Executive Compensation Provisions of the Bills of the House Ways and Means Committee and the Senate Finance Committee

This article discusses the key executive compensation provisions of: (1) the U.S. House Ways and Means Committee mark-up completed on November 9, 2017; and (2) the Senate Finance Committee Chairman’s Mark of the bill released on November 9. The executive compensation provisions in the tax reform proposals focus on two areas: (1) nonqualified deferred compensation; and (2) the deduction disallowance on compensation over $1,000,000 paid to the named executive officers of publicly-traded corporations.

Initial House Bill
The House bill, initially published on November 2, repealed the key Internal Revenue Code section dealing with nonqualified deferred compensation, Section 409A. It replaced Section 409A with a new Section 409B, which would provide that an employee recognizes income as soon as the compensation is no longer subject to a “substantial risk of forfeiture,” the term of art for vesting. The House bill limited the definition of substantial risk of forfeiture to conditions tied to the future performance of services by the employee. Other types of forfeiture conditions, such as a change-in-control or economic performance of the employer, would no longer be permitted. Under these rules, performance-based restricted stock units would be taxable on grant unless they also contain a service-based vesting requirement.

Nonqualified deferred compensation was broadly defined to include severance arrangements and equity based compensation. Accordingly, the initial House bill would have applied to nonqualified stock options and stock appreciation rights, arrangements that were often structured to be exempt from Section 409A. For mergers and acquisitions, especially when private companies are the target, the initial House bill put pressure on acquirors to cash-out, rather than assume the target’s equity awards. A cash-out would be necessary to address the liquidity needs of the target and the target’s employees. In addition, the initial House bill would likely have taxed deferred or contingent merger consideration at the closing of a merger or acquisition in the absence of any requirement of continued service by the target’s employee with the acquiror.

At the conclusion of the House Ways and Means Committee proceedings, the provisions on nonqualified deferred compensation were struck from the House bill. In addition, the Committee amended the bill to provide for the deferred recognition of income from the exercise of stock options and restricted stock units for up to five years when the employer’s stock is not publicly traded. The amendment denies deferral to 1% owners, the CEO, the CFO, and employees who for any of the last ten years have been one of the four highest compensated officers.

Under Section 162(m) of the Internal Revenue Code, a publicly-traded corporation cannot deduct compensation greater than $1,000,000 paid to a named executive officer. The House bill significantly tightens the disallowance. First, the House bill repeals a major exception to the disallowance for performance-based compensation. As a result, compensation deductions for stock options, stock appreciation rights, and other performance-based pay are subject to the disallowance. It also repeals the exception for compensation paid as commissions. Second, the House bill expands the officers subject to the disallowance to include the Chief Financial Officer. Finally, the House bill provides that once a person becomes a named executive officer, compensation paid to that person at any time thereafter is subject to the disallowance. The bill repeals the rule that the disallowance applies only to officers who are employed on the last day of the corporation’s taxable year. As a result, corporations can no longer use the strategy of deferring income until a taxable year when the person is no longer an officer, such as the year in which the officer terminates employment.

Senate Finance Committee’s Chairman’s Mark
The proposals in the Senate Finance Committee’s Chairman’s Mark, scheduled to be presented to the Senate Committee on Finance on November 13, 2017, repeal Section 409A. Like the initial House bill, the Chairman’s Mark provides that an employee recognizes income under a deferred compensation arrangement as soon as the compensation is no longer subject to a substantial risk of forfeiture. Also like the initial House bill, the definition of substantial risk of forfeiture is limited to conditions tied to the future performance of services by the employee. The Chairman’s Mark contains exceptions for restricted stock and incentive stock options.

The Chairman’s Mark contains the same changes to the deduction disallowance for compensation greater than $1,000,000 paid to the named executive officers of publicly-traded corporations as the House bill. In addition, the proposal extends the disallowance to all domestic publicly-traded corporations, and all foreign companies publicly-traded through ADRs. It also provides that it may apply to additional corporations that are not publicly-traded, such as large private C or S corporations.

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Steven H. Sholk, a Director in the Gibbons Corporate Department, concentrates his practice on executive compensation. He is closely monitoring the executive compensation developments in the House and Senate, and is well-versed in the nuances of section 409A and nonqualified deferred compensation plans. Please feel free to contact him to inquire about any of the current developments.