U.S. Tax Reform – Death to Nonqualified Deferred Compensation
The recently released Republican tax reform proposal (H.R. 1 – Tax Cuts and Jobs Act) has a provision that would effectively be a death knell for many common types of nonqualified deferred compensation plans.
Under the Bill, nonqualified deferred compensation will be subject to income tax when there is “no substantial risk of forfeiture”. In plain English, this means nonqualified deferred compensation will be taxed when, or as, it becomes “vested”, instead of when it is paid. (See Section 3801 of the Bill, which would enact new Internal Revenue Code Section 409B.)
Under this approach:
- An employee will no longer be permitted to electively defer compensation out of salary or bonus.
- Under employer sponsored nonqualified plans, employees will be taxed to the extent they have accruals of benefits that are vested. Thus, for example, taxes may be incurred on account of accruals of benefits under an nonqualified “excess plan” that wraps around a tax-qualified plan.
In addition, the new law would extend to stock options and stock appreciation rights, and also would seem to apply to things like profits interests. Thus:
- If an equity based award has “time based vesting”, employees may be taxed on the present value of an award as it vests.
- If an equity based award has performance based vesting, taxation may occur on the present value of the awards at the time the performance standards are met.
Nevertheless, if an equity based award would have vesting contingent upon the occurrence of a transaction, taxation still be delayed until the transaction date.
This approach to taxation of nonqualified deferred compensation is currently the rule for tax-exempt organizations under Code Section 457(f). Under this kind of rule, there is very little that tax-exempt organizations have been able to do in terms of nonqualified deferred compensation. Essentially, the nonqualified deferred compensation arrangements are drafted to provide for vesting only at the end of an employment agreement or only at retirement, with the only exceptions being permitted for vesting at death, disability or involuntary termination of employment without cause. Should H.R. 1 become law in its present form, a similar approach may become the norm for other type of employers.