This Wilson Sonsini Alert provides a high-level comparison of the latest tax reform proposals from the U.S. House of Representatives and the U.S. Senate as they relate to compensation and benefits matters.
This alert also includes a somewhat more detailed introduction into the key compensation and benefits-related provisions of the Senate proposal, and some initial thinking on their potential impact.
Taxation of Options and RSUs Generally Left Unchanged; Repeal of Alternative Minimum Tax
The biggest and most welcome news is that both the House and Senate proposals leave the current law regarding the taxation of stock options and restricted stock units (RSUs) largely intact, stepping away from the initial proposals to tax such awards at vesting. This is a victory for technology and other companies that rely on equity compensation to attract and keep talent.
The proposals also include new additional (but limited) relief for the taxation of private company stock options and RSUs to be deferred if certain conditions are met, which will be welcome news for some private companies.
The proposals also repeal the Alternative Minimum Tax, a change that likely will be celebrated by many.
Recent Timeline
On November 9, 2017, the Senate Committee on Finance released a description of the Senate's take on the Tax Cuts and Jobs Act (the "Senate Initial Mark"), and modified it on November 14, 2017 (the "Senate Amended Mark" and together with the Senate Initial Mark, the "Senate Mark"). On November 16, 2017, the Senate Committee on Finance voted to approve to send to the full Senate a version of the Tax Cuts and Jobs Act reflected in the Senate Mark (the "Senate Bill").
These actions by the Senate Committee on Finance follow actions taken by the House Ways and Means Committee last week to approve and send to the full House of Representatives a version of the Tax Cuts and Jobs Act (the "House Bill"). The House Bill was approved by the full House of Representatives on November 16, 2017. For an analysis of the compensation and benefits-related tax provisions of the House Bill, please refer to our previous client alerts.1
The effective date of the Tax Cuts and Jobs Act under both the Senate Bill and House Bill is January 1, 2018, except as specifically noted below. This timeframe would provide a short window for employers to react.
High-Level Comparison of the House Bill and Senate Bill
The House Bill and Senate Bill include similar provisions on many key compensation and benefits-related provisions with a few notable exceptions as summarized in the chart below.
| Provision | Comparison of House Bill and Senate Bill |
| Deferred Compensation Arrangements | House Bill: Section 409A will continue to govern nonstatutory stock options and other deferred compensation arrangements. This follows the release of several amendments to the originally proposed bill (including the removal of the originally proposed Section 409B, which would have taxed stock options and other forms of deferred compensation upon vesting). Senate Bill: Following the release of the Senate Amended Mark, same as House Bill. |
| Deferral of Tax Event for Private Company Equity Awards | House Bill: Provides a limited ability for certain employees receiving private company stock options and RSUs to defer income on these awards. In general, it appears deferral of income can be up to five years from the exercise date of options and the vesting date of RSUs. Senate Bill: Following the release of the Senate Amended Mark, same as House Bill. |
| Section 162(m) | House Bill:
|
| Entertainment, Fringe Benefit, and Other Business Expense Deductions | House Bill:
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| Retirement Plans | House Bill:
|
| Health and Welfare Plans | House Bill:
|
| Alternative Minimum Tax | House Bill:
|
A More Detailed Introduction to Some Key Provisions of the Senate Bill
No Changes to Timing of Taxation of Equity Awards and Other Deferred Compensation Arrangements
Background: Since the adoption of Internal Revenue Code Section 409A in 2004, employers have carefully structured compensation arrangements that provide for the deferral of compensation in a manner that is exempt from or in compliance with Section 409A, in order to avoid these amounts being currently includable in gross income and subject to an additional 20 percent federal penalty (plus additional penalty taxes in certain states, including an additional 5 percent in California).
Senate Bill: As in the House Bill, the Senate Bill generally preserves the existing tax treatment of equity awards and other deferred compensation with certain enhancements. For many employers, this is a welcome change from the Senate Initial Mark, which proposed eliminating the ability to defer compensation (including certain equity awards) once the compensation "vests," regardless of when it is actually earned or paid. This provision in the Senate Initial Mark was similar to a provision of the originally proposed House Bill that also was removed in the final House Bill.
Tax Deferral Opportunity for Private Company Equity Awards
Background: The House Bill provides that non-executives of private companies may defer taxation of stock options upon exercise and RSUs upon vesting if a list of conditions are satisfied.
Senate Bill: The Senate Bill includes a very similar proposal as the House Bill and provides that a "qualified employee" (as discussed below) of an eligible private company may elect, beginning in the 2018 calendar year, to defer income 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").
Income on 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" (see "Note" immediately below); or
- date the employee revokes his or her inclusion deferral election.
Note: The Senate 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 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 draft language is open to other interpretation; and
- subject to lock-up restrictions implemented in connection with an initial public offering is transferrable or readily tradeable as of the date the employer's shares are first publicly traded or at a later date (e.g., the date the qualified stock is released from the lock-up restrictions).
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: (1) a one percent owner of the employer at any time in the ten preceding calendar years; (2) at any time the chief executive officer or chief financial officer of the employer, or an individual acting in either capacity; (3) a family member (spouse, children, grandchildren, and parents) of anyone described in clause (1) or (2); or (4) among the top four highest compensated officers during any of the ten preceding tax years (any other employee, a "qualified employee").
- The shares were acquired through the exercise of an option or settlement of an RSU and were granted in connection with the performance of services and in a year in which the employer did not have stock that was readily tradeable on an established securities market during any preceding calendar year.
- The equity awards must be offered 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).
- taxation or (2) 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.
A qualified employee may make an inclusion deferral election for qualified stock acquired under a statutory option (such as an incentive stock option) 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.
Practical Considerations:
- The rules for taking advantage of this tax deferral opportunity are fairly restrictive and may make it difficult for many private companies to provide equity compensation to their employees that fully benefits from this relief.
- Given the complexities for taking advantage of this relief, private companies may place a greater emphasis on granting incentive stock options. Incentive stock options are eligible for preferential tax treatment that results in taxation upon a sale or other disposition of the shares acquired upon exercise and will benefit from the proposed repeal of the Alternative Minimum Tax (applicable through 2025) that is included in the House Bill and Senate Bill. Under current law, the Alternative Minimum Tax is seen as one of the biggest drawbacks of incentive stock options.
- Private companies that wish to allow their employees to take advantage of this tax deferral opportunity with respect to existing equity awards that may be exercised or settled in future years may begin to review their historical equity grant practices to assess whether they satisfy the 80 percent and 25 percent requirements described above.
- It remains to be seen how this tax deferral rule (if implemented as currently proposed) may impact the equity grant practices of private companies in future years. To avail themselves of the benefits of this rule, some private companies may consider one or more of the following:
- Granting smaller, but more frequent equity awards in order to be able to satisfy the 80 percent requirements described above. These awards might have shorter vesting schedules than is typical now.
- Introducing new forms of equity into their compensation practices. For instance, private companies that historically have granted stock options may consider granting RSUs.
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.
Senate Bill: Similar to the House Bill, the Senate Bill:
- Eliminates the "performance-based" exception so that any compensation 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.
- Extends the definition of a publicly traded company to include all foreign companies publicly traded through American Depository Receipts, and potentially certain additional privately held companies.
The Senate Amended Mark adds a transition rule so that the proposed changes do not apply to any remuneration under a written binding contract which was in effect on November 2, 2017, and which was not modified after this date in any material respect, and to which the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.
Practical Considerations:
- The proposed amendments would eliminate a publicly traded company's ability to deduct compensation above $1 million that it pays in any year to any covered employees, which likely increases the cost of executive compensation for many publicly traded companies. There is some consolation for many companies in that with the proposed 20 percent corporate tax rate, the lost tax deduction will be smaller than under current law.
- We expect many employers will not be able to take of the limited transition relief under the Senate Amended Mark because it only applies to compensation that was "vested" on or before December 31, 2016.
- While institutional shareholders and their advisors continue to strongly support a focus on pay-for-performance, it remains to be seen whether the Senate Bill (if it becomes law) would cause more publicly traded companies to change their compensation practices, including:
- Providing a higher percentage of an executive compensation in fixed compensation (e.g., base salary) instead of performance-based compensation as a result of performance-based compensation no longer providing tax advantages.
- Providing a higher percentage of performance-based compensation that is based on the achievement of subjective performance goals.
- Modifying or changing objective performance goals mid-performance period to adjust for changes in the company business given that the restrictive amendment rules of the "performance-based compensation" exception would no longer be relevant.
- Using discretion to increase the amount of awards over what performance achievement levels would dictate, if there are business reasons for doing so. Currently, awards will not qualify for the performance-based exception if the use of positive discretion is permitted.
- Limiting the number of employees who are "executive officers" and providing compensation that is relatively consistent to its executive officers in an effort to limit the pool of "covered employees."
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.
Senate Bill:
The Senate 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).
- Excludes from an employee's income and limits the employee's deduction for qualified moving expenses (with certain exceptions for members of the Armed Forces) starting in 2018, but expires on December 31, 2025.
- 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.
- Repeals the employer deduction for expenses for employee meals provided for the convenience of the employer on the employer's business premises (or on or near the employer's business premises through an employer-operated facility).
- 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.
Practical Considerations:
- Eliminating the employer's deduction for employee on-site meal expenses is likely to be unpopular, especially in Silicon Valley where such programs are commonplace.
- 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
Senate Bill: 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 no maintain the minimum essential coverage under the Affordable Care Act.
Changes to Alternative Minimum Tax
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.
Senate Bill:
The Senate Bill:
- Repeals the alternative minimum tax starting in 2018, but the repeal expires on December 31, 2025.
- Allows an AMT credit to offset the taxpayer's regular tax liability for any taxable year. The AMT credit is refundable for any taxable year beginning after 2017 and before 2022 in an amount equal to 50 percent (100 percent in the case of taxable years beginning in 2021) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Thus, the full amount of the minimum tax credit will be allowed in taxable years beginning before 2022.
Senate Amended Mark Changes from Senate Initial Mark
The Senate Amended Mark removed a number of additional compensation and benefits-related proposals from the Senate Initial Mark, including:
- A statutory worker classification safe harbor.
- The application of a 10 percent early withdrawal tax to Section 457(b) plans.
- The elimination of 401(k) plan catch-up contributions for high-wage employees.
Next Steps
Prior to its enactment, the proposed tax reform legislation is likely to continue to change, perhaps significantly. We will continue to monitor the status of the legislation and expect to provide updates as the legislative process moves forward. 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 to discuss how the proposed legislation may impact these programs.
