Tax Reform and the Potential Effects on Equity Compensation

For some weeks now, Congress has been working on a tax reform plan for the president to sign. How will the proposed legislation affect equity compensation? Here are my thoughts, along with input from some of my colleagues in the industry.

Taxes on deferred compensation will stay the same.

Earlier drafts of both the House and Senate bills proposed to radically reshape deferred compensation. The House bill repealed Section 409A, replacing it with a new Section 409B that would have taxed nonqualified deferred compensation (NQDC) and other incentive arrangements at vesting instead of payment.

This would have eradicated the entire point of NQDC programs. By taxing stock options at vest, the draft provision would have created what’s called “dry income” (a situation where a tax is owed but the liquidity needed to pay the tax has not yet been created), making options a substantially inferior instrument. Performance-based instruments, where the performance period exceeded the service period, would also have been taxed upon the service completion date—even though income wouldn’t actually be created until the performance contingency was resolved.

On November 16, the Senate Finance Committee yanked this provision from their bill, resulting in both the House and the Senate walking away from these highly problematic revisions.

Corporate taxes will plummet.

Both the House and Senate bills are contemplating a reduction of the corporate tax rate from 35% to 20%. The final bill might converge at 22%, but this is the cornerstone of tax reform and—at least for the near future—US corporations will realize a drastic decline in their corporate tax rate.

Of course, the statutory tax rate isn’t what companies actually pay in taxes. That number is referred to as their effective tax rate. The effective tax rate shows what companies actually pay, and usually is much lower thanks to an intricate means of optimizing credits, deductions, and the geographic sources of revenues and expenses. Nonetheless, revenue from the US will become a lot cheaper thanks to tax reform.

Mike Melbinger says that companies and compensation committees should consider making the 2018 bonus payment (for 2017 performance) deductible in 2017 under the all-events test of Code Section 461, while preserving deductibility under Section 162(m) where applicable. Also worth considering: Accelerating the vesting of other equity awards that vest in early 2018 (to the extent possible under Section 409A). This raises accounting, Section 162(m), and other issues. Note that some executives may not want to recognize income sooner, but others in high-tax states might be glad for it.

Finally, all compensation committees should consider the impact of the various changes to taxation and deduction rules on pre-established performance metrics, including those to be established for 2018 and future awards.

Section 162(m) revisions will remove tax deductibility.

Of all the proposed changes that affect executive compensation, by far the most extensive are those to section 162(m) of the tax code.

• The exclusion for performance-based compensation will go away. This means that, of all compensation paid to “covered employees,” the portion in excess of $1 million will no longer be deductible even if it’s performance-based.

• More companies will be subject to the rule. Right now, both the Senate and House will broaden the rule to at least include public debt issuers. This will include many private equity-backed companies that have come to expect certain tax deductions. (Watch carefully to see who ends up in and out in the final rule.)

• The scope of covered employees will broaden to include the CFO. This change has been a long time coming, and of course now brings the tax rules more (but not fully) in line with SEC proxy rules.

• Covered employees will stay covered even if their role or compensation subsequently changes. Another overdue fix, this one prevents companies from delaying the payout to a current executive until they retire or take on a smaller, pre-retirement role.

• Pay close attention to how the final transition guidance is written. The final law might include the Senate’s proposed repeal transition period for compensation pursuant to a written binding contract in effect on November 2, 2017. If that’s the case, according to Baker & McKenzie’s Victor Flores and Sinead Kelly, there will likely be questions around whether outstanding performance arrangements—ones that give the compensation committee negative discretion to reduce or eliminate payments—are subject to such binding contracts. The goal of course is to capture, to the best extent possible, tax deductions on outstanding instruments.

There is a silver lining, say Flores and Kelly. Companies won’t have to bring their list of performance goals out for shareholder approval every five years. But companies might want to review their incentive plans to make sure they don’t impose the 162(m) award limits and other requirements more broadly than necessary.

Private companies will be able to issue “qualified equity grants.”

Equity award recipients at private companies famously run into major liquidity problems. Without creative and sophisticated arrangements, there’s usually only one way to exercise vested stock options: Go out of pocket and pay the strike price and satisfy tax withholding responsibilities. Most employees therefore choose to hold on to their options, only to potentially forfeit them if they leave the company prior to a liquidity event.

Dash Victor describes one solution popular among high-tech firms. It extends the post-termination exercise window so that terminating employees can retain their awards and the opportunity to participate in future upside.

The tax reform bill proposes a new Section 83(i) giving private-company employees another way to participate in value creation outside of a liquidity event. Under this provision, companies can issue qualified equity grants that let the employee defer taxation on vesting RSUs or stock options up to five years.

To qualify, the plan must encompass at least 80% of all full-time US employees and deliver the same rights and privileges (though not the same grant sizes). Certain senior employees are excluded from being able to participate. Like an 83(b) election, the new bill would require employees to proactively choose to defer the tax within 30 days of the vesting event. Taxable income would likely be based on the value at vest.

Flores and Kelly observe that while the provision appears promising, it will be interesting to see whether employees take advantage of this deferred tax relief. That’s because the law would require the employee to recognize income within five years of the vesting of the award (at the latest)—even if no liquidity event, such as an IPO, has occurred prior to such date.

The current drafting is unclear as to whether income will be based on the intrinsic value at exercise or vesting. Private companies are inherently volatile. Moreover, the 409A valuations used to form measures of value over time are tied to subjective assumptions and inputs that can easily invert. For this reason, if taxable income is based on the intrinsic value at vesting, it’s possible that the security’s value would decline in the years after. This in turn would give rise to a higher tax liability than the entire cash flow available upon eventual liquidation of the underlying security. And, if there is no liquidity event, the employee could still end up in a dry income situation.

In short, this is one provision that, if drafted properly, could make a considerable difference to how equity is deployed in private companies. But, that requires substantial tweaking and clarification of the current draft.

Award recipients may have less choice in how to sell their securities.

For investors selling securities, current tax law lets them specify which lot they want to sell if they hold lots that have different tax bases (e.g., 200 shares of IBM, one lot which was bought at $75 and one which was bought at $125). The proposed bill changes this by imposing a first in-first out (FIFO) construct on the sale.

Barb Baksa of the NASPP writes that for retail investors, the obvious loophole is to create another brokerage account, transfer the lot they desire to sell into that account, and then sell. Not so with equity compensation awards, however. The rules are written in such a way that same-day-sale and sell-to-cover transactions could be incorporated.

Currently, these transactions exist for the sole purpose of covering the required tax withholding on an option exercise or restricted stock release. The new rules might require that whatever shares are sold must be a prior lot of the same security, rather than tied to the equity arrangement being settled. If that’s the case, it would give rise to a capital gain or loss situation when the entire point of a same-day-sale or sell-to-cover is staying cash-flow neutral upon an equity award settlement. Tax planning will be substantially disrupted if any settlement of equity awards ends up creating tax liabilities.

Per Bruce Brumberg of mystockoptions.com, qualified awards (e.g., incentive stock options or shares acquired through an ESPP) could lose their qualified status if recently-acquired qualified shares are sold as part of a tax withholding on a current exercise or release. As a result, we might see more transfers of previously-acquired qualified shares into separate accounts and inadvertent disqualifications due to employees not knowing about this wrinkle.

Tax-exempt organizations will continue to incur excise taxes on highly-compensated individuals.

Today, under 280G rules, tax-exempt organizations that pay any employee more than $1 million a year must either pay an excise tax or trigger “excess parachute payments.” In their current versions, both the House and Senate bills retain this tax.

Tax-exempt organizations have long come under fire over executive compensation. But large nonprofit entities often recruit executives from the public markets. As a result, they’re under pressure to match or approach the recruits’ current compensation levels. For better or for worse, this provision keeps the compensation schemes of large tax-exempt organizations under the critical scrutiny of potential donors.

Will we see a resurgence of Incentive Stock Options (ISOs)?

Baksa argues it’s time for companies to take another look at ISOs. With a lower corporate tax rate, companies may not be missing out on as much by foregoing the corporate tax deduction. ASU 2016-09’s elimination of the excess tax benefit component of assumed proceeds also converges the diluted EPS treatment between ISOs and nonqualified awards.

The tax lot problem discussed above could result in more disqualifying dispositions, thus undercutting the employee benefits of ISOs—so we’ll need to see how that is or is not resolved in practice. Stepping back a few levels, the decline in ISOs is a bit of an unsolved mystery, since they create material benefits for employees. Nevertheless, most companies that grant ISOs see large numbers of disqualifying dispositions (which undercut the employee tax benefits and create tracking headaches), and conclude it’s cleaner to simply grant nonqualified awards.

Our view is that the quality of participant communication programs has improved substantially. Perhaps the poor historical track record of ISOs can be chalked up to weak communication. We agree that it might be time to give ISOs another shot.

Stay tuned.

We’ll keep monitoring progress in Congress to resolve differences in the Senate and House bills and deliver a final version to the president for signature. When that happens, be ready to move fast—but never forget the adage to measure twice and cut once. The final bill will be hundreds of pages long. As professionals in the community rush to decipher it all, assume there will be large pockets of guidance that are ambiguous or need further interpretation.

We’re excited to see what lies ahead and look forward to discussing it with you.