Effective January 1, 2018, the Tax Cuts and Jobs Act (the Act), otherwise known as the Tax Reform bill was signed into law by President Trump on December 22, 2017. Among other changes and enhancements, the Act changes executive compensation taxation rules. This Practice Advisor provides an overview of the major effects of the changes for publicly-traded companies, tax-exempt organizations and closely-held companies.
Executive Compensation for Publicly-Traded Companies
There are several provisions of the Act that effect publicly-traded companies. Among the technical details, there are three major components we believe are most important:
- While this affects more than just publicly-traded companies, the corporate tax rate has been reduced from 35% to 21%.
- Compensation above $1,000,000 to “covered executives” at publicly-traded companies will no longer be deductible regardless of its performance basis and that a chief financial officer is expressly considered a covered employee.
- The Act expands the definition of a “publicly-held corporation” to include corporations that are required to file reports under Section 15(d) of the Securities Exchange Act of 1934.
In our view, the potentially negative impact in financial reporting by companies may be offset somewhat by the pending reduction in the corporate income tax rate to 21% from 35%.
We expect companies to review their plans and take action to effectively comply with the Act and potentially redesign plans completely going forward. We do not anticipate any direct market adjustments resulting from this change in tax treatment, but that will be determined over the next several months.
As more of an intellectual curiosity, we will be interested to see if there is a tendency for fewer companies to issue IPOs and for an increase in the number of companies that are taken private.
Executive Compensation for Tax-Exempt Organizations
In a nod to parity with the deductibility of executive compensation for publicly-traded, the Act will change the tax treatment of executive compensation over $1,000,000 per year at tax-exempt organizations. More specifically, for organizations tax-exempt under either section 501(a) or section 115(1), the Act will impose a 21% excise tax on any compensation in excess of $1 million and certain excess “parachute” payments paid to any of an organization’s “covered” (five highest-paid) employees.
Once an employee qualifies as a “covered employee” for any year, the excise tax applies to compensation in excess of $1 million and certain parachute payments paid to the person by the organization in any future year. The tax will be paid by the organization and will apply to all compensation other than:
- Payments to tax-qualified retirement plans such as 401(k) and 403(b) plans
- Credits made to non-qualified plans that retain a substantial risk of forfeiture as in a 457(f) plan, although these are included as compensation when the “risk” ends.
- Other amounts that are excludible from gross income.
For the past several years, Congress, through the House Ways and Means Committee (the Committee), and the IRS have struggled with tax exemption and the conglomeration and size of organizations in the tax exempt sector. Issues have ranged from the Committee attempting to redefine what constitutes a 501(c)(3) tax-exempt organization, such as large hospital systems, to a belief that all nonprofit executives make too much money. The Committee specifically stated that they thought executive compensation diverts resources from exempt purposes.
It is too early to tell what, if any, impact the change will have on executive compensation levels. It may be that tax-exempt organizations just absorb this extra cost. We expect that organizations will obviously make plan design changes that enable better tax avoidance, such as discontinuing 457(f) plans where future payments may exceed $1 million. On the fringe of possibilities, the reduction in the corporate tax rate from 35% to 21% combined with the excise tax may entice extremely large tax-exempt organizations to forfeit their tax exempt status and become private companies.
Summary for Closely-Held Companies
The Act also makes certain equity awards granted by privately-held companies eligible for tax deferral. Non-executive and non-owner employees of privately-held companies who exercise a stock option or vest in a restricted stock unit award may be able to elect to defer taxation for up to five years.
The stock option or RSU award for qualified stock must be granted as part of a broad-based plan (80% or more of employees participate) by a company that does not have readily-traded stock.
About RSC Advisory Group
RSC Advisory Group, LLC is a management advisory and consulting firm specializing in pay and performance. The RSC team has worked with clients in a multitude of market sectors and geographic areas. Their current client base includes household-name corporations, internationally known tax-exempt organizations, healthcare systems, as well as smaller, forward-thinking organizations. Their work has spanned start ups, high-performing organizations and those going through re-invention – all who need advice and guidance specific to their situation.
RSC Advisory Group, LLC