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.
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.
Earlier this week, Barb Baksa blogged about some proposed large scale tax reforms. Yes, a key word is “proposed” – nothing is imminent or certain just yet. However, these proposed changes are far reaching and there are several potential implications to stock compensation. I’m not going to summarize all of the items on the table – Barb already did that. I am, however, going to show you where to find answers to some of your questions on the topic. I’m not going to stop there, though. I’m going to show you how to get commentary on other breaking industry news as well.
Breaking News
I’ve mentioned it briefly in the past, but I’ll go into more detail now. The NASPP’s new podcast series, Equity Expert, is where you can expect to find a wealth of information on a variety of equity compensation topics. I’ve gently nudged people to subscribe in the past, but I want you to know that when we have something pressing to talk about, our podcast, web site, blog, and social media sites are where you’ll hear about it first.
Today we posted a great Q&A podcast interview with Bill Dunn of PwC on the proposed tax changes (Episode 5). He answers many of the top questions we’re hearing on this topic. I urge you to go check it out (it’s only 20 minutes long).
Our podcast series covers a wide scope of landscape in this industry, including:
Tips on how to carve your niche in this industry from seasoned plan managers and other experts
Commentary and Q&As on breaking news by subject matter experts
Deep dives into tricky, technical, or other types of micro equity compensation topics
Career advice and resources
Reasons You Should Subscribe Now
It’s free on both our web site and on iTunes (launch iTunes, go to store, click “podcasts”, and search for “Equity Expert”).
It’s portable. Driving in the car or headed to the gym? Download the podcast to your tablet or smartphone and take it with you on the go. With each episode typically between 15-30 minutes in length, you’ll pass the time and learn something in the process.
A subscription means you’ll automatically be notified of new episodes. Subscribing on our web site will ensure you get an email notification. Subscribing on iTunes means new episodes will automatically show up on your device.
I hope I’ve convinced you. We’ve got 5 episodes up so far (featuring John Hammond, Marlene Zobayan, Bill Dunn and our own Barb Baksa), and many more in the works. You’ve got plenty of content available for that next trip to the gym, commute to work, or companionship in the office.
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.