The Joint Committee on Taxation released a description of the Senate Chairman’s Mark to the proposed Tax Cuts and Jobs Act on November 9, 2017, reintroducing adverse equity and performance-based compensation tax provisions that were ultimately stricken from the version approved by the House Ways and Means Committee. The Senate description also fails to include much anticipated amendments earlier introduced and approved by the House Ways and Means Committee, which would have enabled private company employees to defer taxation on certain stock option grants for up to five years.
Changes to Deferred Compensation Rules Could Accelerate Taxation
The Senate bill reinstates the adverse equity and performance-based compensation provisions from prior versions of the House bill that would repeal Section 409A of the Internal Revenue Code (the Code). In particular, the Senate bill tracks the House’s initial proposal to add a new Section 409B to the Code, which would eliminate the ability to defer compensation and instead impose taxation (including income inclusion, wage withholding and W-2 reporting obligations) at the time any payment or award ceases to be subject to “future performance of substantial services.” The implementation of these rules would also require companies to fully re-examine existing deferred compensation arrangements, including cash incentive plans and severance agreements.
- General Taxation of Equity Awards on Vesting. Reinstatement of these earlier provisions by the Senate would result in taxation of non-qualified stock options and other equity awards upon vesting. This would create substantial liquidity concerns for employees and could put pressure on employers to facilitate net exercise and net settlement scenarios, or to implement design changes to their equity compensation practices. Notably, incentive stock options (ISOs) would be exempt from such treatment and, in conjunction with the repeal of the alternative minimum tax, could become more valued equity incentives (see below for more details). The Senate bill, like earlier versions of the House bill, does not clarify how vested equity awards would be valued for the purposes of taxation. However, because ISOs must be granted at fair market value, we presume “409A valuations” would remain applicable.
- Incentive Stock Options May Become More Attractive with Repeal of AMT, But Have Significant Limitations. Consistent with the House bill, the Senate bill leaves Section 422 of the Code, governing the taxation of ISOs, untouched. As a result, ISOs may continue to offer employees eligibility to receive favorable tax treatment by deferring taxation until sale with the added benefit of capital gains treatment not available for non-qualified stock options. In addition, both the House and Senate bills include a proposal to eliminate the alternative minimum tax (the AMT) which currently has the effect of eliminating tax benefits otherwise available ISOs. A repeal of the AMT could make ISOs an even more attractive benefit for employees.
However, ISOs would still remain subject to substantial restrictions that may limit their utility under the proposed tax regime. In particular, under the current tax rules, the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year may not exceed $100,000. ISOs that fail to comply with this provision are treated as non-qualified stock options. Companies with higher valuations would easily hit this threshold for executives and highly-paid employees and therefore would have limited reprieve from the changed deferred compensation rules.
- Potential Relief for Private Companies in Limbo. The House bill as ultimately approved included amendments by House Ways and Committee Chairman Kevin Brady (R-TX), which would permit certain private company employees to defer income on the exercise of options for up to five years. The Senate bill does not incorporate any similar provisions, and as a result, fails to provide any mitigating measures for private companies that will be most impacted by the proposed changes to the deferred compensation rules.
- Special Consideration for PSUs and Event-Based Triggers. Because the Senate bill, like earlier versions of the House bill, relies only on service-based vesting conditions and excludes performance and event-based triggers, some equity awards could become taxable even before vesting. For example, performance-based restricted stock units would be taxable on grant unless, and only to the extent that, they include a service-based vesting component. Similarly, awards with vesting triggers based on exit events such as an initial public offering or change-in-control would be taxable on grant unless they require the recipient to be employed through the liquidity date.
- Impact on Merger Consideration. The accelerated taxation of equity would also place immense pressure on buyers, particularly in the private company context, to cash-out rather than assume equity awards in order to alleviate liquidity concerns for the equity holders and the company alike. Moreover, the proposed rules suggest that deferred or contingent merger proceeds payable to optionees and carve-out plan participants could be taxable at closing of the transaction, rather than upon receipt, absent provisions requiring continued employment through the payment date.
- Grandfathering of Compensation Earned Prior to 2018. If the Senate bill is enacted, the new deferred compensation rules would apply to compensation earned after December 31, 2017 (presumably, including currently unvested options), and generally allow existing deferred compensation arrangements to remain in place provided that they are paid before 2027.
Repeal of Deduction Exceptions for Performance-Based Compensation
Currently, Section 162(m) of the Code limits the tax deduction public companies may take for compensation paid to certain executive officers in excess of $1 million. Both the proposed Senate and House bills will, among other changes, repeal exceptions to this limitation currently offered for qualified performance-based compensation, including non-qualified stock options. Although many companies currently structure their executive compensation to maximize applicable deductions for compensation expense, the value of such deductions and the corresponding impact of the repeal of Section 162(m) performance exceptions may be become less meaningful if corporate tax rates are reduced as anticipated.
The Senate Committee on Finance is scheduled to mark up the proposed bill on November 13, 2017. Fenwick & West will continue to closely monitor any developments in the proposed legislation and encourages clients to reach out with questions.