A summary of the Senate version of the Tax Cuts and Jobs Act was released late yesterday and guess what? Yep, it includes the same provision changing the taxation of NQDC and stock compensation that the House bill had. It’s beginning to feel a little like the movie Groundhog Day. But hey, at least we aren’t talking about the CEO pay ratio anymore.
(Because it’s Friday and my fourth, no fifth, blog this week, I have a picture of a groundhog for you.)
Senate Version
The summary from the Senate version bill looks a lot like the same text that was in the JCT report of the House bill, so I did a document compare just for fun, because that is the sort of thing that is fun for me.
Turns out there are a few minor differences. Most significantly, the Senate version still exempts ISOs and ESPPs, but it sounds like the exemption might only apply if the shares acquired under these awards are sold in a qualifying disposition. This probably doesn’t impact ESPPs, since I think the purchase date would be considered the vest date in most cases, but it could impact how income on a disqualifying disposition of an ISO is determined.
The Senate version also includes the provision that modifies Section 162(m) to update the definition of covered employee and eliminate the exception for performance based compensation.
What’s the Score?
So, if you are keeping score, here’s where the two bills stand with respect to the provisions relating specifically to stock compensation:
NQDC and Stock Compensation Taxed at Vest: House 0, Senate 1 (out of the House bill, in the Senate bill)
Changes to 162(m): House 1, Senate 1 (in both bills)
Deferral of Tax on Stock Options and RSUs for Employees of Private Companies: House 1, Senate 0 (in the House bill, not in the Senate bill)
What’s Next?
Well, for sure, what’s next is the weekend, during which I don’t expect anything to happen on either of these bills. I’m guessing we all could use a little break. Go enjoy yourselves.
The Ways and Means Committee has approved the House bill; next stop for it is floor of the House for debate and a vote. This is expected to happen next week. The Senate bill starts committee markup next week and still has to be voted on by the Senate Finance committee before it can go to the full Senate for a vote.
Once passed by both the House and Senate, both bills will have to be reconciled so that they agree. There are major differences in the bills right now in areas that don’t directly impact stock compensation; the topics I have been writing about are just tiny parts of very broad legislation. But if the differences I’ve noted above aren’t reconciled during committee markup in the Senate or in the floor debates, they will have to be addressed during the reconciliation process.
Just this morning, the House Ways and Means Committee Chairman issued a press release announcing additional changes to the House’s tax reform bill. The changes include removing the section of the bill that would change the tax treatment of NQDC, including stock options and RSUs.
So here’s where things stand with the areas of the bill that I have covered in my blogs this week:
Section 3801: Nonqualified Deferred Compensation
Based on the summary of the Chairman’s most recent mark-up of the bill, this section is removed in its entirety. Thus, the bill would not change the tax treatment of stock options, RSUs, or other nonqualified deferred compensation.
Section 3802: Modification of Limitation on Excessive Employee Remuneration
This section is still in the bill. It redefines who is a covered employee for purposes of Section 162(m) and makes stock options and performance awards subject to the $1 million deduction limitation. See my blog on Tuesday (“Tax Reform Targets 162(m)“) for more information.
Section 3804: Treatment of Qualified Equity Grants
The section is still in the bill. It creates a new type qualified equity award referred to as “Qualified Equity Grants” that would allow employees in private companies to defer taxation of stock options and RSUs for up to five years. See my blog from this morning (“Tax Reform Update“) for more info. The Chairman’s mark includes some technical amendments to the language of this section, but the intent of it does not appear to have been changed.
What’s Next?
At this time, we are still awaiting the Senate version of the bill. There’s some preliminary information available about it but we’re going to have to wait for the full bill to know if it makes any changes to stock compensation. I will keep you updated.
The impact of the Tax Cuts and Jobs Act on stock compensation continues to be a focus here at the NASPP. My understanding is that the bill is supposed to come out of committee in the House possibly as early as today and that we might also see the Senate version of the bill today.
Here are a few updates based on what we know so far.
ISOs and ESPPs Exempt
The Joint Committee on Taxation (JCT) report on the bill clarifies that ISOs and ESPPs are intended to be exempt from the definition of NQDC. That’s good news for those of you who, like myself, are big fans of qualified ESPPs. It also could mean that I wasn’t completely off base on Monday when I suggested this bill might lead to a resurgence of ISOs.
At-the-Money Options NOT Exempt
I know some folks were holding out hope that the failure to exclude at-the-money options from the definition of NQDC was a drafting error but that doesn’t appear to be the case. The JCT report says:
The proposal applies to all stock options and SARs (and similar arrangements involving noncorporate entities), regardless of how the exercise price compares to the value of the related stock on the date the option or SAR is granted. It is intended that no exceptions are to be provided in regulations or other administrative guidance.
So that seems pretty clear. Sounds like someone was annoyed about the exception included in the 409A regs for at-the-money options.
Performance Conditions Don’t Count
An oddity in the proposed legislation is that vesting tied to performance conditions doesn’t count as a substantial risk for forfeiture. For public companies, I think most performance awards are tied to both a service and a performance condition, so this might not be a significant concern (although it probably will be necessary to make sure the service condition extends through the date that the comp committee certifies performance, otherwise the awards would be taxable before performance has been certified). But it’s going to be a significant problem for private companies that want to make vesting in awards contingent on an IPO or CIC.
Retirement Provisions Will be a Problem
The requirement to tax NQSOs and RSUs upon vest will also put a wrinkle in retirement provisions. As you all know, when grants provide for accelerated or continued vesting upon retirement, there’s no longer a substantial risk of forfeiture once an employee is eligible to retire. Thus, under the tax bill, both NQSOs and RSUs that provide for payment upon retirement would be fully taxable for both FIT and FICA purposes when employees are eligible to retire (and restricted stock paid out at retirement is already fully taxable upon retirement eligibility).
Relief for Private Companies
The bill has been amended to include a provision that would allow employees in private companies to make an election upon exercise of stock options or vesting of RSUs that would defer taxation for five years (in the case of stock options, it’s not entirely clear when the five-year period would start). This is nice, but I’m not sure it’s enough. How many private companies are on a five-year trajectory to IPO or can accurately predict when they are five years out from IPO?
Remember when I said you should be aware of the new Section 162(m) rules that apply to certain health insurance providers because they indicate the direction Section 162(m) is heading (“CHIPs: More Than a Cheesy TV Show“)? Well, it’s happening. The tax reform package proposed by the House would make some of the same changes to Section 162(m) that already apply to CHIPs.
What Is 162(m) Again?
For those of you who don’t live and breath corporate tax deductions, Section 162(m) limits the tax deduction that companies can take for compensation paid to covered employees (currently the CEO and the top three highest paid executives, not including the CFO—but this is something the proposed legislation would change) to $1 million. A number of types of compensation are exempted from the limit, however, including performance-based pay—this would also be changed by the proposed legislation.
Update to Covered Employee Definition
The proposed tax reform legislation would update the definition of who is a covered employee under Section 162(m) to once again include the CFO. This change has been coming ever since the SEC revised the definition of who is a named executive officer for purposes of the proxy executive compensation disclosures back in 2006. The only thing that is surprising is that it’s taken over ten years for the tax code to catch up (and, actually, it still hasn’t caught up, but it seems pretty likely that this is going to finally happen).
Once a Covered Employee, Always a Covered Employee
The proposed legislation would also amend Section 162(m) to provide that anyone serving as CEO or CFO during the year will be a covered employee (not just whoever is serving in this capacity at the end of the year). Plus, starting in 2017, once employees are covered by the rule, they remain covered employees in any subsequent years that they receive compensation from the company, regardless of their role or amount of compensation they receive. This will prevent companies from being able to take a tax deduction for compensation paid to covered employees simply by delaying the payout until the individuals retire.
This change has been coming for even longer, ever since the SEC updated their definition of named executive officer to include former officers, which happened so long ago I can’t remember when it was (10 points to anyone who can tell me).
Performance-Based Compensation No Longer Exempt
Finally, the proposed legislation would repeal the current exemption for performance-based compensation. This exemption currently applies to both stock options, even if subject to only time-based vesting, and performance awards. Thus, both types of grants would no longer be exempt from the limitation on the company’s tax deduction.
At one time, this might have spelled the curtailment of performance-based awards. But these days, there is so much pressure on companies to tie pay to performance for executives that I don’t see this having much of an impact of pay practices. It does mean that a fairly sizable portion of executive pay will no longer be deductible for many public companies.
Not Final Yet
As I noted in yesterday’s blog, this legislation has a ways to go before it is final. You can rely on the NASPP to keep you in the know, even if it means I have to write blogs on Sunday night. Check out our alert for law firm memos providing more analysis.
Late last week, the House Ways and Means Committee released the Tax Cuts and Jobs Act, which is its first attempt at legislation to implement major US tax reform. At over 400 pages, the bill makes substantive changes to many areas of tax law, including marginal individual income tax rates, standard and itemized deductions for individuals, and the corporate tax rate. The bill also proposes changes that would have a material impact on stock and executive compensation.
Stock Options Taxed at Vest?
In a surprise development, the bill includes language which would make all forms of nonqualified deferred compensation subject to tax when no longer subject to a substantial risk of forfeiture. There would simply no longer be any way to defer taxation of compensation past the point at which it is vested.
The bill specifically defines NQDC to include stock options, SARs, and unit awards. If enacted, taxation of stock compensation would be modified as follows:
Stock options and SARs would be taxable at vest.
Deferring payout of RSUs would no longer delay taxation of the award; all RSUs would be taxable at vest for both FICA and FIT purposes.
Options and awards that provide for accelerated or continued vesting upon retirement would be taxable for FIT purposes, as well as FICA, when the award holder is eligible to retire.
Substantial Risk of Forfeiture
The proposed legislation treats compensation as subject to a substantial risk of forfeiture only if vesting is conditioned on the performance of services. I suspect that this language is intended to clarify that clawback arrangements don’t delay taxation. A memo by McDermott Will & Emory notes, however, that the language could be construed to mean that awards in which vesting is conditioned only upon an IPO or CIC would not be considered to be subject to a substantial risk of forfeiture. If so, this would make it very challenging for private companies to offer stock compensation in any form to their employees.
What About ISOs and ESPPs?
That is a very good question that I don’t know the answer to. The bill does not appear to include a specific exemption for compensation awarded under Section 422 and 423 but it also doesn’t specifically repeal these sections of the tax code. If ISOs and ESPPs are exempt, these vehicles would be the only way to deliver compensation in the form of stock that wouldn’t require taxation at vest. If so, this could be the one change that might bring ISOs back from the brink of extinction. You can color me speechless.
Effective Date
The new rules would apply to compensation attributable to services performed after December 31, 2017 (yes, less than two months away—nothing like giving companies a little time to rethink their entire equity compensation strategy). Moreover, a memo by Baker McKenzie notes that this language means that all currently outstanding but unvested options and awards would be taxable at vest starting next year.
Have you noticed that your employees have been a little quiet lately? Have stock option exercises been down? Fewer sales to report on Form 4 for Section 16 insiders? It could be that employees and executives are delaying their stock plan transactions in the hopes of a tax cut.
And where your employees are looking to delay income, stock plan transactions are a prime candidate. It’s hard to delay salary and most other forms of cash compensation; even if your company offers a salary or bonus deferral program, under Section 409A, elections to defer have to be made well in advance. But employees can easily choose to delay option exercises and sales of stock.
Impact to the Company
In the short term, the impact may be that you are a little less busy, with fewer exercises to process and Section 16 insider sales to report. But, come the end of the year, this could reduce the company’s tax deduction. Fewer option exercises and fewer disqualifying dispositions will likely mean a smaller tax deduction for your company.
One of the hottest questions I am hearing these days is whether to allow US employees to request additional federal tax withholding on their restricted stock, RSU, and performance awards. So, last week, we conducted a quick survey to find out what NASPP members are doing. Here are the results, in a nifty infographic:
P.S. NASPP members are awesome! We launched this survey on Thursday and by Saturday I had enough responses to close the survey and finalize the results. Thanks to all of you who participated so quickly! You rock! Check out the full survey results.
I have another riddle for you: When does a tax cut result in more tax expense? When you’ve been recording deferred tax assets for years based on a higher tax rate, that’s when.
What the Heck?
As I noted in last week’s blog, the Trump administration has suggested lowering the corporate tax rate to 15% (from 35%). In the long term, that will certainly result in welcome tax savings for corporations. But in the short term, it could result in some unanticipated tax expense, particularly when it comes to stock compensation.
A quick refresher: when companies record expense for nonqualified awards (NQSOs, RSUs, PSAs, etc.) they also record a deferred tax asset (DTA) that anticipates the tax savings the company will ultimately be entitled to for the award. This DTA is based on the company’s current tax rate and reduces the current tax expense reported in the company’s P&L.
For example, let’s say a company records expense of $1,000,000 for nonqualified awards in the current period. The company will also record a DTA of $350,000 ($1,000,000 multiplied by the corporate tax rate of 35%—to keep things simple, ignore any state or local taxes the company might be subject to). Even though the DTA represents a future tax savings, it reduces the tax expense reported in the company’s P&L now.
But if the corporate tax rate is reduced to 15%, the tax savings companies can expect from their awards is also reduced. In this case, the anticipated savings of $350,000 will be reduced too only $150,000 ($1 million multiplied by 15%). The company told investors it expected to realize a savings of $350,000 but now it expects to only realize a savings of $150,000. That $200,000 shortfall will have to be reported as additional tax expense.
What Should You Do?
At this point, nothing. We have a way to go before the administration’s tax proposal becomes a reality. And while I can think of plenty of reasons cutting the corporate tax rate might not be a great idea, having to write off a bunch of DTAs isn’t one of them. Regardless of the DTAs, a lower corporate tax rate will lower taxes for companies.
But it’s good to understand how this works, so that if the proposal does become more likely, you know this is something you’ll need to prepare for.
The Trump Administration released its long-awaited tax reform proposal yesterday. The proposal is a long ways away from being final; legislation still has to be introduced into Congress and passed by both the House and the Senate, and the proposal, consisting of a single-page of short bullet points, is lacking in key details. The NY Times refers to it as “less a plan than a wish list” (“White House Proposes Slashing Tax Rates, Significantly Aiding Wealthy,” April 26, Julie Hirschfeld Davis and Alan Rappeport).
Here are six ways the proposal, if finalized, could impact equity compensation.
1. Lower Individual Tax Rates: The proposal would replace the current system of seven individual tax rates ranging from 10% to 39.6% with just three tax rates: 10%, 25%, and 35%. The plan doesn’t indicate the income brackets applicable to each rate, but it will clearly be a significant tax cut for many taxpayers (except those already in the lowest tax bracket).
Lower individual tax rates mean that employees take home a greater percentage of the income from their equity awards (and all other compensation). This will impact tax planning and may change employee behavior with respect to stock holdings and equity awards. Employees may be less inclined to hold stock to qualify for capital gains treatment and tax-qualified awards and deferral programs may be less attractive.
2. New Tax Withholding Rates: It’s not clear yet what would happen to the flat withholding rate that is available for supplemental payments. The rate for employees who have received $1 million or less in supplemental payments is currently pegged to the third lowest tax rate. But with only three tax rates, this procedure no longer makes sense.
The rate might stay at 25% or, with only three individual tax rates, the IRS might dispense with the supplemental flat rate altogether and simply require that companies withhold at the rate applicable to the individual. This could have the added benefit of resolving the question of whether to allow stock plan participants to request excess withholding on their transactions.
3. Lower Capital Gains Rate. The plan calls for elimination of the additional 3.8% Medicare tax imposed on investments that is used to fund Obamacare. This will increase the profit employees keep from their stock sales.
4. No More AMT. If you’ve been putting off learning about the AMT, maybe now you won’t have to. The plan would eliminate the AMT altogether (there aren’t any details, but I assume taxpayers would still be able to use AMT credits saved up from prior years). This would be a welcome relief for any companies that grant ISOs.
5. Elimination of the Estate Tax. With elimination of the estate tax, the strategy of gifting options to family members or trusts for estate-planning purposes would no longer be necessary.
6. Lower Corporate Tax Rate. The plan calls for the corporate tax rate to be reduced from 35% to 15%. A lower corporate tax will reduce corporate tax deductions for stock compensation, which will mitigate the impact of the FASB’s recent decision to require all tax effects for stock awards to be recorded in the P&L.
Riddle me this: when is a benefit not a benefit? The answer: when that benefit results in a change to the terms and conditions of an ISO. Making changes to ISO can have the unfortunate effect of disqualifying the options from ISO treatment, which might make the optionees less than enthusiastic about the new “benefit.”
The Uber Case
This was highlighted in a recent class-action lawsuit brought by an Uber employee (McElrath v. Uber Technologies). McElrath, an employee of Uber and the plaintiff in the suit, was promised an ISO that vested over four years in his offer letter. But, when the ISO was granted, the vesting schedule was shortened to just six months. This caused a much greater portion of the ISO to exceed the $100,000 limitation. The plaintiff contends that Uber changed the vesting schedule to ensure a corporate tax deduction for the option.
There could be any number of legitimate reasons for Uber to grant the options with a shorter vesting schedule than stated in the offer letter. Additionally, shorter vesting periods certainly offer benefits to employees. I suspect that many companies consider acceleration of vesting to be a change they can make without an award holder’s consent. But this illustrates that, when it comes to ISOs, it is important to consider the tax consequences to the optionee before making any changes.
Modifications, Too
The Uber case doesn’t involve a modification, just a discrepancy between what was granted and what was promised in the offer letter. But this concept also applies any time an ISO is modified. Any change that confers additional benefits on the optionee (other than acceleration of exercisability and conversion of the option in the event of a change-in-control) is consider to be the cancellation of the existing ISO and the grant of a new option. If the new option doesn’t meet all of the ISO requirements (option price at least equal to the current FMV, granted to an employee, $100,000 limitation, etc.), the option is disqualified from ISO treatment.
And, while acceleration of exercisability (which most practitioners interpret to mean vesting) doesn’t result in a new grant, there is still the pesky $100,000 limitation to worry about. In many cases, acceleration of exercisability will cause an ISO to exceed this limitation.
Where a modification disqualifies all or a portion of an option from ISO treatment, it is important to consider whether it is necessary for the optionee to consent to the modification. Most option agreements stipulate that any changes that adversely impact the optionee cannot be executed without the optionee’s consent. Keep this in mind the next time your compensation committee has a bright idea about making existing ISOs better.
