After a fast and furious finish, H.R.1 as amended, once known as the Tax Cuts and Jobs Act and now known as the oh-so-catchy “An act to provide for reconciliation pursuant to Titles II and V of the concurrent resolution on the budget for fiscal year 2018”, (so let’s just call it “the Act”) was passed by the U.S. House of Representatives and the Senate, followed by President Trump signing it into law on December 22, 2017 (Public Law No: 115-97). The Act is generally effective January 1, 2018 and contains several provisions affecting the tax treatment of nonqualified deferred compensation.
The Act’s provisions governing nonqualified deferred compensation are as follows:
- Non-qualified stock options (NSOs) and restricted stock units (RSUs) - The timing of income taxation under the Act remains the same as under current law (income tax is applied to NSOs at the exercise date and to RSUs at the settlement date). However, there is a “new” income tax deferral opportunity (the treatment of FICA and FUTA is unaffected) for certain private company equity-based awards (NSOs and RSUs only) granted under certain broad-based employee plans which are exercised (in the case of NSOs) or settled (in the case of RSUs) after December 31, 2017. The opportunity involves “qualified stock” (an NSO or RSU) of an “eligible corporation” (a non-publicly-traded company which has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation, determined on a controlled group basis, in the US (or any US possession) are granted NSOs or RSUs) and a new “Code Section 83(i) election” which can be made by an eligible employee within 30 days after an applicable vesting date and can serve to defer taxation for up to five years after vesting of the awards. Employer notices will be required. A company’s CEO, CFO and 1% owners (currently or within the prior ten years), and family members of such persons, along with the four highest compensated officers in the current or any of the ten prior years, will not be eligible for the election.
- Incentive stock options (ISOs) - Under current law, at the time of exercise, the amount of “spread” between the fair market value of the option upon exercise and the exercise price is used for purposes of determining the Alternative Minimum Tax (AMT) owed by the grantee making the exercise. Under the Act, effective for tax years beginning after December 31, 2017, individual AMT exemption amounts and thresholds are modified, increasing the exemption to $109,400, and raising the phase-out threshold to $1 million, for joint filers.
- Publicly-traded companies - The Act amends Code Section 162(m) to eliminate the performance-based compensation exception to the $1 million deduction limit (as a result, equity compensation will no longer be excluded from the application of the $1 million deduction limit) and to provide that the principal financial officer is considered a covered individual, along with the principal executive officer plus the three highest paid employees (and their beneficiaries). The Act also provides that the classification of a covered individual stays in place once achieved (even after termination of employment). Note that the definition of “publicly-traded company” for purposes of Code Section 162(m) includes any company that is (i) an issuer of securities which are required to be registered under Section 12 of the Securities Exchange Act of 1934 (the “Securities Act”) or (ii) required to file reports under Section 15(d) of the Securities Act. The amended provisions of Code Section 162(m) do not apply to remuneration that is provided pursuant to a written binding contract that was in effect on November 2, 2017 and that was not modified in any material respect on or after such date.
- Tax-exempt organizations - New Code Section 4960 provides for the application of a 21% excise tax (tied to the corporate tax rate) on remuneration paid in excess of $1 million (other than excess parachute payments, which are subject to a new excise tax which is similar to Code Section 280G) to any of the five highest paid employees for the tax year. New Code Section 4960 is effective for tax years after 2016. “Remuneration” for this purpose includes cash and the cash value of all noncash items (including benefits), except for designated Roth contributions and certain medical services (there is a carve-out for compensation of certain qualified medical professionals that is directly attributable to the performance of medical or veterinary services). Remuneration is considered “paid” when the rights to such remuneration are no longer subject to a “substantial risk of forfeiture”. A "substantial risk of forfeiture" is determined under Code Section 457(f), meaning that an individual's right to compensation is subject to a “substantial risk of forfeiture” if his or her rights are conditioned on the future performance of substantial services by the individual. Once an employee qualifies as a covered person, the characterization survives as long as the organization pays him or her remuneration. In addition, a new “parachute” excise tax equal to the corporate tax rate (21%) will apply to any amounts paid on a separation from service to covered persons (excluding medical professionals) with an aggregate present value of three times or more of the employee’s “base compensation” (applying rules similar those under Code Section 280G). Applicable tax-exempt organizations include those organizations exempt from tax under Code Section 501(a). Special rules will apply to compensation paid by related entities. Note that colleges and universities will be affected by Code Section 4960.
- LLCs taxed as partnerships - The Act slightly modifies the rules for grants of compensatory profits interests. Transfers of such interests held for less than three years (up from two years under current law) would be treated as short-term capital gain. We expect regulations will be issued to further clarify this modification. The three-year holding period will apply even if the taxpayer makes a Code Section 83(b) election to include an amount in income on the grant date.
Companies will need to quickly assess the impact of the Act on their deferred compensation arrangements.