The Tax Cuts and Jobs Act proposes sweeping changes to the taxation of executive compensation and employee benefits, including equity awards. It aims to be effective as of January 1, 2018 - which means limited time to react.
The key proposed changes of the bill (originally released on November 2, 2017) affecting equity-based compensation are outlined below. However, given that we have already seen one amended version of the original bill come out in its first 24 hours, be aware that the proposals are in a state of flux. We will try to keep up with the changes, but please reach out to us to stay abreast.
- Stock Options/SARs Taxed at Vesting. The bill introduces new section 409B, which seeks to eliminate nonqualified deferred compensation by imposing income tax once such compensation is no longer subject to a substantial risk of forfeiture. Under the bill, nonqualified deferred compensation expressly includes stock options, stock appreciation rights (SARs) and other rights to compensation based on the value or appreciation in value of shares of an employer company (whether cash or stock-settled). This means stock options and SARs would be taxed at vesting. The bill does not address how the taxable income at vesting would be calculated. This is reminiscent of the pre-July 1, 2015 rules in Australia.
Although the bill does not address employee stock purchase plans (ESPPs), including those intended to qualify under section 423, the definition of nonqualified deferred compensation is broad enough to capture options granted under ESPPs. However, as long as the participant is required to continue employment through the purchase date or if the purchase is made within 2 1/2 months following the end of the employer company’s tax year during which the participant terminated employment, the ESPP would likely be taxable at the time of purchase.
- Impact on RSUs. Time-vested restricted stock units (RSUs) that are paid out when the employee meets the time-vesting conditions will continue to be taxed at vesting. It will no longer be possible to defer taxation until delivery of shares following the vesting date, unless the conditions of the short-term deferral exception are met, which are more narrow under the bill than they are under the current rules under section 409A. In addition, RSUs that provide for continued vesting in case an employee becomes retirement eligible (or terminates due to retirement) will be subject to federal income tax (as well as FICA taxes) upon reaching retirement eligibility. This likely means that such a provision would not be advisable going forward.
- Impact on PSUs. Taxation of performance-based RSUs would occur when the employee meets the time-vesting conditions (if any). In other words, a performance-based condition would not suffice to delay taxation beyond the end of any time-based vesting period. If PSUs are not subject to time-vesting conditions, they would be taxed at grant. The bill does not address how the income should be calculated under these circumstances.
- Impact on Section 162(m). Section 162(m) limits the amount of compensation paid to certain “covered employees” (which under the amendments contemplated by the bill would include the CEO, the CFO and the three other most highly paid officers) that can be deducted by the company to US$1 million annually, subject to certain exemptions, such as for performance-based compensation which could include PSUs and stock options. The bill proposes to repeal the exemption for performance-based compensation. Consequently, PSUs and stock options granted to covered employees will no longer be deductible to the extent that the employee’s compensation exceeds US$1 million.
- Transition Rules. The bill applies to amounts attributable to services performed after December 31, 2017 and does not provide “grandfathering” for arrangements entered into before January 1, 2018. As a result, as of January 1, 2018, outstanding unvested stock options, deferred unvested RSUs, including RSUs with a retirement vesting provision where the employee is not yet retirement-eligible, and unvested performance-based RSUs that do not also contain a time-based vesting requirement would become taxable in the year in which they “vest.” This means taxation upon any scheduled vesting date for the options or deferred RSUs, upon meeting retirement-eligibility for the RSUs with retirement vesting, or immediately for performance-based RSUs that lack a time-based vesting requirement.
As noted, the new rules do not apply to deferred compensation attributable to services performed before January 1, 2018, but require that such amounts be included in income no later than 2025. Therefore, as an example, if an employee deferred receipt of his or her shares subject to vested RSUs until 2030, the value of the shares will need to be included in income prior to 2026 (even if they are not distributed until 2030). The bill requires Treasury to provide guidance (within 120 days of enactment) on accelerating payments under existing vested deferred compensation arrangements to address these requirements without violating section 409A.
Although this is a proposed bill, companies would be well advised to review their outstanding equity awards now and prepare for the worst. If these changes go forward, there will be only a short time to prepare for earlier-than-expected taxable events (e.g., for outstanding unvested stock options that vest in 2018 or employees with RSUs with a retirement provision who become retirement eligible in 2018) and to develop participant communications regarding the changed taxation.
Companies should also review their equity award strategy for future awards granted to U.S. taxpayers. If the bill is adopted as currently written, it seems unlikely that stock options will be a desirable award type and RSU retirement provisions may have to be eliminated or modified. Companies with global employee populations will need to consider whether it makes sense to make changes only for the U.S. population or more sweepingly for everyone, which could require a review of the non-U.S. tax and compliance issues for any new type of award.
For a more detailed analysis of the impact of the bill on other areas of executive compensation and employee benefits, please refer to our more comprehensive alert on these topics.
Please contact your Compensation attorney with any questions related to the proposed tax regulations.
For more information on the broader implications of the proposed tax regulations on your company, please see the Tax News and Developments alert Ways and Means Committee Releases “Tax Cuts and Jobs Act,” issued by Baker McKenzie’s tax practice (November 3, 2017).