Co-authored by Ariel Gaknoki
The House Ways and Means Committee on November 2, 2017, released the proposed Tax Cuts and Jobs Act, which may have significant impact on the taxation of equity and performance-based compensation for both private and public companies. The 400-plus-page draft bill was revised on November 3, 2017, and remains subject to further revision by the House, Senate and members of the White House Administration, including the Treasury Department in the coming days. If enacted in its current form, the bill would become effective January 1, 2018.
Changes to Deferred Compensation Rules Could Accelerate Taxation
The proposed bill effectively repeals Section 409A of the Internal Revenue Code (the Code), which currently sets forth a complex set of procedures allowing employees and other service providers to defer compensation earned in one year to future years in order to delay taxation. With the addition of a new section 409B, the proposed bill nearly eliminates the ability to defer compensation and instead imposes taxation (including income inclusion, wage withholding and W-2 reporting obligations) at the time any payment or award ceases to be subject to "future performance of substantial services." The implementation of 409B as written would require companies to fully re-examine existing deferred compensation arrangements, including cash incentive plans and severance agreements. In particular, however, 409B would significantly alter the way companies utilize equity and performance-based compensation.
General Taxation of Equity Awards on Vesting. 409B would result in taxation of non-qualified stock options and other equity awards upon vesting. This would create substantial liquidity concerns for employees and could put pressure on employers to facilitate net exercise and net settlement scenarios, or to implement design changes to their equity compensation practices. Notably, 409B does not appear to impact the taxation of incentive stock options (ISOs), which in conjunction with the repeal of the alternative minimum tax, would make ISOs more valuable (see below for more details). The bill does not clarify how vested equity awards will be valued for the purposes of taxation. However, because ISOs must be granted at fair market value, we presume "409A valuations" would remain applicable. Incentive Stock Options May Become More Attractive with Repeal of AMT, But Have Significant Limitations. The proposed bill leaves Section 422 of the Code,...