Updates to Taxation of Executive Compensation and Employee Benefits Under the Proposed House Tax Legislation

November 10, 2017

On November 9, 2017, the House Ways and Means Committee approved the Tax Cuts and Jobs Act (the “Act”) in order to send the Act to the full U.S. House of Representatives.  The version approved by the Committee differs in a number of material respects from the version presented to the Committee for markup just one week ago.  We provided a summary of the initial version of the Act [here] and also provided a summary of the key proposals affecting executive compensation and employee benefits [here], both of 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.  In this Alert, we focus on the material changes to the Act relating to executive compensation and employee benefits made in the process of the Committee’s markup.

Introduction of “Qualified Stock” for Awards to Employees of Privately Held Corporations

The version of the Act presented to the Committee on November 2 would have imposed income taxes on grants of options and restricted stock units once substantial future services were no longer required to be provided.  Under current law, income taxes are generally not imposed on options until the later of the time of exercise or vesting and on restricted stock units (or RSUs) until the later of the time of vesting or delivery of the shares.  Last week’s version of the Act would have taxed these awards even if the recipient had not yet received any shares of stock.

As we stated in our prior Alert, we expected to see “much comment and criticism”.  That criticism was applied very promptly, and in response to the most obvious deficiency—the taxation of these awards granted by privately held companies for which no public market is available for recipients to sell shares in order to cover their tax liabilities—the Act was revised to introduce the concept of “qualified stock” for compensatory stock awards to employees.

Under the Act, qualified stock is any stock in a corporation if the stock is received by an employee of the corporation through the exercise of an option or settlement of a restricted stock unit that was awarded in connection with the employee’s performance of services for the employer and was granted at a time when the employer is an “eligible corporation”.   In order to qualify as an eligible corporation for a given calendar year, the employer’s stock must not have been publicly traded in any year preceding the year of the grant of the award and the corporation must make the grant under a written plan under which not less than 80 percent of all employees providing services to the employer in the United States are actually granted options or RSUs in the same calendar year that possess the same rights and privileges.  This 80% annual grant threshold is quite impractical, since not even companies that grant compensatory stock awards to all of their employees (such as many Silicon Valley startups) make such grants in a single calendar year.

If all of the various requirements are satisfied, including the making of an election by the employee to have this treatment apply, qualified stock is not taxed until the earliest of the following events: (1) the date that the stock first becomes transferable, (2) the date that the employee becomes ineligible to receive the benefit (as described further in the next paragraph), (3) the date that any stock of the employer becomes publicly traded on an established securities market, (4) the date that the employee revokes his or her election, or (5) the fifth anniversary of the date that the stock first becomes transferable or is no longer subject to a substantial risk of forfeiture.  Since the deferral of taxation is intended to remove a potential burden for employees holding illiquid stock, the proposed law contains restrictions on employers from repurchasing their own shares as a means of providing employees with a mechanism to monetize their stock awards.

One technical note:  Last week’s legislation proposed to limit the definition of “substantial risk of forfeiture” to the performance of substantial future services in the context of nonqualified deferred compensation (new proposed Section 409B).  Since the concept of “qualified stock” is being introduced as an amendment to a different section of the Internal Revenue Code (Section 83), we would expect that the established (and broader) definition of “substantial risk of forfeiture” already found in Section 83 would apply.  What this means, for example, is that the need to achieve bona fide performance goals could also qualify as a substantial risk of forfeiture and therefore delay income taxation.

Not all employees are eligible to receive this tax benefit.  The limits on participation are broader than comparable provisions of current law governing incentive stock options or Section 423 employee stock purchase plans.  Under this version of the legislation, the favorable tax treatment for qualified stock is not available to any person who is serving, or has ever served, as the employer’s chief executive officer or chief financial officer, (including certain family members of the CEO or CFO), is a 1% owner of the employer, or at any time in the preceding 10 years has been one of the 4 most highly compensated officers of the employer.

These proposed provisions would generally become effective for options exercised and RSUs settled after December 31, 2017.  Since, if enacted as presently drafted, these provisions could apply to options and RSUs that have already been granted and are presently outstanding, the transition rules should prove to be especially challenging to draft and administer.

Reversal of Effective Elimination of Unfunded Non-Qualified Deferred Compensation

In our last Alert, we explained that the initial version of the Act presented to the Committee last week would largely eliminate unfunded non-qualified deferred compensation by adding a new Section 409B and repealing current Section 409A.  It took only a few days for that position to be fully reversed.  In the version of the Act reported out by the Committee yesterday, Section 409B has been removed and current Section 409A has been restored.  Since under Section 409A, most options are not taxed until exercise and most grants of RSUs are not taxed until issuance of the stock, the addition of “qualified stock” that was added earlier in the Committee’s markup may have been effectively rendered pointless.[1]

This also means that the current law regarding deferred compensation plans sponsored by tax-exempt organizations (other than state and local governments) under Section 457 would not be changed by the Act.  Furthermore, Section 457A (which covers deferred compensation paid by partnerships and certain foreign corporations) would also remain in effect under the Act.

Postponement or Relaxation of the Proposed Repeal or Limitation of Certain Exclusions Relating to Fringe Benefits

Over the past week, the Act was amended to delay the repeal of, or retain in part, certain employer-provided fringe benefits.  The fringe benefits affected by these changes include the following:

  • Dependent Care Assistance Programs.  The Act delays the elimination of dependent care flexible spending accounts (dependent care FSAs) until the end of 2022 (five years).
  • Qualified Moving Expense Reimbursement.  Last week’s version of the Act would repeal the exclusion from an employee’s income of any reimbursement received from an employer of qualified moving expenses related to a job relocation.  (The employee could still take a deduction for qualified moving expenses under Section 217 to offset this inclusion in income, but at a minimum it makes the preparation of the employee’s tax return more complicated and could still result in some mismatches between income and deductions that end up increasing the employee’s tax liability.) The Act was amended this week to preserve that exclusion, but only for members of the Armed Forces of the United States on active duty who move pursuant to a military order and incident to a permanent change of station.

Next Steps in the Progress of Tax Legislation

The Act is expected to be presented to the full House for a vote later this month.  In addition, the U.S. Senate yesterday announced its own version of tax legislation that differs materially from the Act. It is expected that each of the Senate and the House will adopt different versions of tax legislation, which will then be presented to the Joint Committee on Taxation in order to try to reconcile the different versions.  This process still has a long way to go, and if the events of the last week offer any predictive value, there will be plenty of changes in what has been developed to date.

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.

   [1]   However, the proposed tax legislation released yesterday by the U.S. Senate does include limitations on non-qualified deferred compensation that are comparable to those provisions of Section 409B that were just deleted by the House on the same day.  So there will be further significant developments on this topic.

The following Gibson Dunn lawyers assisted in preparing this client update: Steve Fackler, Michael Collins and Sean Feller.

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 protected])
Michael J. Collins – Washington, D.C. (+1 202-887-3551, [email protected])
Sean C. Feller – Los Angeles (+1 310-551-8746, [email protected])

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