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Proposed Tax Cuts and Jobs Act Would Send Executive Compensation Back to the Stone Age

The Tax Cuts and Jobs Act, as initially proposed by the U.S. House of Representatives on November 2, 2017, includes provisions that would dramatically impact many common incentive and deferred compensation programs, including the potential demise of stock options.  If adopted, these provisions would significantly limit U.S. businesses in their flexibility to design competitive compensation programs tied to their specific business needs.  It will push companies towards annual-only performance periods, time-vesting conditions for longer periods, and less use of equity compensation — all contrary to the best interests of growing and innovating our economy.

Summary of §409B

Section 3801 of the Tax Cuts and Jobs Act would create a new section, Internal Revenue Code (IRC) §409B, that, among other things: 

  1. Drastically reduces the ability to defer compensation for all U.S.-taxpayer employees and other service providers (directors and consultants) at all levels of for-profit businesses — public companies, private companies, start-ups, etc.

    o   Applies to all levels of service providers — not just highly paid executives.

  2. Requires income to be recognized when compensation is no longer subject to a “substantial risk of forfeiture” (SRF), with a much narrower definition of SRF than under current tax law:

    o   SRF can be based only on requirement to provide substantial future services (in other words, time-vesting). 
    o   Specially excludes SRF based on performance conditions (as currently permitted under IRC §83 and §409A).  
    o   Specifically excludes SRF based on compliance with a noncompete (as currently permitted under IRC §83). 

  3. Broadly defines “nonqualified deferred compensation” (NQDC) to include any amounts that could be paid later than March 15 of the year after the year the SRF lapses, with explicit exceptions for qualified retirement plans, certain welfare benefit plans (for example, vacation and disability), and transfers of property (excluding options) subject to IRC §83, and specifically includes as NQDC:
    o   Stock options and stock appreciation rights; and
    o   Restricted stock units (RSUs) and other forms of phantom equity.

  4. Applies to all compensation earned for services beginning January 1, 2018 — so the impact would be immediate — and requires an end to all pre-2018 deferrals by the end of 2025.

Major Impacts to Common Compensation Arrangements

As proposed, §409B would effectively end — or require dramatic redesign of — many common compensation arrangements used today: 


§409B Potential Impact

Stock Options and RSUs

§409B would effectively eliminate the use of stock options and stock appreciation rights and significantly limit design flexibility for phantom equity (including RSUs) for all U.S. businesses.  Stock options, in particular, are a foundational form of incentive compensation for businesses at all levels, in part because they are simple in concept, well understood, effectively align interests of employees with shareholders, and provide rewards only for actual value creation for shareholders.  Forcing employees into §83 restricted stock awards as the only form of permitted equity compensation will be impractical for many start-ups/private companies/small businesses because it requires liquidity to pay taxes before the shares are liquid and when the companies need to preserve cash for growth.  This will also be a global competitive disadvantage for U.S. business, as most industrialized economies in Asia, Europe, and elsewhere recognize stock options as an appropriate form of incentive compensation.  A summary of the Tax Cuts and Jobs Act prepared by the Staff of the Joint Committee on Taxation states that “statutory options” (tax-qualified ISOs and options under tax-qualified ESPPs) are not intended to be eliminated by §409B, though this exception does not appear in the text of the bill.

Performance-Based Compensation

§409B would severely restrict both public and private companies in designing and implementing long-term, performance-based compensation plans (cash- and equity-based).  It is commonplace in such plans to provide an opportunity for an employee to continue to vest in an award, subject to the ultimate performance outcomes, in case of certain terminations of employment such as death, disability, termination by the company without cause, or in some cases, retirement.  §409B would apparently trigger tax at termination of employment (although it is unclear as to how the amount would be determined when performance has not been completed).  This will severely hamstring design flexibility or eliminate the programs altogether.  Such programs are broadly used both in private companies (typically as long-term cash awards) and public companies, where institutional shareholders strongly urge companies to adopt these types of programs as in the best long-term interests of shareholders.  These programs are used with all levels of key employees, sales people, etc. — not just executives.

401(k) Restoration Plans

§409B would eliminate the ability to use 401(k) restoration plans, leaving many U.S. employees with inadequate retirement savings.  IRC limits on 401(k) plans can adversely impact retirement savings for employees beginning at $120,000 of earnings (the “highly compensated employee” threshold).  Smaller companies with blue-collar workforces often establish NQDC 401(k) “restoration” plans to permit retirement savings by these impacted employees that they cannot make in their tax-qualified 401(k) plan.  §409B would likewise eliminate the use of other forms of elective NQDC deferral plans, such as plans for nonemployee directors to defer their cash and stock director fees or various forms of stock deferral plans for employees.

Other Retirement Plans

§409B would likely eliminate other forms of supplemental retirement plans, or force the use of lengthy, time-vesting schedules that hurt employees and diminish retentive value (because employees tend to deeply discount the compensation value of amounts vesting longer than five years).  Many community banks and privately held businesses use supplemental retirement plans in lieu of equity compensation as a retention and incentive tool for top managers.  These plans often provide make-up retirement benefits not available under qualified defined benefit or defined contribution retirement plans because of limits such as the $120,000 highly compensated employee definition or the $270,000 plan eligible compensation limit.  For community banks, these programs support bank regulatory principles by aligning employees with the interests of creditors and depositors in the bank.

Deferral Programs Supporting Risk-Management Practices

§409B is directly at odds with the regulatory direction of U.S. and European banking regulators more generally, which have guidelines and rules that push financial institutions to have annual incentive compensation awards deferred for three-to-five-year periods in order to ensure that initial annual performance is sustainable and that risk management policies are observed by risk-takers.  The concept of risk-takers goes well beyond executives and top-paid management and can include broad groups of employees in similar incentive plans.  These principles have also been more broadly adopted outside of the financial services industry in response to institutional shareholder demands and to ensure that compensation programs properly support risk-management best practices.  §409B as proposed would likely require a major redesign of these deferral programs and would likely significantly water down the effectiveness of the programs by forcing tax payments on amounts that would otherwise be subject to forfeiture/claw back for conduct contrary to risk-taking policies or in the event of subsequent financial restatements.

Salary Continuation (Severance)

§409B would apply to routine salary continuation/severance arrangements paying severance over periods as little as three months, forcing companies into lump sum severance payments.  This would apply to employees at all levels, not just executives.  Salary continuation serves several very reasonable business purposes, including providing companies with a tool to enforce post-employment covenants and to more easily administer post-employment health benefit arrangements by providing a ready source for deducting the employee portion of group health premiums.  A summary of the Tax Cuts and Jobs Act prepared by the staff of the Joint Committee on Taxation indicates that §409B is, in fact, intended to apply to severance, meaning there would be less likelihood of a regulatory exception.

Other Unintended Consequences

The broad definition of NQDC in §409B will almost inevitably diminish a wide range of compensation arrangements covering all employees, including various types of broad-based employee fringe benefit programs (for example, service reward programs).  We learned this same lesson in the roll out of IRC §409A, which has a similar, though less broad, definition of NQDC.  Forcing early taxation on these types of programs will dampen innovative compensation design and create additional competitive disadvantages for U.S. businesses as compared to global competitors.

§409B appears intended to be a revenue-raising provision that is unrelated to any driving policy concerns or issues.  The Tax Cuts and Jobs Act includes a number of other revenue-raising provisions that would impact compensation and benefits programs, including the elimination of the performance-based compensation exception and other changes to the $1 million deduction limit under IRC §162(m).  None are as potentially significant or challenging to for-profit businesses as §409B. 

Copyright 2023 K & L GatesNational Law Review, Volume VII, Number 313

About this Author

James Earle, KL Gates Law Firm, Charlotte, Corporate and Employment Law Attorney

Jim Earle focuses his practice on counseling publicly traded companies and other complex employers on matters related to executive compensation. Mr. Earle’s clients operate globally in a wide range of industries, including financial services, manufacturing, food, telecommunications, utilities and other service-based companies.

Mr. Earle’s executive compensation practice focuses on counseling clients regarding all aspects of the employment, compensation, benefits and severance of directors, executive officers and other senior managers. He has...

Matthew Jones, KL Gates Law Firm, Chicago, Labor and Employment Law Attorney

Mr. Jones takes a practical approach to helping clients solve problems. As a partner in K&L Gates’ Chicago office, Mr. Jones focuses his practice on counseling publicly traded companies and other sophisticated employers on matters related to executive compensation. He invests the time to understand his clients’ specific businesses and needs in order to help them achieve their goals efficiently. Mr. Jones has significant experience counseling clients regarding all forms of executive compensation, including the design, administration, and public disclosure of stock...

Richard Nettles, KL Gates Law Firm, Washington DC, Labor and Employment Attorney

Richard Nettles is an associate in the firm’s Washington, D.C. office. Mr. Nettles focuses his practice on employee benefits, executive compensation, and related disclosure and corporate governance matters.

His executive compensation practice includes advising public and private company clients in the context of major corporate transactions, such as mergers, acquisitions and spin-offs, particularly with respect to equity compensation and issues arising under Internal Revenue Code Sections 162(m), 280G and 409A. Mr. Nettles advises clients on a...