The Senate Finance Committee and the House of Representatives have each proposed their own versions of the Tax Cuts and Jobs Act, and both portend dramatic changes to executive compensation and employee benefit practices.
On Nov. 20, the Senate Finance Committee released its own version of the Tax Cuts and Jobs Act, containing proposals modifying certain executive compensation provisions of the Internal Revenue Code. Generally, its version is substantially similar to the House of Representatives’ version of the Tax Cuts and Jobs Act as it concerns executive compensation provisions. The House version (H.R. 1) was released Nov. 2, modified by the House Committee on Ways & Means on Nov. 10, and passed by the House on Nov. 16.
Both the House version and the Senate Finance Committee’s proposed version include proposals to:
Create a new Section 83(i) that will allow the deferral of income from certain qualified equity grants made by private companies;
Significantly expand the scope of the $1 million deductibility limitation on executive compensation described in Section 162(m), including eliminating the exceptions for commissions and performance-based compensation; and
Create a new Section 4960 that imposes a new excise tax on covered employees of tax-exempt employers.
Given that the provisions listed above exist in both versions, the likelihood of them surviving in a final version of the Tax Cuts and Jobs Act, if approved by Congress, increases. However, reconciliation of the two bills will require significant negotiation, and passage of the act remains uncertain.
Current law vs. proposals
Under current law, Section 162(m) caps how much executive compensation public companies can deduct from their taxable income, limiting the deduction paid to the company’s CEO and three other most highly compensated officers (other than the CFO) who are employed on the last day of the employer’s fiscal year. Under Section 162(m), exceptions apply for qualified performance-based compensation and commissions, which do not count against the $1 million deduction limit. If those exceptions were eliminated, all compensation paid to a covered employee of more than $1 million effectively would be nondeductible.
Elimination of the Section 162(m) exceptions for qualified performance-based compensation and commissions “would result in a significant lost tax deduction for companies that have come to rely on these exceptions in designing their executive compensation programs,” a client alert from law firm Skadden stated.
Another significant change: Both bills would amend the definition of “applicable employers” to cover companies subject to Section 162(m) that have publicly traded debt instruments. Currently, only corporations with publicly traded equity are subject to Section 162(m). The proposed changes relating to Section 162(m) would become effective for tax years after Dec. 31, 2017. The inclusion of companies with public debt could negatively affect portfolio companies held by private equity sponsors, legal experts note.
Both versions of the legislative text also propose to expand the current definition of “covered employees” to include the principal financial officer, and covered employees from preceding taxable years.
Although adding the CFO as a covered employee is not surprising, “expanding the scope of covered employees so that all compensation received from the company in future years would be subject to the $1 million limit is surprising,” Skadden stated, noting that these provisions would “significantly impact” how companies design and implement executive compensation programs. “However, if the corporate tax rate is ultimately reduced by tax reform legislation, this would soften the impact of the loss of the deduction taken by companies for compensation paid to executives.”
The good news is that compliance relief could come in the form of deferred compensation. Both the proposed House and Senate versions would keep in place the current tax treatment of non-qualified deferred compensation, including Code Sections 409A, 457A and 457(f).
“This comes as a big sigh of relief for many, as companies would otherwise have had to undertake a complete overhaul of their deferred compensation programs—including equity award grants, non-qualified retirement plans and severance arrangements—to comply with the changes to the timing of taxation that were proposed by the original versions of the bills and that were subsequently deleted,” Skadden stated.
“Companies should give serious consideration to the impact of the changes under Section 162(m) of the Internal Revenue Code (Code), as this is one area of legislation in which the House and Senate bills are aligned,” Skadden stated. “Companies should also be thinking about the impact of other proposed changes on their executive compensation and employee benefit programs, such as health care reform, fringe benefits provided to employees, technical rules regarding 401(k) and other retirement plans and, for private companies, the opportunity to permit employees to defer tax on options and restricted stock units.”
Law firm Proskaeur has published a helpful comparison chart of the executive compensation provisions in the Tax Cuts and Jobs Act, comparing the original and revised House versions with the Senate draft.