Tax Reform: Proposed Legislation Contains Opportunities And Surprises For Stock Compensation

The Tax Cuts and Jobs Act, now under consideration by the Ways and Means Committee in the House of Representatives, is the first effort in Congress at providing tax-reform specifics. See a handy interactive guide to the legislation from the law firm Davis Polk.

Alert (Nov. 21): On Nov. 16, the House of Representatives passed the Tax Cuts & Jobs Act. Its future remains unclear in the Senate, which is preparing its own tax-reform bill. That bill has been approved by the Senate Finance Committee.

Parts of the draft legislation would have an indirect impact on stock compensation (nonqualified deferred comp too), while other sections would have a major impact. They are summarized in the following paragraphs.

1. Simplification of individual income-tax rates. The bill proposes to shift from the current seven tax brackets to new brackets with rates of 12%, 25%, 35%. Additionally, the current top tax rate of 39.6% would continue, though with a higher income threshold (over $1 million for married joint filers and $500,000 for unmarried individuals and married individuals filing separately). How changes in income-tax rates would tie into the flat supplemental rate of withholding on stock compensation is unclear and would need clarification, as the structure of the rate is based on the current seven brackets. Since the 39.6% bracket has survived, contrary to earlier GOP discussions, and the 25% rate still exists, perhaps the flat withholding rates on stock compensation would stay the same.

2. No change in the capital gains rates (15% and 20%). The draft legislation does not change the capital gains rates. However, it creates a new income threshold for the 20% rate that is slightly above the current threshold for the 36% income-tax bracket ($479,000 for married joint filers and $425,800 for single taxpayers).

3. The termination of the alternative minimum tax (AMT). Among those who receive grants of incentive stock options (ISOs), much rejoicing would occur if the AMT were repealed. Companies might then use incentive stock options more frequently. The proposed AMT repeal is part of the House's draft legislation, as are new rules on how AMT credit carryforwards could be refundable through 2022. Under the provision, you would be able to claim a refund of 50% of the remaining credits (to the extent the credits exceed regular tax for the year) for the tax years 2019, 2020, and 2021. In 2022, you would be able to claim a refund of any remaining credits.

What would pay for the end of the AMT is the elimination of the deduction for state and local income taxes and real-estate property taxes on tax returns. Given the odd way in which the AMT is calculated, those deductions can trigger the AMT. Strangely enough, if they are eliminated along with the AMT, taxpayers with ISOs may actually see less tax savings than they might otherwise expect to get from the AMT repeal.

Other Provisions With Potentially Big Impacts

1. Nonqualified deferred compensation would become taxable once there is no longer a substantial risk of forfeiture. This would be a major change. Currently, under IRC Section 409A, tax is deferred until the income, e.g. deferred salary or a deferred bonus, is distributed (see myNQDC.com, our sibling website on NQDC plans). Stock options and stock appreciation rights could get caught up in the definition of NQDC, at least in the House draft legislation. If so, that could lead to taxation at vesting! However, considering the way in which stock options and SARs were initially penalized in the early versions of the Section 409A regulations, we would expect that if this provision continues it will be amended to apply only to discounted grants. According to the Description Of HR 1, The "Tax Cuts And Jobs Act" (see page 209), prepared by the Joint Committee on Taxation, what the report refers to as statutory options (ISOs and tax-qualified ESPPs) would be exempt from the definition of nonqualified deferred compensation under the proposed tax-law change.

Alert: In its Tax Cuts & Jobs Act, the House dropped the provision (Section 3801) that would have imposed the changes described above for NQDC and equity compensation. The amendment making this change was issued on November 9. (See also an alert from FW Cook.) The Senate's tax-reform bill initially introduced a similar provision, but it too was dropped in alignment with the House version (see an alert from the law firm Fenwick & West).

2. The performance-based exception to the Section 162(m) limit on deductible compensation would be repealed. Publicly traded companies would no longer be able to deduct annual performance-based compensation (e.g. stock options, performance shares) in excess of $1 million for the CEO, CFO, and the top three highest-paid employees.

3. The Empowering Employees Through Stock Ownership Act, which passed in the House in 2016 but was not voted on in the Senate, could become part of the final legislation. That legislation sought to allow an employee in a privately held company to defer taxes at option exercise or RSU vesting for up to seven years as long as the company's equity awards met certain conditions. The current draft legislation in the House has a similar provision but reduces the deferral period to five years.

Further Reading

For a broader summary and analysis of the tax-reform legislation, including links to commentaries from law, accounting, and consulting firms, see the related FAQ at myStockOptions.com.

Nonqualified Deferred Comp In Year-End Planning: Can You Change Deferral Elections To Receive Money In 2012, Or Move Scheduled Future Income Distributions Into 2012?

As tax rates are likely to rise after 2012, at least for the high-income taxpayers who typically participate in nonqualified deferred compensation (NQDC) plans, many people are looking at ways to accelerate income into 2012 to get the lower tax rates available now. (Higher tax rates ahead will make nonqualified plans more popular, but that is a blog topic for another day.) It is crucial to understand that NQDC deferrals already made for 2012 income cannot be shifted into 2012. Instead, keeping tax increases in mind, now is the time to focus on deferring 2013 compensation income, as deferral elections for next year must be made before year-end.

Under the rules of Internal Revenue Code Section 409A, one core NQDC concept is that you must make an irrevocable election to defer the income during the year before the year when you earn it and thus would have otherwise received it. Therefore, you are not allowed to change or cancel deferral elections for the current year's income and instead receive the income in that year. This differs from the rules in a 401(k) or 403(b) plan, where you can modify the amount of income for deferral during the year when you are earning it. In NQDC plans, exceptions are made for participants who have just joined the company and for performance-based compensation.

As for shifting future distributions into 2012, this can occur only in very specific situations and depends on your plan. Unless something triggers an early distribution under a specific provision in a nonqualified deferred compensation plan, it is also impossible to move into the current year a payout elected for a future year. If you want to reschedule a distribution, you need to follow strict rules. These force you to make the change at least 12 months before the originally scheduled distribution date, and to redefer the money to a new date at least five years beyond that original distribution date.

The only exception that is under your control occurs with amounts deferred and vested before 2005 in NQDC plans with haircut provisions. Separate from this, an indirect acceleration would be allowed by the Section 409A rules if your distribution were scheduled for January of the following year and your company on its own moved the distribution forward not more than 30 days, to December of the current year. (For more on this very limited situation, see the related FAQ on myNQDC.com, our website devoted to nonqualified deferred compensation plans.)

For the way tax increases may influence your decision on whether and how much to defer, see the articles The Growing Importance Of Nonqualified Deferred Compensation Amid Rising Tax Rates and Advantages To Deferring Income In An Uncertain Tax Environment, also on myNQDC.com.

Section 409A Developments Affect Nonqualified Deferred Compensation And Stock Plans

Internal Revenue Code Section 409A, added by the American Jobs Creation Act and provoked by the abuses at Enron, greatly influences nonqualified deferred compensation plans and also has an impact on stock compensation. Any professional involved with these two areas of compensation needs a working knowledge of 409A. Even participants must know about 409A, as substantial penalties for violating its rules fall on the participant and not the company.

myNQDC.com has clearly written, reader-friendly FAQs on Section 409A that reflect the types of questions participants care about. The 409A rules explained in these FAQs, and other content elsewhere on the site, permeate all aspects of nonqualified deferred compensation. For its part, myStockOptions.com features a detailed FAQ on 409A and its impact on stock plans, along with covering certain aspects of 409A in other content. Although initially there was concern about the impact of Section 409A on regular at-market stock option and SARs grants in publicly traded companies, and on employee stock purchase plans, these worries faded after more regulations emerged. However, companies must still be careful about various aspects of 409A to avoid discounted stock options, delays in paying out performance share awards, and mistakes in restricted stock unit plans that allow deferral of share delivery at vesting.

The following Section 409A developments will be of interest to both professionals and participants:

1. W-2 reporting for NQDC. As we explain in FAQs on this topic in the myNQDC.com section Taxes: Reporting, the amount of income deferred during the tax year may be indicated in Box 12 of Form W-2 using Code Y once the IRS has issued more guidance on the point. (For income from a 409A violation, Code Z is currently used.) This guidance—and thus the required W-2 reporting—is not expected for some time, according to Bloomberg BNA's Compensation Planning Journal. It seems that the IRS is currently preoccupied with other proposed and final rules, including the Income Inclusion Regulations that relate to 409A and the penalty calculations.

2. IRS audits. According to the newsletter HRS Insight by PricewaterhouseCoopers the IRS is "now stepping up its enforcement activity" in 409A compliance for nonqualified plans and stock plans. Some areas of IRS attention in corporate audits that could expose costly compliance errors:

• incorrect reliance by companies on the short-term deferral rule in making payouts to avoid 409A consequences
• inappropriate identification of specified employees, a point that matters for various purposes, such as in the six-month delay in payouts to these employees after employment termination
• tax implications of discounted stock options and how the fair market value is set for the exercise price, particularly in privately held companies
• plan documents that do not clearly specify the time and form of payment for deferred amounts, as with an employment agreement's severance provision allowing an employee to elect a lump-sum or installment distribution at termination