In the weeks and days leading up to the release of the House tax reform bill, the news media focused on 401(k) plans and the possible elimination of the ability of employees to save for retirement on a pre-tax basis. Pre-tax 401(k) deferrals appear to be safe, at least for now. Instead, the House bill targets executive compensation and, if enacted, would drastically change the compensation practices of public, private and tax-exempt employers.
Non-Qualified Deferred Compensation. Under current law, employees and other service providers can defer compensation subject to the technical and complex rules of Code Section 409A. The tax bill repeals Code Section 409A and replaces it with a new Section 409B. Under proposed Section 409B, all deferred compensation would be taxable when there is no longer a substantial risk of forfeiture ("SRF") even if the compensation is not payable until a later taxable year. This new provision would apply to public, private and tax-exempt employers. The only condition that would qualify as a SFR is a service condition. That is, only service-based vesting would be recognized; performance-based vesting would be disregarded. Stock options and SARs are specifically included in the definition of deferred compensation under Section 409B meaning that these common forms of equity compensation would also be taxed at vesting even if not yet exercised. Other widely used forms of executive compensation, including severance, SERPS, RSUs, PSUs, and phantom equity would all be subject to the new rule. It is not clear, however, if the bill is intended to apply to incentive stock options and other statutory options.
New Section 409B would be effective for amounts attributable to services performed after 2017. Code Section 409A would continue to apply to existing non-qualified deferred compensation arrangements until the last tax year beginning before 2026, when such arrangements would become subject to the new provision.
Qualified Performance-Based Compensation. Section 162(m) currently limits to $1 million the annual deductions that public companies may take on compensation paid to the chief executive officer and the next three highest paid officers. Under current law, there is an exception for qualified performance-based compensation, the CFO is generally exempt from the limitation and the executive officers must be employed on the last day of the fiscal year in order for the deduction limitation to apply. The bill would eliminate the qualified performance-based compensation exemption, cover the CFO's compensation, and apply the deduction limitation to individuals who at any time after 2016 were named officers (and their beneficiaries) and continue to receive compensation (including after termination of employment).
These changes would be effective for tax years beginning after 2017.
Compensation Paid by Tax-Exempt Employers. Under current law, compensation paid to executives of tax-exempt employers is not subject to any specific dollar limitation. The tax bill includes a new Code Section 4960. Under proposed Section 4960, a tax-exempt employer would be subject to a 20% excise tax on compensation over $1 million paid to any of the current or former highest-paid employees. Severance and other termination payments would also be subject to the excise tax if the payments have an aggregate present value of more than three times the employee's annual compensation.
New Section 4960 would also be effective for tax years beginning after 2017.
Tax bills rarely become law without substantial changes being made. Despite changes that are likely to come in the days ahead, the House bill highlights the increased scrutiny placed on the executive compensation practices of public, private and, now, tax-exempt employers, and indicates that Congress likely views executive compensation as an area of tax revenue. We will continue to monitor these executive compensation developments.
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