The federal tax-reform bill signed into law by President Trump does not touch stock options and deferred compensation, but it does make substantial changes to executive compensation that necessitate additional disclosures this year and in the coming few years.
Currently commissions and performance-based compensation are not subject to the $1 million limit for individual compensation that companies can deduct on their tax returns. The tax bill not only eliminates this exception but extends the applicability of the deduction limit, found in Section 162(m), to include a company’s CFO and adds in all foreign companies publicly traded in the U.S. in the form of American depositary receipts.
The final bill’s proposed definition may also include some additional corporations that are not publicly traded, such as large private C or S corporations, depending on interpretations.
The new law also allows some employees of private companies to defer immediate taxation for up to five years on the gain from exercising a vested stock option or when a share of restricted stock becomes vested. The deferral isn’t available to owners of 1% or more of shares, the chief executive officer, the chief financial officer and of the four most highly compensated officers for any of the last 10 years.
Because it was pushed by lobbyists to incentivize private companies to broaden the employee population that gets shares, it also requires that corporations provide stock compensation to at least 80% of its employees with the same rights and privileges in order to qualify for the tax deferral.
Michael Melbinger, a partner at law firm Winston & Strawn LLP who also blogs about the latest developments regarding responsible compensation practices at CompensationStandards.com, told MarketWatch in an interview that not only does the Republican tax legislation not impose terrible tax consequences on stock options and deferred compensation, but, based on his more than 30 years’ experience in these matters, “the elimination of the performance-based compensation exception will lead to a surge in the popularity of incentive stock options, and an uptick in the use of deferred compensation for covered employees.”
That’s already happening. Netflix announced on Thursday it would eliminate performance bonuses for its top executives and substantially increased base salaries, citing the elimination of an exception to a deductibility cap for performance bonuses that quashes any incentive to prioritize bonuses over salaries.
These major changes may impact the quality of compliance with the executive-compensation-deduction limits, for example. That’s to be expected, Melbinger said, because overall compliance has varied over the last 20-plus years. “I continue to be surprised by the number of companies that apparently either do not seek or do not receive thorough technical advice on these issues,” he told MarketWatch.
Since these tax changes would not go into effect until the 2018 tax year, payments and the corresponding deductions may be accelerated into the 2017 tax year, because “significant dollar amounts are involved,” according to Melbinger.
Companies should already be looking at how they will present this information on proxy statements for 2017 annual meetings. In those proxies, companies may need to discuss the deductibility of amounts paid in fiscal 2017 (specifically, any amounts paid that were not deductible because of the existing caps and the deductibility — or lack of deductibility of excess amounts to be paid in the 2018 fiscal year). After that, Melbinger said, he will be advising companies that the Securities and Exchange Commission may expect companies to make full disclosure of why any executive-compensation amounts were paid despite no longer being deductible.
The IRS needs to put out additional guidance, too, on how the transition should work, according to Melbinger, because interpretations will vary wildly. The bill will never address all of the varied situations companies will be facing. “For some purposes, such as tax accounting,” Melbinger told MarketWatch, “companies and their advisers need to make a judgment in January 2018 whether compensation amounts they reported as deductible in previous financial statements will continue to be deductible.”
Another big change in the bill concerns who is considered a “covered” employee under the rules. Today, before the bill’s passage, companies determine who is a covered employee at the end of the year, based on whether he or she is a named executive officer, or NEO, required to be listed in the proxy.
The tax law adopts a “once a covered employee, always a covered employee” approach. That means, for example, that if an employee is listed as an NEO in 2017 is demoted or fails to make the cut in 2018, he or she is still a covered employee and subject to the compensation deductibility caps in 2018 and beyond, even after death, according to Melbinger.
In another example, if a CEO retired in 2017 and exercised stock options in 2020, the gain recognized in 2020 in excess of $1 million would not be deductible.
All of these changes apply to taxable years beginning after Dec. 31, except if the executive compensation is paid under a written, binding contract that was in effect on Nov. 2.