The draft tax reform bill from U.S. House of Representatives Ways and Means Committee titled “The Tax Cuts and Jobs Act”, was introduced in the House on November 2, 2017. If passed as proposed, this act will have significant implications for the way corporations grant equity-based compensation and recognize the tax effects of equity programs in their financial statements. These changes would go into effect in 2018.

More specifically, the draft bill includes many changes to individual and corporate taxes, focusing largely on when taxation occurs in regards to compensation, both with the individual taxpayer and the company. The table below summarizes the proposed changes:

As a result of the proposed reforms, the manner in which executive compensation is structured would need to dramatically change in order to avoid adverse tax impacts to both companies and the employees. The details of these changes and some of the repercussions are described in the following sections of this alert.

Timing of Taxation

Section 3801 of the draft tax reform bill provides that taxation of nonqualified deferred compensation (NQDC) will be accelerated to the time in which there is no substantial risk of forfeiture (for this purpose this only applies to the provision of services by the grantee). In most situations this would be at the time of vest, instead of at the time of payment. This would apply to time-vested restricted stock and stock units, performance-vested restricted stock and stock units, and stock options and stock appreciation rights. It would also cover cash-settled stock units and stock appreciation rights. The current complexities under IRC Section 409A will no longer be an issue, as elective deferrals of compensation would be eliminated. The impact of taxation at vest will need to be mitigated by either changes to the plan design or in employee education of how the awards will be taxed.

Private Companies: An amendment issued November 6, 2017 provides that there is an exception to this tax-at-vest change, in which holders of illiquid equity in private companies can defer taxation of the acquisition of this shares for up to five years after vest. This election to defer can only be made in regards to stock options or restricted stock units issued under a private company equity plan that was granted to no less than 80% of the U.S.-based full-time employees. This election is also not available to anyone who is or has ever been the CEO or CFO of the company, is related to the CEO or CFO of the company, was considered an IRC Section 162(m) covered employee in the prior 10 years, or is a 1% owner of the company.

Certain “Hit at Any Time” Performance Metrics

A common feature used in stock-based long-term incentive plans today is a “hit at any time” performance criteria, where the award vests as soon as the performance criteria is achieved, but in some cases the shares underlying the award are not distributed to the employee until the end of the performance measurement period. Some common examples of the types of performance awards that could be affected by this include:

Award vests upon completion of drug approvals
Award vests at the time the company’s stock price exceeds a target value for 20 consecutive days
Award vests when total sales exceed $5 million

Due to the definitions that exist surrounding certain “hit at any time” performance metrics, time-based vesting needs to be added to these plans to mitigate taxation issues; otherwise participants would be subject to immediate taxation at the time the performance criteria is attained, but won’t be able to sell shares to cover the related tax liability until the end of the performance measurement period. The easiest way to mitigate this is to include a time-based vesting component whereby the award will vest upon performance AND a specified amount of service. This way the timing of the taxable event to the participant will be easily understood and the participant will be able to sell shares to fund the tax liability. Many companies already include this time-based vesting criteria in their awards, and companies that don’t already include such criteria should adjust accordingly.

Employee Stock Options

The change in the tax code will be particularly problematic for employee stock options that can be exercised at any point between the vest date and expiration date. Because employees will now be subject to taxation at vest, the proposed changes to the tax code represent an economic penalty for employees who choose to hold their stock options, rather than immediately exercise at vest. Employees choosing to hold their stock options would be required to pay taxes without exercising the stock options and selling the options shares to fund the tax liability. Under the draft tax reform bill, European style options that expire on the vest date might become the preferred vehicle of stock option grants. While employee stock options that expire at vest will limit the period over which employees can benefit from the appreciation in the price of the employers’ stock, under this approach the employee will assured of the stock options not creating a financial hardship.

Post Vest Holding Periods

The corporate governance and financial accounting benefits of mandatory post-vest holding periods has resulted in holding periods becoming increasingly prevalent in time-vested and performance-vested restricted stock awards. Post-vest holding periods are viewed positively by corporate governance advocates, proxy advisory firms, and institutional shareholders. Additionally, ASC 718 (the financial accounting standard governing stock-based compensation) provides the impact of a post-vest holding period should be reflected as a reduction in the compensation expense produced by the award. To maximize the financial accounting benefit of the holding period, the awards are frequently structured as restricted stock units that are settled at the end of the holding period, which is typically one year or two years after the vest date. Under the current rules, taxation is deferred until the time the units are settled, which allows 100% of the award to be subject to the holding period. However, under the proposed rules, the awards would be subject to taxation at vest. While the post-vest holding period offers a benefit to the shareholders and the company’s income statement, the negative impact on employees of taxation at vest would necessitate a change in the structure of the awards in which only the net after-tax profit shares are subject to the post-vest holding period. This would achieve the company’s objectives of strengthening the corporate governance aspects of its stock-based compensation program and simultaneously reducing compensation expense, while at the same time removing a potential hardship for the employee. Although the reduction will be smaller than if the entire award is required to be held, we continue to believe provisions like these are great governance measures – especially on performance awards to ensure long-term alignment – and the taxation “tail” should not wag the design “dog”.

162(m) Deductibility Limits

In regards to Section 3802, the current rules of IRC Section 162(m) would change significantly in the world of equity-based compensation, and in how we define “covered employees” under the Code. Under the current rules of IRC Section 162(m), commissions and qualified performance-based compensation (as defined in Section 1.162-27(e)(2)) are not subject to the $1 million tax deductibility limit, meaning companies are entitled to a tax deduction for these components of compensation regardless of the $1 million limit. Qualified performance-based compensation includes not only time-based stock options, stock appreciation rights, and performance-vested awards of stock based compensation, but also includes cash incentive plans. Under the proposed tax reform bill, commissions and qualified performance-based compensation will no longer be exempt from the $1 million limit. As a result, the tax deduction will be lost for ALL compensation in excess of $1 million. This will increase the cost to the company of executive compensation significantly, as performance compensation represents the majority of a covered employee’s compensation package.

Additionally, the definition of a covered employee will change. Under the current rules, covered employees include the CEO and the four highest paid executive officers, excluding the CFO. An officer was a covered employee only for the fiscal years in which he or she satisfied the criteria in the definition. Under the proposed rules, covered employees will include the CEO, CFO, and the three highest paid executive officers. Additionally, once an executive is a covered employee, the $1 million deduction limit would continue to apply to all compensation paid to that employee at any time, including after retirement or other termination of employment.

Conclusion

There are other areas of executive compensation that the proposed law touches on, but until the bill ultimately works its way through the legislative system, it is unclear which portions of the bill will survive.

If passed, these drafted rules would go into effect for compensation that’s attributable to service performed from 2018 and forward. The current tax treatment would apply to existing NQDC until the year of 2025, at which time the new rules would apply to absolutely all compensation plans. Aon recommends staying abreast of the status of this draft tax reform bill, given its already significant impact on executive and equity compensation. If enacted, these new rules would drastically impact incentive compensation design and introduce further complexity to an already complex piece of compensation. Aon intends to publish further information as this bill evolves, but please reach out to your Aon consultant if you would like to discuss further.