The conference committee charged with aligning the Senate and House versions of the Tax Cuts and Jobs Act announced late last week that they have come to an agreement. The final bill is expected to be approved in both the House and Senate this week and then signed into law by the president.
Here’s where the bill ended up with respect to the provisions that impact stock compensation.
Individual Tax Rates: The final version of the bill released by the conference committee largely matches what was in the Senate version, except that the maximum individual tax rate is reduced to 37%. So we end up with seven individual tax rates: 10%, 12%, 22%, 24%, 32%, 35%, and 37%. The highest rate kicks in at $500,000 of income for single taxpayers but at only $600,000 for joint filers (instead of the $1 million threshold that was originally proposed). The individual tax rates sunset after 2025 and will revert back to the current rates at that time.
Supplemental Withholding Rate: For employees who have received supplemental payments of $1 million or less during the year, the supplemental rate is tied to the third lowest individual tax rate, which will be 22% under the aligned bill. For employees who have received supplemental payments of more than $1 million during the year, the rate is tied to the maximum individual tax rate, which will be 37%.
AMT (for Individuals): This is probably the closest we’ve come to a repeal of the AMT (at least in my memory) but still no cigar. The bill does increase the exemption amounts and phaseout thresholds, so fewer taxpayers will be subject to the AMT. These changes sunset after 2025.
Corporate Tax Rate: Reduced to 21% with no sunset.
Estate Tax: Increases the estate tax threshold to about $11 million; no repeal and no sunset.
Section 162(m):
The CFO is once again subject to 162(m).
Anyone serving as CEO or CFO during the year is also subject to 162(m) (instead of just the individuals serving in those roles at the end of the year).
Once a covered employee for a company, always a covered employee for that company.
Stock options and performance awards will no longer be exempt from the deduction limitation.
Includes an exemption for compensation paid pursuant to a written, binding contract (such as a stock option or award agreement) in effect as of November 2, 2017, if not modified after that date.
Qualified Equity Grants: The final bill includes a provision that would allow employees in privately held companies to elect to defer tax on stock options and RSUs until five years after the arrangements vest, provided certain conditions are met.
Stock Options and RSUs: No change to the current tax treatment of stock options, SARs, or RSUs. The provision that would have taxed these arrangements at vest was removed from both versions of the bill before it was passed by House and Senate.
Determination of Cost Basis: No change from current law. The Senate version of the bill would have required identification of securities sold to be on a FIFO basis but this is not included in the final bill.
Back in mid-October, just before the NASPP Conference, the SSA and IRS announced the cost-of-living adjustments for 2018. I had expected to get around to blogging about this sooner, but then the House released its version of the Tax Cuts and Jobs Act and the topic of tax reform and its potential impact on stock compensation eclipsed all other topics.
COLAs
I’ve provided a description of the adjustments that impact stock compensation below. Here is an IRS chart that provides a complete list of updates.
FICA
The maximum amount of earnings subject to Social Security tax will increase to $128,700 in 2018 (up from $127,200 in 2017). The Social Security tax withholding rate will remain at 6.2%. With the new wage cap, the maximum withholding for Social Security will be $7,979.40. [Note: The SSA has since lowered the wage base for 2018 to $127,400, resulting in maximum withholding of $7,960.80. See my December 12 update.]
Medicare tax rates also remain the same and are not subject to a maximum (the threshold at which the additional Medicare tax applies is likewise unchanged).
Highly Compensated Employee Threshold
The threshold level of compensation at which an employee is considered highly compensated for purposes of Section 414(q) will remain unchanged at $120,000 in 2018. This threshold defines “highly compensated” for purposes of determining which employees can be excluded from a qualified ESPP under Section 423.
Update on the Tax Reform Bill
And, for your tax reform fix, here is an update: the House passed its version of the bill and the Senate Finance Committee approved its version to proceed to the full Senate. Debate on the bill is expected to start in the Senate after Thanksgiving. One GOP senator (Ron Johnson, WI) has already said he won’t vote it and a few other GOP senators appear to be undecided. None of the Democrat senators are expected to vote for it, so the bill won’t pass if the GOP loses two more votes (at least not this time—they could always go back to the drawing board and bring a new bill to a vote).
The provisions in both bills that directly impact stock compensation are the same as they were last Thursday (taxing stock options at vest is out, Section 162(m) expansion is in, and tax-deferred arrangements for private companies are in).
For what it’s worth, GovTrack reports that Skopos Labs gives it a 46% chance of passing (as of November 20, when I last checked it).
Happy Thanksgiving!
This will be our only blog this week because of the holiday. I wish you all a happy Thanksgiving and I hope you have a celebration that is completely free from discussions of both tax reform and equity compensation.
It’s no April Fool’s joke—on March 31, the IRS and Treasury issued final regulations under Section 162(m). The final regs are largely the same as the proposed regs that were issued back in 2011 (don’t believe me—check out the redline I created); so much so that I considered just copying my blog entry on the proposed regs and changing the word “proposed” to “final” throughout. But I’m not the sort of person that takes short-cuts like that, so I’ve written a whole new blog for you.
For more information on the final regs, check on the NASPP alert, which includes several law-firm memos.
The IRS Says “We Told You So”
The final regulations implement the clarification in the proposed regs that, for options and SARs to be exempt from the deduction limit under Section 162(m), the plan must specify a limit on the maximum number of shares that can be granted to an individual employee over a specified time period. It is not sufficient for the plan to merely limit the aggregate number of shares that can be granted, even though this creates a de facto per-person limit; the plan must separately state a per person limit (although the separately stated per-person limit could be equal to the aggregate number of shares that can be issued under the plan). One small change in the final regs was to clarify that the limit doesn’t have to be specific to options/SARs; a limit on all types of awards to individual employees is sufficient.
When the proposed regs came out, I was surprised that the IRS felt the need to issue regs clarifying this. This had always been my understanding of Section 162(m) and, as far as I know, the understanding of most, if not all, tax practitioners. In his sessions over the years at the NASPP Conference, IRS representative Stephen Tackney has said that everyone always agrees on the rules until some company gets dinged on audit for not complying with them—then all of a sudden the rules aren’t so clear. I expect that a situation like this drove the need for the clarification.
In the preamble to the final regs, the IRS is very clear that this is merely a “clarification” and that companies should have been doing this all along, even going so far as to quote from the preamble to the 1993 regs. Given that the IRS feels like this was clear all the way back in 1993, the effective date for this portion of the final regs is retroactive to June 24, 2011, when the proposed regs were issued (and I guess maybe we are lucky they didn’t make it effective as of 1993). Hopefully, you took the proposed regs to heart and made sure all your option/SAR plans include a per-person limit. If you didn’t, it looks like any options/SARs you’ve granted since then may not be fully deductible under Section 162(m).
Why Doesn’t the IRS Like RSUs?
Newly public companies enjoy the benefit of a transitional period before they have to fully comply with Section 162(m). The definition of this period is one of the most ridiculously complex things I’ve ever read and it’s not the point of the new regs, so I’m not going to try to explain it here. Suffice it to say that it works out to be more or less three years for most companies.
During the transitional period, awards granted under plans that were implemented prior to the IPO are not subject to the deduction limit. Even better, the deduction limit doesn’t apply to options, SARs, and restricted stock granted under those plans during this period, even if the awards are settled after the period has elapsed. It’s essentially a free pass for options, SARs, and restricted stock granted during the transition period. The proposed regs and the final regs clarify that this free pass doesn’t apply to RSUs. For RSUs to be exempt from the deduction limit, they must be settled during the transition period. This provides a fairly strong incentive for newly public companies to grant restricted stock, rather than RSUs, to executives that are likely to be covered by Section 162(m).
I am surprised by this. I thought that some very reasonable arguments had been made for treating RSUs the same as options, SARs, and restricted stock and that the IRS might be willing to reverse the position taken in the proposed regs. (In fact, private letter rulings had sometimes taken the reverse position). I think the IRS felt that because RSUs are essentially a form of non-qualified deferred comp, providing a broad exemption for them might lead to abuse and practices that are beyond the intent of the exemption.
This portion of the regs is effective for RSUs granted after April 1, 2015.
The Chairman of the House Ways and Means Committee has released a discussion draft of proposed legislation that could dramatically change the tax treatment of stock compensation as we know it. Here is a summary of the proposals.
No More Deferrals of Compensation
The good news is that Section 409A would be eliminated; I still don’t fully understand that section of the tax code and maybe if I just wait things out a bit, I won’t have to. But the bad news is that it would no longer be permissible to defer taxation of stock compensation beyond vesting. Instead, all awards would be taxed when transferable or no longer subject to a substantial risk of forfeiture.
This would eliminate all elective deferral programs for RSUs and PSUs. The NASPP has data showing that those programs aren’t very common, so you probably don’t care so much about that. On the other hand, according to our data, about 50% of you are going to be very concerned about what this will do to your awards that provide for accelerated or continued vesting upon retirement. In addition to FICA, these awards would be subject to federal income tax when the award holder is eligible to retire. Say goodbye to your good friends the rule of administrative convenience and the lag method (and the FICA short-term deferral rule)–those rules are only available when the award hasn’t yet been subject to income tax. This could make acceleration/continuation of vesting for retirees something we all just fondly remember.
As drafted, this proposal would also apply to stock options, so that they too would be subject to tax upon vest (the draft doesn’t say anything about repealing Section 422, so I assume that ISOs would escape unscathed). But one practitioner who knows about these things expressed confidence that there would be some sort of exception carved out for stock options. I have to agree–I don’t have data to support this, but I strongly suspect that the US government gets a lot more tax revenue by taxing options when they are exercised, rather than at vest (and that someone is going to figure this out before the whole thing becomes law).
Section 162(m) Also Targeted
The proposal also calls for the elimination of the exception for performance-based compensation under Section 162(m). This means that both stock options and performance awards would no longer be exempt from the deduction limitation. At first you might think this is a relief because now you won’t have to understand Section 162(m) either. I hate to rain on your parade, but this is going to make the tax accounting and diluted EPS calculations significantly more complex for options and performance awards granted to the execs subject to this limitation.
And that’s a bummer, because the proposal says that once someone becomes subject to the 162(m) limitation, they will remain subject to it for the duration of their employment. Eventually, you could have significantly more than five execs that are subject to 162(m). That’s right–five execs. The proposal would make the CFO once again subject to 162(m), a change that’s probably long overdue.
And There’s More
The proposal would also change ordinary income tax rates, change how capital gains and dividends are taxed, and eliminate the dreaded AMT (making the CEP exam just a little bit easier). And those are just the changes that would impact stock compensation directly. There is a long list of other changes that will impact how you, your employees, and your employer are taxed. This memo by PwC has a great summary of the entire discussion draft. In addition, we are in the process of recording a podcast with Bill Dunn of PwC on the draft–look for it soon in the NASPP podcasts available on iTunes.
When Does This All Happen?
That’s a very good question. This proposal has a long ways to go on a road that is likely to be riddled with compromise. As far as I can tell, it hasn’t even been introduced yet as a bill in the House. It has to be passed by both the House and the Senate and then signed into law by the President. So I wouldn’t throw out those articles you’ve saved on Sections 409A and 162(m) and the AMT just yet. It’s hard to say what, if anything, will come of this.
Back in May, the Senate Finance Committee published a report of possible ways that the tax treatment of employee benefits might be changed as part of the tax reform project that the Committee is working on. Today I take a look at some of the strategies they are considering.
These strategies were suggested by witnesses at hearings that the Committee held, as well as by various bipartisan commissions, tax policy experts, and members of Congress. Not all members of the Committee agree on which direction constitutes “reform” for the tax code (e.g., whether tax reform should reduce the deficit or lower tax rates), so some of the ideas are contradictory. It’s sort of a grab bag of tax reform.
Section 162(m)
The report suggests expanding the group of employees whose compensation is subject to the deduction limit under Section 162(m); applying the limit to all stock compensation, including stock options; and reducing the maximum deduction companies are entitled to. If this all sounds familiar, it’s because it’s already happening for health insurance providers (see my blog “CHIPs: More Than a Cheesy TV Show“). If Congress goes in this direction, I have to believe that the IRS might take it one step further and implement the allocation rules that they have proposed for health insurance providers as well. This could have a pretty significant impact on stock plan administration.
An alternative suggestion to all of these ideas is to repeal Section 162(m) altogether. With all the media outrage over executive compensation, I’d be pretty surprised if this is the direction Congress takes. But, never say never–I’ve been surprised many times in my life.
Section 409A and Deferred Compensation
Despite the draconian rules under Section 409A, deferred compensation continues to be a point of controversy. The report suggests requiring all non-qualified deferred compensation to be taxed when earned. Which would make it “nondeferred compensation” or just regular compensation. Essentially the ability to defer taxation on any compensation outside of a tax-qualified plan would be eliminated. If deferrals aren’t eliminated entirely, then perhaps the amount of compensation that can be subject to deferral might be limited.
Or, rather than eliminating the ability to defer compensation, an alternative suggestion is to require companies to pay a special investment tax on earnings attributable to non-qualified deferred compensation. If the compensation hasn’t been paid out, then the company is presumably earning a return on the unpaid amounts and could be paying a special tax on that return. I can only begin to imagine the complicated rules that would apply to stock compensation under this approach. I foresee lots of NASPP Conference sessions.
The report also suggests repealing Section 409A altogether, repealing it for only private companies, or repealing the 20% penalty.
Stock Options
As noted above, the report suggests making stock options subject to Section 162(m) without exception. Use of full value awards had already outpaced usage of stock options–this would be just another nail in the coffin.
The report also suggests eliminating incentive stock options; I can’t see many public companies shedding a tear over this, but private companies might be bummed. Hopefully this idea wouldn’t be extended to include ESPPs, however.
And, you guessed it–Senator Levin’s proposal (“Senator Levin, Still Trying“) on limiting corporate tax deductions for stock options to the amount of expense recognized for them rears its ugly head in the report as well.
Today’s blog entry is about CHIPs. Not the Erik Estrada and John Wilcox variety, but Certain Health Insurance Providers. The IRS has proposed regulations implementing the $500,000 deduction limit that applies to CHIPs under the President Obama’s health care package.
Why Do You Care?
If you aren’t a health insurance provider, you probably are wondering why you should care about this. And, right now, you probably don’t. But the placing further restrictions on the limit on corporate tax deductions under Section 162(m) for all companies is something that is currently on the table in DC. I think it’s likely that any additional restrictions would mimic, at least in part, the restrictions that apply to health insurance providers. Thus, even if you aren’t CHIP, I think it’s worth five minutes of your time to read today’s blog entry so you have an idea of what might be coming down the pike.
What’s Different?
The following table provides a quick illustration of how the limit for CHIPs differs from the standard limitation we are all familiar with under Section 162(m). As you can see, it’s about more than just $500,000.
Limit for CHIPs
Standard 162(m) Limit
Applies to:
Public and private companies
Public companies only
Max Deduction:
$500,000
$1,000,000
Covered Employees:
All employees + directors + most consultants
NEOs only
Performance Compensation:
Not exempted
Exempted
Timing:
When earned
When paid
Why You Should be Worried
The new limit that applies to CHIPs has some significant implications for stock compensation. First, because performance compensation isn’t exempted, stock options and performance awards are subject to the limit (which does have a silver lining in that CHIPs don’t have to worry about meeting 162(m) requirements when implementing these plans–say hello to our long-lost friend, discretionary payouts).
Second, because the limit applies when compensation is earned, not when it is paid, to figure out whether the company can claim its deduction for stock awards, the deduction has to be allocated on a daily pro rata basis over the period the awards was earned. You would expect this to be the vesting period, but it isn’t. For options, the period is measured from grant to exercise; for restricted stock, it’s grant to vest; and for RSUs, it’s grant to payout. So let’s say an option is exercised just prior to the end of its ten-year contractual term–that’s 11 tax years that the deduction would be allocated over.
That’s complicated enough, but things get really complicated when you think about the impact on your DTA accruals for tax accounting purposes and the tax benefit assumed for diluted EPS purposes. Makes you glad your company isn’t a CHIP (unless you are a CHIP, in which case, good luck with all that).
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!
The popularity of performance-based equity compensation is growing. If your company is adopting a new performance plan, these are the top 5 things you’ll need to know in order to administer and communicate it to participants.
Performance criteria
Companies can spend a lot of time hammering out the best performance criteria to motivate employees as there are seemingly endless possibilities. The stock plan management team needs to have a very clear understanding of the performance measures being tracked for the grant (e.g., target EPS, milestones, or relative TSR) and how performance will impact the grant (e.g., will it determine the payout date, payout amount, or strike price).
These unique parameters determine how performance-based grants should be valued and how their expense is amortized. For example, if the performance goals are considered market-based, then the valuation takes the likelihood of vesting based on those conditions into consideration. Expense for awards that are not paid out due to not achieving the market condition is not reversed. You can find more on the valuation and amortization of performance-based grants in the article “Accounting for Performance and Market Awards” from Equity Methods.
Performance period(s)
With performance-based grants, the vesting period and the performance period may not be the same (in fact, it’s recommended that the vesting date be far enough after the end of the performance period to allow for approval of performance goal achievement). Some grants even have multiple performance periods within one grant. If the performance and vesting schedules differ, it is important that each is well-documented and tracked. It may not be possible to track separate periods within the same database, so detailed documentation is essential.
Performance attainment
It will also need to be very clear when performance measurement will take place and who will be responsible for determining the degree to which performance targets have been achieved. In order to qualify as “performance based” grants under 162(m), the compensation committee will need to certify that the performance targets have been met. To facilitate a smooth certification process, the other groups and individuals involved must be ready to report to the compensation committee as cohesively and promptly as possible. It may be just one group or person who can verify the performance target(s); in which case the company should develop a process to insure that that group or individual is prepared to evaluate performance at the end of the performance period. On the other hand, the evaluation may require multiple groups; in which case there should be a process in place to coordinate.
Terminations (and other details)
There are many important grant parameters that are not necessarily unique to performance-based grants. For example, the inclusion of dividends or dividend equivalents, the details of change of control provisions, and how terminations will impact the grants. I highlight terminations because there are additional considerations for performance grants, and because they are the most likely scenario to consider.
The trickiest termination consideration is what to do about grants where one or more performance periods have been met prior to termination; particularly for termination due to death, disability, or retirement.
Grant input and tracking
After all the details of a performance plan are in place and understood by everyone involved, there is still the challenge of how to get as much of the specifics of plan into the stock plan administration software. Many stock plan administration databases have some degree of tracking and reporting capabilities for performance-based grants. However, due to the amount of variation among existing performance plans, it is likely that there will be some degree of “outside the box” thinking around how to input each company’s performance plan.
If you are getting ready to input performance grants into your stock plan administration software, be sure to meet with your software provider to determine what can be entered in the database and what must be tracked outside the database or otherwise customized. You’ll need to be sure that you’ve found the best balance between the way the grant reflects in the participant interface, on expensing reports, and even how it impacts plan reserves.
Planning
Of course, the best way to have a manageable performance plan is to have the stock plan management team be an integral part of the planning process! The best way for the stock plan management team to get invited to the planning table is to be knowledgeable regarding performance plans prior to the adoption of a new plan.
Whether you’ve just been asked to manage a performance plan or your company is exploring the possibility, we have a fantastic program designed to get you prepared. Offered for the first time this year as a one-day intensive program preceding the 18th Annual NASPP Conference, “Practical Guide to Performance-Based Awards” will give you the substantive knowledge necessary to implement or administer this unique and emerging form of equity compensation.
Early bird rates for the pre-Conference sessions end on April 15th. If you are planning to attend both the Conference and the “Practical Guide to Performance-Based Awards”, you get a double-discount if you register before the early-bird rates for both end on April 15th. Register today!