November 8, 2017
On November 2, 2017, House Republicans released their much-anticipated tax reform proposal, entitled the Tax Cuts and Jobs Act (the “Act”). We provided a summary of the Act here, which noted that there is significant uncertainty as to whether some or all of the provisions in the Act will take effect, and, if they do, in what form. If enacted, certain provisions of the Act would have a major impact on executive compensation and various employee benefits, including qualified retirement plans and fringe benefits. We summarize the provisions of the Act relating to executive compensation and employee benefits below.
As an offset to lower individual tax rates, the Act substantially limits amounts on which taxes can be deferred by individuals as nonqualified deferred compensation. The basic principle is that an individual would be taxed on compensation as soon as that compensation is no longer subject to an obligation to perform future substantial services. Other types of restrictions, such as bona fide performance goals, that under current law delay taxation until if and when they are achieved, would not defer taxation. The proposed tax legislation takes the form of introducing a new Code section—Section 409B. The existing elaborate rules governing the taxation of nonqualified deferred compensation under Section 409A would be repealed in their entirety.
Section 409B would effectively eliminate long-term nonqualified deferred compensation as a means of delaying income taxation for years into the future by virtue of taxing compensation once any service requirement has been fulfilled. Unlike Section 409A, there would be no penalties in the form of additional income taxes, interest and penalty taxes imposed under Section 409B.
Certain concepts under Section 409A will or should remain. First, the concept of payment on or before 2 ½ months after the end of a tax year in which the right to compensation vests (the so-called “short-term deferral rule”) would remain in effect. Second, transfers of property in connection with the performance of services, which are taxed under Section 83, would not be covered under Section 409B. Third, since Section 422 would not be repealed under the Act, incentive stock options should remain in effect. The proposed legislation gives the Treasury Department broad authority to exempt various forms of compensation from Section 409B, so we would expect (as is the case in the Section 409A regulations) that if this legislation were enacted in its present form, the Section 409B regulations would expressly exempt incentive stock options.
Options generally, however, receive unusually unfavorable treatment under Section 409B. Both options and stock appreciation rights would become taxable when any service-based requirements are satisfied, regardless of whether or not the option is exercised, the underlying stock is publicly traded, or the option is then still subject to other restrictions such as performance goals that have not yet then been achieved. We expect this provision in particular to draw much comment and criticism. At least one member of Congress has already proposed allowing deferral of taxation of options until five years after vesting (or, if earlier, when the option is exercised).
Deferred compensation plans sponsored by tax-exempt organizations (other than state and local governments) under Section 457 would be eliminated. Section 457A (which covers deferred compensation paid by partnerships and certain foreign corporations) would also be repealed, presumably because the standard for taxation that is established for those arrangements is the same as has been proposed under Section 409B.
These provisions would become generally effective for compensation attributable to services performed on or after January 1, 2018. Deferred compensation accrued prior to 2018 is not entirely grandfathered, rather it must be taxed (generally upon actual payment) no later than December 31, 2025. Note that this requirement includes even deferred compensation accrued prior to 2005, the year in which Section 409A originally became effective.
The Act would substantially expand the scope of non-deductible executive compensation above $1 million in a single fiscal year for public companies. It does so by making a number of important changes to Code Section 162(m).
These changes to Section 162(m) would be effective for tax years beginning after December 31, 2017.
The Act also includes several changes directed at tax-qualified retirement plans. Unlike the executive compensation provisions discussed in this client alert, none of these changes should be controversial, and we think it is likely that some or all of these changes will be enacted (either as part of the Act or in other legislation).
During the drafting of the Act, there were rumblings that the Act could make a number of unpopular changes, such as significantly reducing the limit on employee “401(k)” contributions and characterizing all employee contributions as “Roth” after-tax contributions. However, none of those provisions were included in the current version of the Act.
The changes in the Act that would impact tax-qualified plans are:
In the name of “simplification”, the Act also repeals or limits a number of exclusions or exemptions relating to employer-provided fringe benefits from an employees’ taxable income. The fringe benefits affected include the following:
Gibson, Dunn & Crutcher is focused on the Act and how it would affect our clients, and we will continue to provide updates as more information about the Act or tax reform in general becomes available.
 Although presumably the presence of these vesting conditions should affect the valuation of the compensation to be paid.
The following Gibson Dunn lawyers assisted in preparing this client update: Steve Fackler, Michael Collins, Sean Feller and Arsineh Ananian.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, or the following:
Stephen W. Fackler – Palo Alto and New York (+1 650-849-5385 and 212-351-2392, email@example.com)
Michael J. Collins – Washington, D.C. (+1 202-887-3551, firstname.lastname@example.org)
Sean C. Feller – Los Angeles (+1 310-551-8746, email@example.com)
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