The Tax Cuts and Jobs Act (TCJA), which passed in late 2017, and other recent legal developments have created new opportunities and challenges for executive compensation

The changing landscape of executive compensation impacts a wide range of employers, from public companies, to startups, to not-for-profits. The TCJA and other recent legal developments create many new pitfalls, but they also open the door for some more flexible and tax-efficient compensation arrangements. Understanding these changes can be a critical part of designing an effective and compliant compensation program. This article highlights several of the most important of these developments.

HOT TOPIC 1

CHANGES TO 162(m) DEDUCTION LIMIT ON PUBLIC COMPANY EXECUTIVE COMPENSATION

Section 162(m) of the Internal Revenue Code generally limits a public company’s deduction for compensation paid to its “covered employees” to no more than $1 million per year. Prior to the TCJA, much of the impact of 162(m) could be mitigated by taking advantage of several important exceptions. Effective for tax years beginning on or after January 1, 2018, the TCJA significantly broadened the scope of 162(m) by:

• Eliminating an exception for performance-based compensation
• Expanding the group of individuals covered by 162(m)
• Treating an employee who is covered by 162(m) in any year as covered in all future years.

Arrangements grandfathered from the 162(m) changes 
The TCJA provides a transition rule for compensation payable under a written binding contract that (i) was in effect on November 2, 2017, and (ii) is not materially modified after that date.

Grandfathered arrangements continue to be subject to the old 162(m) rules, including the applicable exceptions and the old covered employee rules. As a result, taking steps to monitor and comply with these grandfathering rules can produce significant tax savings.

What amounts are grandfathered?
An amount is payable under a written binding contract only if the company is legally obligated under state contract law to pay the compensation if any contingencies in the contract (such as a vesting condition) are satisfied. The IRS takes a narrow view of what amounts are payable under a legally binding contract. For example, if a deferred compensation plan provides that the rate of earnings credited to participant accounts may be changed at the employer’s discretion, earnings that accrue after November 2, 2017, may not be grandfathered even if the earnings accrue on otherwise grandfathered amounts.

How Is grandfathered status lost?
An otherwise grandfathered arrangement will lose its grandfathered status if it is materially modified after November 2, 2017. If a grandfathered arrangement is materially modified, no amounts paid after the modification will be eligible for transition relief. Subject to several specific and narrow exceptions, material modifications include increasing the amount of compensation payable under a grandfathered arrangement and changing when a grandfathered amount will be paid. In some circumstances, even adopting a new arrangement can jeopardize the grandfathered status of an existing arrangement if the new arrangement is substantially based on the same elements or conditions as the grandfathered arrangement.

In addition, a grandfathered arrangement renewed after November 2, 2017, will lose its grandfathered status as of the date of the renewal. Likewise, a written binding contract that is terminable or cancelable by the company without the employee’s consent is treated as renewed on the earliest date that a termination or cancellation, if made, would be effective. Nevertheless, a contract is not treated as terminable or cancelable by the company if it can only be terminated or canceled by terminating the employee’s employment.

The importance of recordkeeping
To preserve the increased tax deduction available for grandfathered arrangements, it is critical to identify potentially grandfathered arrangements and maintain necessary records of grandfathered amounts.

For example, it is very important to track November 2, 2017 account balances or accrued benefits under deferred compensation plans. This is true not just for participants who are currently covered employees. Because deferred compensation can be paid many years in the future, an individual who is not a covered employee today could be promoted into a covered position before that deferred compensation is paid.

HOT TOPIC 2

MANAGING EXECUTIVE COMPENSATION PLAN DOCUMENTS FOLLOWING THE 162(m) CHANGES

Now that the 162(m) exception for performance-based compensation has been largely eliminated, employers have more freedom in designing executive compensation programs.

Simplification of documents and administrative processes
Numerous complex terms that were included in incentive compensation plan documents in order to satisfy 162(m) may now be considered for removal or modification. A few examples would include:

• Plan provisions requiring that performance goals be pre-established (generally within the first 90 days of the year).
• Terms prohibiting discretionary adjustments to performance metrics and outcomes.
• Provisions requiring that incentive compensation amounts be objectively determinable.
• Shareholder-approved lists of specific performance measures.
• Maximum limitations on individual awards.
• Compensation Committee processes previously required for 162(m) compliance.

What do the proxy advisory firms say?
Institutional Shareholder Services (ISS) has stated that shifts away from performance-based compensation to discretionary or fixed pay elements will be viewed negatively. In its latest FAQs relating to evaluation of equity compensation plans, ISS has stated that it encourages companies to maintain plan provisions that represent good governance practices, such as individual award limits, even if they are no longer required under 162(m). In its latest proxy guidelines, advisory firm Glass Lewis suggests that the best practice for companies is to provide robust disclosure to shareholders so that they can make fully informed judgments about the reasonableness of proposed compensation plans.

The next steps
Even with more limited tax deductibility, many companies will continue to make performance-based compensation a significant component of executive pay, whether to continue performance incentives to executives or for shareholder relations purposes. However, they now have much greater flexibility in designing their incentive pay programs and plans can now be amended to increase the individual limit without resubmitting the plan for shareholder approval.

Expanding flexibility in regard to making adjustments for unforeseen events or circumstances, including the addition of positive discretion, is viewed by many companies as particularly desirable. Also, arrangements with separating executives may be simplified now that plan payouts upon employment termination may be made based on target levels of performance (instead of actual performance results), which has not been permitted under many plans due to 162(m) considerations.

HOT TOPIC 3

IRS GUIDANCE ON EXCISE TAX ON EXECUTIVE COMPENSATION PAID BY TAX-EXEMPT ORGANIZATIONS

The TCJA added new Section 4960 to the Internal Revenue Code. It imposes an excise tax at the corporate tax rate (currently 21%) on certain compensation paid by applicable tax-exempt organizations (ATEOs) to their highest-paid employees. ATEOs include 501(c)(3) entities and certain other types of tax-exempt entities.

Who is covered?
“Covered employees” include any current or former employee of an ATEO who (i) is one of the five highest-compensated employees of the ATEO for the current taxable year, or (ii) was a covered employee for any tax year beginning after December 31, 2016. This means that once an employee is a covered employee, he or she will always be a covered employee.

What compensation is covered?
The 4960 excise tax applies to (i) remuneration paid for a taxable year in excess of $1,000,000, plus (ii) any excess parachute payment paid by the ATEO or any related organization to any covered employee. “Remuneration” for this purposes generally includes all wages subject to federal income tax withholding, except designated Roth contributions, and any amounts that are included in income under Section 457(f) of the Internal Revenue Code.

What are excess parachute payments?
The rules for excess parachute payments under 4960 are similar to the rules under Section 280G of the Internal Revenue Code. As with 280G, an amount is not considered a parachute payment under 4960 unless the amount of the payment exceeds three times the employee’s “base amount” (generally average Form W-2 wages for the preceding five years).

However, in contrast to 280G parachute payments, which are only payments that are contingent on a change of control, “parachute payments” for purposes of 4960 are amounts in the nature of compensation that are contingent on the covered employee’s separation from employment in any context. However, the IRS has indicated that this is intended to be limited to “involuntary” separations (which could include “good reason” terminations).

HOT TOPIC 4

NEW TAX DEFERRAL OPPORTUNITY FOR PRIVATELY HELD EQUITY

The TCJA added new Section 83(i) to the Internal Revenue Code. It allows certain employees of privately held companies who receive stock under a qualifying stock option or restricted stock unit (RSU) program to defer income tax for up to five years. There are significant limitations on the features of a program that can take advantage of 83(i). However, in certain circumstances, especially for startups, 83(i) may have significant appeal.

Important limitations of 83(i)
A qualifying stock option or RSU program must be offered to at least 80% of the company’s U.S. employees, including U.S. employees of affiliated companies. The number of options or RSUs granted to each eligible employee need not be the same, but each eligible employee must receive more than a de minimis grant. The company’s most senior executives – its four highest-paid officers and its CEO and CFO – and most owner-employees cannot take advantage of 83(i). Therefore, it is really only useful for a privately held company looking to grant equity to a significant portion of rank-and-file employees. It is not a tool for compensating senior executives.

Potential advantages of 83(i)
In the limited situations in which an 83(i) program is viable, it can create a significant benefit for lower-level executives and other employees. An election to defer taxation under 83(i) generally must be made within 30 days of the date the option is exercised or the stock underlying the RSU is delivered. Income tax on the stock the employee receives can be deferred for up to five years after that date, and appreciation after the date of the election is taxed as capital gain.

However, the tax deferral period is cut short (i) if the stock becomes transferrable, (ii) if the employee becomes a senior executive or owner-employee who is ineligible for 83(i), or (iii) if the company’s stock becomes publicly traded. Therefore, 83(i) is largely a tool to defer income tax on startup company equity until that company has a liquidity event.

HOT TOPIC 5

RECENT LITIGATION REGARDING BOARD OF DIRECTORS COMPENSATION

Several Delaware court cases in recent years have highlighted litigation exposure for boards of directors of public companies in regard to their director compensation programs. A Delaware Supreme Court case now may increase the likelihood that plaintiffs may be able to defeat a motion to dismiss in such cases, resulting in costly litigation.

The Investors Bancorp case
In December 2017, the Delaware Supreme Court, in In re Investors Bancorp, Inc. Stockholder Litigation, applied a rigorous standard of judicial review in refusing to dismiss a case alleging excessive director compensation.

The court held that directors facing lawsuits from shareholders claiming that the directors breached their fiduciary duties by making excessive compensation awards to themselves have the burden of proving they were fair to the corporation – i.e., the “entire fairness” standard of review.

Earlier Delaware cases
Before the Investors Bancorp decision, Delaware courts generally had applied the deferential “business judgment” standard of review where director awards were made under certain shareholder approved plans. As a direct result of these earlier Delaware cases, many companies made changes to their director compensation plans, including amending plans to impose explicit, meaningful limits on amounts of compensation that potentially could be paid to directors. The Investors Bancorp decision suggests that those plan terms may not be sufficient to avoid the entire fairness standard of review.

What should boards do now?
Many companies may now need to reconsider the terms of their nonemployee director compensation programs in light of the Investors Bancorp decision. One approach suggested by the decision is to have shareholders approve a plan that provides for self-executing awards in fixed amounts and on fixed terms, which would be viewed as an advance ratification of the directors’ compensation decisions.

Other companies may choose to retain some discretionary authority for directors in setting their own compensation, even if in doing so the presumption of the business judgment rule may be lost. Ultimately, further evolution of these rules will result from additional court decisions.

 

SECTION 409A: DEFERRED COMPENSATION PITFALLS

What You Don’t Know CAN Hurt You

Section 409A of the Internal Revenue Code governs “deferred compensation” and applies to all employers. Failure to comply can result in immediate taxation, i.e., income tax acceleration, of all amounts involved, a 20% excise tax and interest penalties. However, Section 409A can also apply to many types of arrangements not traditionally thought of as deferred compensation. In fact, any time an employee or other service provider, including directors, has a legally binding right to compensation that is or could be paid in a future year, Section 409A may apply. The following are some examples of arrangements that may be subject to Section 409A.

BONUSES
Unless structured so as to be Section 409A-exempt, annual bonuses will be subject to Section 409A. The most common exemptions are that the employee remain employed in order to receive the bonus or that payment of the bonuses will be made in all cases no later than March 15 of the following year. Bonuses can also be exempt if they are completely discretionary. If your bonus program does not adhere to one or more of these exceptions, you may inadvertently have created a deferred compensation arrangement subject to Section 409A.

SEVERANCE
If an employment agreement or offer letter contains severance provisions, it is by definition an amount promised to be paid in a later year or years. There are Section 409A exceptions for certain types of severance if specific requirements are met, including a limit on the amount and the requirement that the severance be payable only upon “involuntary” separation. Severance arrangements, whether contained in an employment agreement or a contemporaneous separation agreement, must be carefully structured so as to avoid creating Section 409A issues.

RELEASES
Do you require a release from employees to receive non-exempt severance or other termination pay? If so, does the release provide that payments will be made/start once the release is signed and returned, and not revoked? The IRS says this potentially runs afoul of Section 409A unless the arrangement is properly structured because the employee could potentially control the tax year(s) in which they are paid by turning in or holding onto the release.

STOCK OPTIONS
“Qualified” stock options – incentive stock options (ISOs) and employee stock purchase plan (ESPP) options — are automatically exempt from Section 409A. Other types of options – “nonqualified options” – will only be exempt if granted with an exercise price at least equal to fair market value. Below-market or discounted stock options are generally subject to Section 409A and option terms can result in the exercise price being considered below market.

If any of the above potentially apply to you, do not panic! Steps can be taken to prevent or limit the consequences of violating Section 409A, including IRS-approved correction procedures.