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Article | Executive Pay Memo North America

How might Biden’s tax proposal affect  executive compensation design?

Governance Advisory Services |Executive Compensation
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By Steve Seelig , Stephen Douglas and William (Bill) Kalten | May 11, 2021

Deferred compensation may prove more popular as high earners navigate rate increases.

President Biden is prepared to ask Congress to nearly double the long-term capital gains tax rate for “households making over $1 million,” from the current 20% top rate to 39.6%, the same as proposed for the top ordinary income tax rate. This proposal is part of the American Families Plan announced last month in a fact sheet released by the White House. The capital gains rate will remain the same for those earning under $1 million. When calculated with the 3.8% surtax on net investment income, which applies to investors with modified adjusted gross income (MAGI) above $200,000 ($250,00 married and filing jointly), this will mean a top long-term capital gains rate of 43.4%.

The American Families Plan proposal would also eliminate the current rule that permits a step-up in basis of unrealized capital gains at death, which has meant that appreciation for inherited property is never subject to capital gains tax. Recent statements from the White House indicate those gains would be taxed immediately at death, subject to a $1 million exemption for each beneficiary ($2.5 million per couple when combined with existing real estate exemptions). We expect more clarity on how this rule works as legislative language is proposed.

The American Families Plan proposal is separate from Biden’s proposal to fund his infrastructure plan by increasing the top corporate tax rate from 21% to 28%, a level that would still be lower than the top corporate rate of 35% in place before it was lowered in 2017. This increase would be paired with a doubling of the global minimum corporate tax to 21%, which would also make it harder for companies to avoid tax by shifting income to lower-tax countries.

Thus far, we haven’t heard much yet of the Biden campaign’s promise to apply Social Security payroll taxes to earnings above $400,000. If enacted, this change would mean the 6.2% tax would continue to be applied to wages up to the taxable wage base (currently $142,800) and then would recommence for wages above $400,000. The Medicare tax of 1.45% will continue to apply to all wages, along with the additional Medicare tax of 0.9% on wages above $250,000.

Navigating divergent rules will be tricky

As will soon become apparent, when tax rules collide with one another, avenues that appear to lead to a good result can be strewn with obstacles. Let’s set forth a few principles to keep in mind to better illustrate how competing short-term goals might not line up with long-term planning:

  1. When ordinary income tax rates are set to increase, conventional wisdom would suggest paying out compensation early to avoid that increase.
  2. With higher ordinary income tax rates, it often makes sense to defer payment compensation payments (and taxation) until a future year so that earnings can build up tax-free and payments can be in a year when a recipient has a lower marginal tax rate.
  3. A pending increase in capital gains tax rates typically prompts property and stock sales in the year before the change is implemented, particularly when unrealized appreciation in those holdings would be taxed immediately at death rather than having an automatic step-up in basis that would otherwise discourage the need for those sales.
  4. However, if a current year capital gains tax raises adjusted gross income for that year so that the individual is pushed above Biden’s proposed $1 million threshold and into the higher capital gains rate, those sales may not take place. This would depend on whether the $1 million trigger is based on prior year income.
  5. Avoiding the higher capital gains rate would encourage individuals who are modestly above the $1 million threshold to reduce their compensation in the year income is measured for the $1 million threshold by deferring more compensation.
  6. Larger deferred compensation balances could encourage an annuity payment regime if that would help reduce income below $1 million for payments made postretirement.
  7. However, this might not work where non-qualified deferred compensation (NQDC) payments annually would bring income over $1 million for each annuity year. These high-benefit individuals might take a lump sum to be subject to the higher capital gains rates only for a single year.
  8. Perhaps most important, the 3.8% net investment income surtax does not apply to deferred compensation held by the company. This means that an individual with more than $1 million in income would pay a 3.8% higher tax rate on appreciation, dividends and other earnings on capital assets than he or she would on those assets that appreciate within a company-held NQDC plan, which would be taxed only at the 39.6% ordinary income rate.

When navigating these divergent rules, companies remain constrained by an existing tax code regime that frowns upon flexibility in timing compensation payments. Internal Revenue Code (IRC) section 162(m) continues to limit corporate tax deductions to the first $1 million of compensation paid to any "covered employee" during any current or future year, including those made postretirement. The expansion of the definition of "covered employees" in the 2017 Tax Cuts and Jobs Act also repealed the exclusions for qualified performance-based compensation and commissions. Although the 2017 law permits companies to ignore the $1 million pay cap for compensation payments made under a binding written contract in place as of November 2, 2017, such “grandfathered” status is lost if the agreement is materially modified. In addition, IRC section 409A requires that form and timing of payment elections for existing deferrals of compensation, such as excess 401(k) plans and deferred restricted stock units, must still be respected (with certain exceptions), further limiting planning flexibility.

Planning ideas for 2021 and beyond

Let’s consider the above principles using a working assumption that ordinary income tax rates, capital gains rates and corporate tax rates would increase starting in 2022, rather than becoming effective some time during 2021, and that the company has a calendar-year fiscal year.

Pay annual bonuses before 2021 year-end: For 2021, companies may consider paying their annual bonuses before the end of the year based on best estimates of financial performance known at that time, rather than within two and a half months of year-end. Many companies already make these estimates for their bonus pool to lock in their ability to take a deduction for most, if not all, of their bonus pool during that calendar year, so the mechanism already exists to accelerate these payments. For executives, this will cause accelerated payments to be taxed at a 37% income tax rate instead of the increased 39.6% rate.

Care will need to be taken to not overpay executives before year-end based on actual year-end results evidenced in the audited financials; therefore, leaving wiggle room so that, for example, only 90% of the estimate bonus is paid early would make sense here. Proxy disclosure would not change, in that the Summary Compensation Table reports bonuses earned during a fiscal year, without regard to the actual payment date; thus, even if, in our example, 90% is paid before year-end with a true-up payment in the following February, the disclosure would be the same as if all was paid in February. Companies will need to determine if any footnote or other disclosures in the Compensation Discussion and Analysis are warranted.

FICA taxes also may be reduced with the early bonus payment, particularly if the proposal to subject wages above $400,000 to social security tax is also enacted for 2022.

While early bonus payments may yield tax savings for the individual, this must be balanced against the smaller tax benefit the company could receive if its corporate tax rate was to increase. Paying early would yield a less valuable deduction, based on a maximum 21% rate for 2021, compared with a more valuable deduction at a maximum of 28% if the corporate rate increases go through.

Terminate and liquidate NQDC during 2021: There may be a temptation to consider accelerating the payment date of existing NQDC to sometime during 2021 to avoid the ordinary income tax increase. A lot of boxes need to be checked before this can take place, the biggest being that section 409A generally permits early distributions only if the company terminates and liquidates all plans of the same type (e.g., all defined benefit-type) and does not start any new plans of that type for two years. Based on the above principles that deferred compensation will be valued after the tax law changes, we don’t foresee companies wanting out of the deferred compensation business for two years. The section 162(m) issues would also arise both for grandfathered plans and for the potential lost deduction for immediate payments. On the other hand, losing a deduction in a lower corporate tax environment is not as onerous as in a high-tax environment. Regardless, the potential corporate tax implications must be modeled before a termination/liquidation is undertaken.

Accelerate vesting and payment of equity during 2021: This may be an easier lift from a tax standpoint in that section 409A is generally indifferent to early vesting, but there is great peril in doing this for senior executives in the eyes of shareholders and proxy advisors. That said, if the notion here is that this is a one-time deal and that the next grant cycle’s value will be reduced by the same value that was accelerated, perhaps that would assuage some skeptics. Before even thinking about this alternative, talk to major shareholders to gauge their reactions.

Expand voluntary deferral opportunities for 2022 and beyond: Deferring compensation until a future payments date has always been a preferred approach for higher paid employees. The combinations of compounded interest on untaxed savings, plus the potential to delay those payments until an individual’s ordinary income tax rate drops to the next level down, always has been appealing.

The American Families Plan proposals, if enacted, could make NQDC programs even more popular:

  1. Deferrals can help avoid the net investment income tax on other assets: For those near the $200,000/$250,000 MAGI threshold, employee deferrals would be attractive to help stay below those levels to avoid imposition of the 3.8% net investment income tax on employee-owned assets.
  2. Deferrals themselves avoid the net investment income tax: Deferring compensation in an employer NQDC means that earnings and dividends will avoid the 3.8% net investment income tax. Even though employees pay ordinary income tax at distribution, the net impact of compounded earnings on deferrals and avoiding the 3.8% tax makes this a more tax-efficient strategy. Plus, the longer the period of the deferral, the longer the 3.8% tax can be avoided, so perhaps annuity-type payment schedules crafted to be used for future living expenses make sense. If instead those deferrals would be taken into income in the current year and were reinvested in other assets, not only would the taxed distribution leave less to invest, the 3.8% tax would apply to earning on those investments until they are sold.
  3. Deferrals can help avoid the increased capital gains rate: Although we don’t know which tax year will be used to measure if a “household makes over $1 million” to trigger the increased capital gains rate, it is fair to assume deferring compensation can help employees stay below that level. This will require employees to forecast when they will need to sell capital assets (including company stock), which could mean deferral rates could change from year to year. In addition to monitoring compensation income, employees also would need to forecast whether capital gains recognized for a given year would themselves be additive to the $1 million threshold calculation.
  4. Distribution timing can help avoid the increased capital gains rate in future years: While deferrals can help avoid the $1 million trigger during an employee’s working years, distribution timing will help determine if the threshold is exceeded in future years, including postretirement. Optimally, distribution timing would be crafted so that household income would always avoid exceeding that $1 million level, but this may not be possible for wealthier employees.
  5. Distribution timing also can help avoid the 162(m) $1 million compensation limit on company deductions: Delaying distributions can line up nicely with the company’s desire to avoid the section 162(m) $1 million pay cap for future payments to “covered employees.” Recall, any compensation payments in any year (even postretirement and post-death) to a “covered employee” count toward the $1 million deduction limit. Although measuring $1 million in compensation under 162(m) (total compensation paid) differs from the $1 million per household capital gains rate threshold, the notion of keeping each of those calculations under $1 million for any distribution year can align to help both parties.

    Nonetheless, companies will have executives whose NQDC balances or benefits would be over $1 million even if distributed in the form of installment payments. These executives could find it preferable to take their NQDC distribution in a lump sum. Assuming an executive’s household income from other sources was below $1 million in future years, this could mean he or she would have a higher capital gains tax rate for only a single year; however, this latter approach does not help the company, in that section 162(m) would cause it to lose a deduction for a large portion of that executive’s NQDC balance.

    Worth repeating is that the above ideas can work only if companies are mindful of the restrictions in section 409A and the potential loss of grandfathered treatment under section 162(m), if they change payment terms and timing for NQDC.

    A quick example will illustrate: In this greatly simplified example, a “covered employee” elected to have a $10 million NQDC balance distributed in a lump sum in 2026 because her household income will be far below $1 million in future years. Assuming this is all the compensation that the executive received from the company that year, she would be subject to the higher capital gains tax rate for only a single year. The company would not fare as well: $9 million of this distribution would be nondeductible under section 162(m).

    If instead, the executive took a 15-year certain installment annuity distribution, the distribution would be below the $1 million household income threshold level and would be fully deductible to the company. In this hermetically sealed hypothetical, everybody wins.

    Note: This example did not explore the complexities of navigating section 409A, which greatly reduce the flexibility to accomplish these goals but are not insurmountable depending on the age and retirement timeline of the executive.

Defer payment of equity grants and/or offer more stock options: The tax-planning ideas here are the same as those discussed in the prior section. Many companies already offer the ability to defer payment of restricted stock units or performance shares until a future year, but often they limit the percentage of compensation earned for which deferral is permissible and/or they limit the timing of when the deferral must be paid. As noted, the new rules taken together suggest it may be helpful to add or enhance these deferral programs.

Stock options and stock appreciation rights create more flexibility for executives to time their income tax inclusion, but most programs make grants with only a 10-year term and/or require exercise soon after separation. This means the deferral opportunities discussed above may not be available under current plan designs. Whether companies would consider longer terms or permit them to run post-separation may be worth considering.

Start thinking about these issues now

The above discussion outlines just how complex these rules can be in their interaction, which illustrates that higher-paid employees will depend on their employers to help them with tax planning flexibility within their compensation programs. Now is the time to begin thinking about steps that may be required if these tax law changes make their way into law.

Authors

Senior Director, Executive Compensation (Arlington)

Senior Director, Retirement and Executive Compensation

Senior Director, Retirement and Executive Compensation

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