U.S. House and Senate Pass Reconciled Tax Cuts and Jobs Act: Bill Retains Key Compensation and Benefits Provisions
December 20, 2017
On December 20, 2017, the U.S. House of Representatives and the U.S. Senate passed the Tax Cuts and Jobs Act as submitted on December 15, 2017, by the appointed U.S. House and Senate conference committee (the "Conference Bill"). President Trump is expected to sign the Conference Bill into law. The Conference Bill retains and clarifies the key compensation and benefits provisions and otherwise reconciles the respective final versions of the Tax Cuts and Jobs Act passed by the House on November 16, 2017 (the "House Bill") and the Senate on December 2, 2017 (the "Senate Bill").
This client alert provides a summary and description of the key compensation and benefits provisions in the Conference Bill, and analyzes its potential impact. For additional information regarding the development of the legislation, please see our prior WSGR alerts dated November 7, November 9, November 17, and December 7, 2017.
High-Level Summary and Comparison of the House Bill, the Senate Bill, and the Conference Bill
|Provision||House Bill||Senate Bill||Conference Bill|
|Section 162(m)||Same as Senate Bill.|
|Deferred Compensation Arrangements||Same as House Bill.||Same as House Bill and Senate Bill.|
|Deferral of Tax Event for Private Company Equity Awards||Same as House Bill.||Same as House Bill and Senate Bill.|
|Alternative Minimum Tax (for Individuals)||Same as Senate Bill, except increased phase-out amount is higher than in the Senate Bill.|
|Entertainment, Fringe Benefit, and Other Business Expense Deductions||Similar to House Bill, except: ||Same as Senate Bill.|
|Retirement Plans||Same as Senate Bill.|
|Health and Welfare Plans||Same as Senate Bill.|
A More Detailed Introduction to Some Key Provisions of the Conference Bill
Additional Limitations on Deductibility of Compensation under Section 162(m)
Background: Internal Revenue Code Section 162(m) limits the annual tax deduction to $1 million for compensation paid to each of a publicly traded company's chief executive officer and three highest compensated officers (other than the chief financial officer) (each, a "covered employee"), except with respect to qualified performance-based compensation, commissions, or to certain compensation paid by a company that recently became publicly traded. Publicly traded companies commonly structure executive compensation programs so that a portion of the executive's compensation is intended to comply with the performance-based compensation exception.
Conference Bill: The Conference Bill:
- Eliminates the "performance-based" exception so that any compensation paid by a publicly traded company over $1 million is not deductible.
- Expands the "covered employee" definition to include the publicly traded company's principal financial officer as of the end of the employer's taxable year, which aligns the scope of the "covered employee" group with its original definition as adopted in 1993.
- Expands a publicly traded company's annual tax deduction limitation to include any employee who has ever been a covered employee in taxable years beginning after December 31, 2016, with respect to that publicly traded company.
- Expands coverage of Section 162(m) to include foreign companies publicly traded through American Depository Receipts, and potentially certain additional privately held corporations that are not publicly traded but that have public debt.
- Includes a grandfather rule providing that the changes to Section 162(m) do not apply to any remuneration under a written binding contract, which was in effect on November 2, 2017, and which was not materially modified thereafter.
Grandfather Rule. Public companies should carefully consider whether they have "written binding contracts" in place as of November 2, 2017, that would allow them to take advantage of the grandfather rule described above. The Conference Bill does not provide meaningful guidance on which contracts qualify as "written binding contracts" in this context.
It is likely that equity awards granted before November 2, 2017, that are designed to satisfy the requirements of the "performance-based" compensation exception would qualify as "written binding contracts." However, it is less clear whether cash bonus plans that are designed to satisfy the requirements of the current "performance-based" compensation exception and that also include the compensation committee's ability to exercise negative discretion would qualify as "written binding contracts" for this purpose. Additional guidance from the U.S. Treasury Department may be forthcoming.
2017 Considerations. In light of the 14 percent reduction in the corporate tax rate beginning in 2018 included in the Conference Bill and the corresponding reduction in the tax deduction companies may take with respect to executive compensation, public companies (and other companies to which Section 162(m) coverage is being expanded under the Conference Bill) may consider accelerating the deductibility of certain cash and equity incentive compensation from 2018 to 2017 to maximize their tax benefit.
These companies that are seeking to maximize their 2017 tax benefit may consider:
Any actions to accelerate payment or deduction in 2017 should be carefully considered and coordinated with the applicable tax and securities laws, accounting rules, and the company's governing documents. For example, accelerating the deduction for compensation intended to be performance-based under Section 162(m) may be challenging in certain circumstances.
2018 and Future Year Considerations. The removal of the exception under Section 162(m) deductibility limits for "performance-based" compensation takes with it the need to adhere to the rigid requirements of the exception, providing the small silver lining of more flexibility in setting executive compensation. Given that performance-based compensation no longer provides company tax advantages, we expect companies to give strong consideration to moving toward more fixed compensation and more flexible arrangements. However, institutional shareholders and their advisors continue to strongly support a focus on pay-for-performance, so it remains to be seen how much the changes to Section 162(m) included in the Conference Bill actually cause public companies to change their compensation practices.
In light of the reduction in the corporate tax rate under the Conference Bill as discussed above, the lost tax benefit to some public companies may not be meaningful, and these companies may choose to make no or limited changes to their executive compensation program in response to the Conference Bill.
Among the changes companies may wish to consider:
Deferred Compensation Arrangements Unaffected, New Tax Deferral Opportunity for Private Company Equity Awards
Background: Under current law, assuming options and restricted stock units (RSUs) are carefully structured to be exempt from or compliant with Section 409A, income is deferred on options until exercise and on RSUs until vesting.
Conference Bill: The Conference Bill, consistent with the House Bill and Senate Bill:
- Maintains the current law governing deferred compensation arrangements, and
- Introduces a new rule for private companies allowing for the deferral of income otherwise resulting from the acquisition of the eligible private company's shares through the exercise of a stock option or the settlement of an RSU (such shares, "qualified stock") in the case of non-executives of private companies if certain conditions are satisfied.
Tax Deferral Period. Under this new rule, taxation of such qualified stock may be deferred until the earlier of the:
- first date the qualified stock become transferable (including to the employer);
- date the qualified employee first becomes an "excluded employee" (as described below);
- first date the employer's stock becomes readily tradeable on an established securities market;
- five-year anniversary of the date the employee's right to the stock becomes "substantially vested"; or
- date the employee revokes his or her inclusion deferral election.
The Conference Bill leaves many unanswered questions regarding how the U.S. Treasury Department may interpret what it means to be "substantially vested" as it relates to options, "transferrable" or "readily tradable on an established securities market," including, for example, whether qualified stock that is acquired through the exercise of a stock option is considered "substantially vested" (and therefore the deferral period begins) on the exercise date or the vesting date. The likely intent and better reading is exercise date, but the language is open to other interpretation.
The explanation to the Conference Bill included an important clarification that income inclusion is not delayed as a result of shares being subject to lock-up restrictions implemented in connection with an initial public offering. This means that the shares may be taxable prior to the individual being able to sell them.
Eligibility. To be eligible for the election to defer taxation on qualified stock, the following conditions must be satisfied:
- The employee making the deferral election must not be an "excluded employee," which means the employee must not have been:
- a one percent owner of the employer at any time in the current and the ten preceding calendar years;
- at any time the chief executive officer or chief financial officer of the employer, or an individual acting in either capacity;
- a family member (spouse, children, grandchildren, and parents) of anyone described in the first two bullets; or
- among the top four highest compensated officers during the current and any of the ten preceding tax years (any other employee, a "qualified employee").
- The stock must be received in connection with the exercise of an option or in settlement of an RSU, and such option or RSU must have been granted in connection with the performance of services as an employee.
- No stock of the employer issuing the option or RSU may be readily tradeable on an established securities market during the year the option or RSU was granted, or in any preceding calendar year.
- The employer must offer options or RSUs on terms that provide the same rights and privileges in the calendar year (other than with respect to the number of underlying shares) to at least 80 percent of employees providing services in the U.S. (for years before January 1, 2018, the same rights and privileges requirement will not apply). The conference committee's explanation to the Conference Bill clarifies that this requirement is not satisfied in a taxable year by granting a combination of stock options and RSUs, and instead all such employees must either be granted stock options or RSUs for that year.
- The employer must not have repurchased any of its outstanding stock in the preceding year, unless either:
- at least 25 percent of the dollar amount of the repurchased stock was stock issued to employees electing to defer taxation; or
- all of the outstanding stock for which deferral elections have been made were repurchased.
- The deferral election must be made within 30 days after the right to the qualified stock is first substantially vested or transferable (whichever comes first).
- An employer that transfers qualified stock to a qualified employee must provide a notice to the qualified employee at the time (or a reasonable period before) the employee's right to the qualified stock is substantially vested. Failure to provide the notice may result in a penalty of $100 for each failure, subject to a $50,000 maximum penalty, for all failures during any calendar year. The penalty applies to failures to provide the notice that occur after December 31, 2017.
Impact on ISOs and ESPPs. A qualified employee may make an inclusion deferral election for qualified stock acquired under a statutory option (such as an incentive stock option (ISO)) or an option under an employee stock purchase plan (ESPP) but this would cause the statutory option to lose it tax-preferred status under the U.S. tax code and instead be taxed as a nonstatutory stock option.
These rules are fairly restrictive and may make it difficult for many private companies to provide equity compensation to their employees that fully benefits from the qualified stock deferral option.
Private companies wishing to take advantage of the qualified stock deferral option should begin planning now. In particular, these companies can begin to:
Changes to Alternative Minimum Tax (Individuals)
Background: Under current law, an alternative minimum tax is imposed on individuals based upon an amount by which the tentative minimum tax exceeds the regular income tax for the taxable year. If an individual is subject to AMT in any year, the amount of tax exceeding the individual's regular tax liability is allowed as a credit (the "AMT credit") in any subsequent taxable year to the extent the individual's regular tax liability exceeds his or her tentative minimum tax liability in such subsequent year.
Conference Bill: The Conference Bill maintains the individual AMT, but significantly reduces its impact through December 31, 2025, by increasing the amounts exempted under the AMT by approximately 27 percent and the phase-out of those exemptions four fold, in each case for tax years beginning after December 31, 2017, and before January 1, 2026.
|Current 2018 AMT Exemption*||Conference Bill 2018 AMT Exemption*||Current 2018 AMT Phase-Out Threshold*||Conference Bill 2018 AMT Phase-Out Threshold*|
|Married Filing Jointly||$86,200||$109,400||$164,100||$1,000,000|
|Married Filing Separately||$43,100||$54,700||$82,050||$500,000|
While not as welcome as an outright repeal of the AMT for individuals, these changes may decrease the number of individuals affected by the AMT.
For holders of ISOs that would no longer be subject to the AMT on exercise as a result of the changes in the Conference Bill, these changes may increase the attractiveness of exercising ISOs before there is liquidity on the underlying shares as these holders could defer recognizing income until the shares are transferred or otherwise sold.
Amendments Impacting Deductibility of Entertainment, Fringe Benefit, and Other Business Expenses
Background: Employers currently can deduct certain expenses related to entertainment, amusement or recreation activity or facility expense, certain fringe benefits provided to employees (e.g., employee discounts, working condition, and transportation fringe benefits), and expenses for goods, services, and facilities.
Conference Bill: The Conference Bill:
- Eliminates the employer deduction for (i) an activity generally considered to be entertainment, amusement or recreation, (ii) club membership dues, or (iii) a facility or portion thereof used in connection with items (i) and (ii).
- Retains the current 50 percent deduction for expenses for food or beverages associated with operating their trade or business.
- Applies the 50 percent deduction limitation to expenses for employee meals provided for the convenience of the employer on the employer's business premises (as well as for employee meals provided on or near the employer's business premises through an employer-operated facility and qualifying as a de minimis fringe benefit), for expenses incurred and paid after December 31, 2017, and until December 31, 2015. Any such expenses incurred and paid after December 31, 2025, will not be deductible.
- Eliminates employer deduction for all qualified transportation benefits, and except as necessary for employee safety reasons, any expense incurred for providing transportation (or any payment or reimbursement) for commuting between the employee's residence and place of employment.
- Eliminates the exclusion from an employee's income of, and limits the employee's deduction for, qualified moving expenses (with certain exceptions for members of the Armed Forces) starting in 2018 and expiring on December 31, 2025.
- Allows eligible employers to claim a general business credit equal to 12.5 percent of the amount of wages paid to a qualifying employee during any period in which the employee is on family and medical leave (FMLA) if the rate of payment under the program is 50 percent of the wages normally paid to an employee. The credit is increased by 0.25 percent for each percentage point by which the rate of payment exceeds 50 percent, to a maximum of 25 percent. The proposal would be effective for wages paid starting in 2018, but would expire on December 31, 2019.
The elimination, beginning in 2026, of a company's deduction for employee on-site meal expenses is likely to be unpopular, especially in Silicon Valley, where such programs are commonplace. However, it is some comfort that the Conference Bill provides a 50 percent deduction for such expenses from 2018 through December 31, 2025.
While the above changes limit the company's deduction for qualified transportation fringe benefits, they do not restrict employers from sponsoring qualified transportation fringe benefit plans that allow employees to make pre-tax salary reductions for qualified parking and transit passes. Given the popularity of these programs, many employers may choose to continue to offer this employee benefit.
The FMLA credit is a welcome addition for many employers who currently offer paid FMLA to their employees, and may provide additional incentives for these employers to expand this benefit or for other employers to begin offering paid FMLA leave.
Amendment of Certain Provisions for Retirement and Health Plans
Conference Bill: The Conference Bill, consistent with the Senate Bill, includes the following changes that impact retirement and health plans:
- Repeals the special rule that allows IRA contributions to one type of IRA (either traditional or Roth) to be re-characterized as a contribution to the other type of IRA.
- Repeals the tax assessed on individuals that do not maintain the minimum essential coverage under the Affordable Care Act.
The Conference Bill is now prepared for the president's signature. We expect to provide updated analysis as we continue to study the Conference Bill's provisions. In the meantime, we encourage you to review your company's compensation plans and programs and reach out to any member of the employee benefits and compensation practice at Wilson Sonsini Goodrich & Rosati to discuss how the legislation may impact these programs.
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