Key Executive Compensation Provisions of the Tax Act
Gibbons Corporate & Finance News - Legislative Tax Alert
January 3, 2018
This article discusses the key executive compensation provisions of the Tax Act. There are three key provisions:
- an election by a qualified employee of an eligible corporation to defer recognition of income for five years on the transfer of qualified stock to the employee;
- the disallowance of deductions for annual compensation over $1,000,000 paid to the named executive officers of publicly-traded corporations; and
- the imposition of a 21% excise tax on excess tax-exempt organization executive compensation.
Deferral of Income Recognition for Qualified Stock
Before enactment of the Tax Act, an employee who received vested stock on the exercise of a nonqualified stock option, or on settlement of a restricted stock unit (“RSU”), recognized income equal to the fair market value of the stock. When the corporation’s stock was not publicly traded, the employee held illiquid stock and had to pay the tax out of pocket with cash. The Tax Act creates a new Section 83(i) aimed at start-up corporations to alleviate this hardship.
The Act allows a qualified employee to elect to defer the recognition of income on the employer’s transfer of qualified stock to the employee. The employee must make the election no later than 30 days after the first time that the employee’s right to the stock is substantially vested or is transferable.
If the employee makes the deferral election, the employee recognizes the income on the earliest of: (1) the first date that the qualified stock becomes transferable to the employer or a third-party; (2) the date that the employee first becomes an excluded employee; (3) the first date on which any stock of the employer becomes readily tradable on an established securities market; (4) the date five years after the first date that the employee’s right to the stock becomes substantially vested; or (5) the date on which the employee revokes his or her deferral election.
If the employee makes the deferral election, the amount of income included at the end of the five-year deferral period is the value of the stock when the employee’s right to the stock first becomes substantially vested. This rule applies regardless of whether: (1) the stock’s value has declined during the deferral period; (2) the stock’s value has declined below the employee’s tax liability with respect to the stock; or (3) the stock’s value has increased during the deferral period.
The employee can make a deferral election for stock attributable to an incentive stock option, but the option is no longer treated as an incentive stock option. Furthermore, the employee cannot make a deferral election for nonvested stock for which the employee makes a Section 83(b) election to recognize income on receipt of the stock.
Effect of Prior Purchases
An employee cannot make a deferral election for a year if, in the preceding year, the corporation purchased any of its outstanding stock. This prohibition does not apply if at least 25% of the total dollar amount of the stock so purchased is stock with respect to which a deferral election is in effect (“deferral stock”), and the determination of which individuals from whom deferral stock is purchased is made on a reasonable basis.
Stock that the corporation purchases from an individual is not treated as a purchase of deferral stock if immediately after the purchase the selling individual holds any deferral stock for which a deferral election has been in effect for a longer period than the election for the purchased stock. Accordingly, in applying the purchase requirement, an individual’s deferral stock with respect to which a deferral election has been in effect for the longest period must be purchased first.
The restrictions on repurchases of a corporation’s outstanding stock may limit the corporation’s ability to exercise call rights and to repurchase stock after an employee’s termination of employment.
With respect to the employer’s compensation deduction, when an employee makes a deferral election, the deduction is deferred until the employer’s taxable year in which or with which ends the employee’s taxable year in which the employee recognizes the income.
Definitions of Qualified Employee and Qualified Stock
A qualified employee means an individual who is not an excluded employee, and who agrees as part of the deferral election to ensure that the employer’s income tax withholding requirements are met. An excluded employee means any individual who: (1) was at least a one-percent owner of the corporation at any time during the ten preceding calendar years, or who first becomes a one-percent owner in a taxable year; (2) is, or has been at any prior time, the CEO or CFO; (3) is a family member of an individual described in clause (1) or (2); or (4) has been one of the four highest compensated officers for any of the preceding ten taxable years, or who first becomes one of the four highest compensated officers in a taxable year.
Qualified stock means any stock of a corporation if: (1) an employee receives the stock in connection with the exercise of an option or in settlement of an RSU, and (2) the option or RSU was granted by the corporation to the employee in connection with the performance of services, and in a year in which the corporation was an eligible corporation.
It is important to note that stock received in connection with other forms of equity compensation, such as stock appreciation rights and restricted stock, is not qualified stock.
Qualified stock does not include any stock if, at the time the employee’s right to the stock becomes substantially vested, the employee may sell the stock to, or otherwise receive cash in lieu of stock from, the corporate employer.
Definition of Eligible Corporation
A corporation is an eligible corporation for a calendar year if: (1) no stock of the employer corporation (or any predecessor) is readily tradable on an established securities market during any preceding calendar year, or in the current calendar year; and (2) the corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the United States are granted stock options, or RSUs, with the same rights and privileges to receive qualified stock (the “80-percent requirement”).
The 80-percent requirement cannot be satisfied in a taxable year by granting a combination of stock options and RSUs. Rather, the employees must either be granted stock options or RSUs for that year. Employees will not fail to be treated as having the same rights and privileges to receive qualified stock solely because the number of shares available to all employees is not equal in amount, as long as the number of shares available to each employee is more than a de minimis amount.
The 80-percent requirement means that a privately-held corporation that wishes to grant options or RSUs only to a limited group of executives or management employees will not be an eligible corporation. It will be unable to issue qualified stock, and the grantees will be unable to make a deferral election.
A corporation that transfers qualified stock to a qualified employee must provide a notice to the employee at the time, or a reasonable period before, the employee’s right to the stock is substantially vested. The notice must: (1) certify that the stock is qualified stock; (2) advise the employee of the deferral election; (3) advise the employee that if the employee makes the election, the amount of income recognized at the end of the deferral period will be based on the value of the stock at the time of vesting; and (4) advise the employee that the amount of income recognized at the end of the deferral period will be subject to income tax withholding.
A deferral election does not affect the timing for withholding of Social Security, Medicare, and FUTA taxes. These taxes are due when the stock vests.
An employer’s failure to provide the notice is subject to a penalty of $100 for each failure, and a maximum penalty of $50,000 for all failures during any calendar year.
The deferral of income for qualified stock is exempt from the rules for nonqualified deferred compensation under Section 409A.
The provisions apply to stock attributable to options exercised and RSUs settled after December 31, 2017.
Deduction Disallowance for Compensation Greater Than $1,000,000
Under Section 162(m) of the Internal Revenue Code, a publicly-traded corporation cannot deduct compensation greater than $1,000,000 paid to a covered employee. The Act significantly tightens the disallowance in four ways.
First, the Act 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 will be subject to the disallowance. It also repeals the exception for compensation paid as commissions.
Second, the Act expands the officers subject to the disallowance to include the principal financial officer. The officers covered by the disallowance are the principal executive officer, the principal financial officer, and the three most highly compensated officers required to be reported on the corporation’s proxy statements (other than the principal executive officer and the principal financial officer). A person is covered if he or she holds one of these positions at any time during the taxable year.
Third, the Act provides that once a person is a covered employee for a taxable year beginning after December 31, 2016, compensation paid to that person at any time thereafter is subject to the disallowance. The Act 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.
Finally, the Act 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.
The provisions apply to taxable years beginning after December 31, 2017. A transition rule applies to compensation paid pursuant to a written binding contract that was in effect on November 2, 2017, and that has not been materially modified after this date. Before amending employment agreements and incentive plans, publicly-traded corporations should determine whether the amendment would be a material modification that would cause a loss of deductibility.
Excise Tax on Excess Tax-Exempt Organization Executive Compensation
Under the Act, a tax-exempt employer is liable for an excise tax equal to 21% of the sum of: (1) any compensation (other than an excess parachute payment) in excess of $1,000,000 paid to a covered employee by an applicable tax-exempt organization for a taxable year; and (2) any excess parachute payment paid by the organization to a covered employee. Accordingly, the excise tax applies to an excess parachute payment regardless of whether the covered employee’s compensation exceeds $1,000,000.
A covered employee means an employee or former employee who is one of the five highest compensated employees for the taxable year, or was a covered employee of the organization (or a predecessor) for any preceding taxable year beginning after December 31, 2017. For example, under this definition, the excise tax will have a profound adverse impact on tax-exempt universities that have entered into multimillion dollar compensation packages for football and basketball coaches.
An applicable tax-exempt organization is an organization exempt from tax under Section 501(a), an exempt farmer’s cooperative, a federal, state, or local government entity with excludable income, or a political organization. Key applicable tax-exempt organizations are hospitals and universities.
Compensation means wages for income tax withholding purposes other than designated Roth contributions, and deferred compensation that is no longer subject to a substantial risk of forfeiture regardless of whether the employee has received the deferred compensation. An employee’s compensation is subject to a substantial risk of forfeiture if his or her rights are conditioned on the future performance of substantial services.
An excess parachute payment means the amount by which any parachute payment exceeds the portion of the base amount allocated to the payment. A parachute payment means a payment contingent on the employee’s separation from employment, and the aggregate value of the payments equals or exceeds three times the base amount. The base amount is the average annualized compensation includible in the employee’s income for the five taxable years ending before the date of the employee’s separation.
For example, assume that an employee’s base amount is $250,000. If the employee receives a lump sum severance payment on separation of $1,000,000, the employer is liable for an excise tax of $157,500 on the $750,000 that exceeds the $250,000 base amount ($750,000 X .21 = $157,500).
The Act contains two important exemptions. First, the Act exempts compensation paid to employees who are not highly compensated employees (as defined under Code Section 414(q)) from the definition of parachute payment. Second, the Act exempts compensation attributable to medical services of qualified medical professionals from the definitions of compensation and parachute payment. Compensation paid to a licensed medical professional directly related to the performance of medical or veterinary services is not taken into account. Compensation paid to such a professional in any other capacity is taken into account. A medical professional includes a doctor, nurse, or veterinarian.
The IRS will need to provide guidance for allocating compensation paid to licensed medical professionals who perform different services. For example, a university teaching hospital will need to allocate compensation to doctors who provide medical services, teach medical students and residents, attend medical conferences, perform medical staff peer review, publish articles, and perform administrative duties.
The provisions apply for taxable years after December 31, 2017.