and their management teams as the Bill would make it significantly more difficult to design compensation that is taxable only at such time as management teams would have the liquidity to pay the taxes.

The Bill provides transition relief that appears to grandfather compensation attributable to services performed before January 1, 2018 so long as the amounts are included in income in the later of the last taxable year beginning before 2026 or the taxable year in which there is no substantial risk of forfeiture of the rights to such compensation.

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Because these rules, if ultimately adopted, will likely go into effect at year-end, companies and executives alike are advised to follow the status of these provisions of the Bill and, if the Bill is ultimately enacted, to be prepared to attempt to find workarounds (including potentially accelerating or extending vesting periods) in the short window between the date that the Bill is approved and the date that the Bill becomes effective at year end.