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Recent Tax Legislation Includes Significant Changes to the Taxation of "Qualified Equity Grants", While Possibly Signaling Other Deferred Compensation Reforms to Come

By Laura L. Stapleton on December 22, 2017

The House of Representatives and the Senate have been busy these past few weeks in their attempt to drag some semblance of H.R. 1, also known as the Tax Cuts and Jobs Act (“TCJA”), over the proverbial goal line, and it appears that they have done so this week. Barring any additional procedural snafus, the TCJA should land on President Trump’s desk for his signature before the break for the holidays. While there hasn’t been much publicity surrounding the possible changes to non-qualified deferred compensation plans, employers of privately held companies should pay particular attention to the end result of the TCJA as passed in its final form.

Under current law, §83(a) of the Internal Revenue Code of 1986, as amended (the “Code”), provides that an employee must recognize compensation income when certain equity awards have vested and the fair market value of such award is determinable. Recently enacted Code §83(i) would allow a “qualified employee” (an employee that is not the CEO, CFO or one of the four highest compensated officers of the employer within the prior 10 year period and who does not own more than one percent of the outstanding equity of the employer) to make an election (within 30 days of vesting) to defer tax for up to five years on any “qualified equity grant”. To fall under the definition of a “qualified equity grant”, the stock must be awarded through the exercise of a stock option or a restricted stock unit (or “RSU”, the exercise of which is called the “settlement”) and in connection with the employee’s performance of services. Code §83(i) is only available to employees of certain privately held corporations, or “eligible corporations”, who have granted either RSUs or stock options to at least 80 percent of its employees pursuant to a written plan and whose stock is not readily tradable on an established securities market. It is important to note that the Conference Committee specifically noted that employers may not issue a combination of RSUs and stock options in a single tax year in an attempt to meet the 80% test.

The Conference Committee adopted the House’s second amendment to the initial version of the TCJA, which clarified that equity awards in the form of RSUs are not subject to Code §83 (with the exception of the then proposed Code §83(i) discussed herein above); therefore, a Code §83(b) election is unavailable to holders of RSUs. Generally, an employee will make an election under Code §83(b) in order to accelerate the recognition of income in the tax year in which an equity award is granted, rather than deferring recognition until the restrictions have lapsed and the award vests. The benefits of accelerating income recognition under Code §83(b) are often two-fold: (i) the fair market value of the equity award is typically lower when it is granted; and (ii) any appreciation in the equity’s fair market value afterwards is taxed at the rate imposed upon capital gains.

As a comparison, a RSU is similar in some respects to a “restricted stock award” (“RSA”) in that both RSUs and RSAs are valued in relation to the employer’s stock and are often tied to performance goals of either the employee (such as remaining an employee for a certain number of years) or the employer (such as selling a certain number of widgets). RSUs differ from RSAs in that the employee customarily has the ability to receive either the employer’s stock or the cash value in lieu of such stock, but the full value of the RSUs are often not awarded until the performance goal is met (and the RSU thereby vests) and are subject to forfeiture if such goal is not met. Further, an employee holding RSUs has no voting rights since the employee does not own the stock. Whereas, RSAs typically come with immediate voting rights since the employee actually owns the employer’s stock when the RSA is granted, but the stock is subject to restrictions that must lapse for the stock to vest. Occasionally, a nonqualified deferred compensation plan will require the holders of RSAs to pay a discounted price for the RSA but the employee may choose the timing of the income recognition, which would be the difference between the fair market value of the RSA less the discounted purchase price paid by the employee, if any, with the fair market valuation determined on either (i) the date the RSA vests, which would be comparable to the income tax treatment of RSUs upon vesting; or (ii) the date the RSA is granted if the employee makes a Code §83(b) election.

In connection with the passage of Code §83(i), the House contemplated additional modifications to the taxation of nonqualified deferred compensation plans through the proposed repeal of Code §409A and the proposed enactment of Code §409B. Currently, Code §409A provides a very detailed set of rules pursuant to which nonqualified deferred compensation plans must abide. Failure to comply with Code §409A can result in a tax disaster for an employee through immediate recognition of previously deferred compensation, plus interest (at the rate of one percent plus the substantial underpayment rate, which has been four percent during this last quarter of 2017) and imposition of a penalty equivalent to 20 percent of such deferred compensation. The House’s initial version of the TCJA would have repealed Code §409A and replaced it with proposed Code §409B (with a limited exception under the then proposed Code §83(i) discussed above), pursuant to which an employee must recognize compensation income in the tax year in which an equity award vests and have the appropriate amount of tax withheld, eliminating the ability to defer income recognition until exercise, regardless of whether the award is paid or the employer funds the plan, thus creating a liquidity issue for the employee. Employers would be required to satisfy their withholding requirements upon vesting; however, there is no corresponding compensation deduction until the award is actually paid.

The House’s second amendment, which passed on November 10th, deleted its initially proposed Code §409B, which would leave Code §409A intact; however, proposed Code §83(i) remained. The Senate essentially adopted the House’s amended version with the agreement in the Conference Committee generally adopting the same, with a few details beyond the scope of this post. Of particular importance for employers to note is that Code §83(i) specifically provides that in order for a RSU to fall within the definition of a “qualified equity grant”, the employee may not have the right to receive cash in lieu of the employer’s stock upon vesting and settlement of the RSU. Even without the employee’s ability to receive cash in lieu of the stock upon settlement of RSUs, the enactment of Code §83(i) is very favorable to employee-shareholders and RSUs remain as a valuable tool for employers to compensate and incentivize their employees.

Additionally, even though proposed Code §409B was not enacted and §409A was not repealed, the House’s proposal may signal potential future changes to the taxation of deferred compensation plans and employers may want to review their existing or proposed equity compensation plans as it is possible that such changes may be proposed in the near future with other revenue-raising legislation.

If you have any questions regarding the potential impact of the TCJA on your or your clients’ nonqualified deferred compensation arrangements, please contact Laura Stapleton directly at 214-749-2428.