Tax Bills Would Modify Section 162(m) Exec Comp Deduction, Other Provisions

While much of our focus on the current House and Senate tax bills has been on the retirement-related provisions, there are a number of provisions worth noting that would alter the existing tax treatment of executive compensation and various other compensation and benefit provisions.

As we reported, both the House and the Senate Finance Committee approved separate pieces of legislation on Nov. 16. All eyes will now be on the Senate, which is set to begin considering the Finance Committee-reported legislation following the Thanksgiving break.

In order to pass the legislation by a simple majority in the Senate, the budget framework requires that Congress not exceed a net $1.5 trillion tax cut over the period 2018-2027. The framework also says that the legislation cannot add to the deficit after this period. To help comply with the budget requirements, lawmakers have been searching for various revenue raisers to help offset the overall cost of the tax cuts.

One of those revenue raisers is a proposal to modify the current limitation on so-called “excessive” employee remuneration under Code Section 162(m).

Under the House bill, the $1 million yearly limit on the deduction for compensation with respect to a “covered employee” of a publicly traded corporation under Section 162(m) would be expanded to include the CEO, CFO and the three highest paid employees.

The current exceptions for commissions and performance-based compensation would be repealed, such that the $1 million deduction limit would apply to stock options, stock appreciation rights, performance stock units and performance shares. In addition, once an employee qualifies as a covered employee, the deduction limitation would apply to that person so long as the corporation pays remuneration to that person (or to any beneficiaries).

The House also extends the Section 162(m) limit to include all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs). The proposed definition would include certain additional non-publicly traded corporations, such as large private C or S corporations.

Like the House, the Senate bill also changes the definition of “covered employee” to include the principal executive officer, the principal financial officer, and the three other highest paid employees.

In addition, a covered employee for a tax year beginning after 2016 would remain a covered employee for all future years. The provision would also eliminate exceptions for commissions and performance-based compensation.

The Senate bill includes a transition rule specifying that the proposed changes do not apply to any remuneration under a written binding contract in effect on Nov. 2, 2017, and that is not modified in any material respect. It also removes an earlier proposed requirement that to qualify for transition relief the right of the covered employee would no longer be subject to a substantial risk of forfeiture on or before Dec. 31, 2016.

Both the House and Senate provisions would be applicable to tax years beginning after 2017. The House provision is estimated to raise $9.3 billion over the 10-year period 2018-2027, while the Senate provision is estimated to raise slightly less at $6.9 billion.

Excise Tax on Tax-Exempt Organization Exec Comp

Both the House and Senate bills would impose an excise tax of 20% on compensation in excess of $1 million paid to any of the five highest-paid employees of a tax-exempt organization (or any person who was such an employee in any preceding tax year beginning after 2016). The tax would apply to the value of all remuneration paid for services, including cash and the cash-value of most benefits.

The excise tax would also apply to excess “parachute payments,” or payments in the nature of compensation that are contingent on an employee’s separation and, in present value, are at least three times the employee’s base compensation. The base amount would be the average annualized compensation includible in the covered employee’s gross income for the five tax years ending before the date of the employee’s separation from employment.

The changes would apply to tax years beginning after 2017. This provision is estimated to raise revenues by $3.6 billion over the period 2018-2027.

Treatment of Qualified Equity Grants

Both the House and Senate include a provision that would allow employees to elect to defer recognition of income attributable to stock received on exercise of an option or settlement of a restricted stock unit (RSU) until an opportunity to sell some of the stock arises, but no longer than five years from the date that the employee’s right to the stock becomes substantially vested.

More specifically, if an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the tax year that includes the earliest of:

  • the first date the qualified stock becomes transferable, including, solely for this purpose, transferable to the employer;
  • the date the employee first becomes an excluded employee;
  • the first date on which any stock of the employer becomes readily tradable on an established securities market;
  • the date five years after the first date the employee’s right to the stock becomes substantially vested; or
  • the date on which the employee revokes their inclusion deferral election.

Elections would apply only to stock of the employee’s employer and the options or RSUs would have to be granted in connection with the performance of services by the employee. A written plan would have to provide that at least 80% of the employees of the company would be granted stock options or RSUs with the same rights and privileges. In addition, certain employees would not be permitted to make the election, such as 1% owners, and the CEO and CFO.

RSUs would not be eligible for a Code Section 83(b) election and receipt of qualified stock would not be treated as a nonqualified deferred compensation plan for purposes of Section 409A.

The provision would apply to stock attributable to options exercised, or RSUs settled, after 2017, subject to a transition rule. This provision would decrease revenues by $1.2 billion over 10 years.

Carried Interest

Both the House and Senate include a provision stipulating that certain partnership interests received in connection with the performance of services would be subject to a three-year holding period in order to qualify for long-term capital gain treatment.

Transfers of applicable partnership interests held for less than three years would be treated as short-term capital gain. This treatment would affect partnership in connection with the performance of substantial services to businesses which consist of engaging in capital market transactions or other specified investments.

The provision would apply to tax years beginning after 2017. This provision would increase revenues by $1.2 billion over 10 years.

Other Provisions

Both the House and Senate bills include other noteworthy compensation and benefit provisions of interest to industry stakeholders. Below is a listing of some these provisions.

House Bill Changes

  • Limitation on exclusion for employer-provided housing
  • Repeal of the exclusion for employee achievement awards
  • Sunset after 2022 exclusion for dependent care assistance programs
  • Repeal of exclusion for qualified moving expense reimbursement
  • Repeal the work opportunity tax credit
  • Repeal of deduction for employer-provided qualified transportation and parking
  • Repeal of deduction for employer-provided gyms
  • Clarification of unrelated business income tax treatment of state and local retirement plans
  • Repeal the employer-provided child care credit
  • Disallow deduction for contributions to an Archer MSA (existing balances could continue to be rolled over to an HSA)

Senate Bill Changes

  • Limitation on deduction by employers of expenses for certain fringe benefits, including meals and entertainment expenses and qualified transportation fringes
  • Provide employer credit for paid family and medical leave
  • Expand excise tax on excess-benefit transactions to also apply to labor, agricultural and horticultural organizations under Section 501(c)(5) and business leagues, chambers of commerce, real estate boards and boards of trade under Section 501(c)(6).

Subject to Change…

As the legislation works its way through the process, it is worth keeping an eye on what happens with the proposed repeal of the Affordable Care Act’s individual mandate that was added to the Senate bill.

Repeal of this provision is estimated to raise over $300 billion, and if it is dropped, the Senate would have to find other revenue offsets or make other changes to the legislation in order to meet the budget requirements. As we noted in previous reports, there are more stringent budget rules in the Senate that could derail the legislation or force major changes depending on the final cost estimates.

Note that all of these provisions are subject to further changes and modifications as the legislation works its way through the process — and bear in mind that nothing is final until everything is final.

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