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Potential impact of American Families Plan on executive compensation

Executive Compensation|Total Rewards
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By Stephen Douglas , William “Bill” Kalten and Steve Seelig | May 31, 2021

The plan would increase the long-term capital gains top tax rate for households making over $1 million to 39.6%, among other changes.

On April 28, the Biden administration released a fact sheet with more details on its American Families Plan, including important implications for executive compensation. The plan proposes to increase the long-term capital gains tax rate for “households making over $1 million” from the current 20% top rate to 39.6%, the same rate proposed for the top ordinary income tax rate. The capital gains rate would 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 would 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 administration 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).

The American Families Plan proposal is separate from President Biden’s proposal to fund his infrastructure plan by increasing the top corporate tax rate from 21% to 28%. This increase would be paired with a doubling of the global minimum corporate tax to 21%.

In addition, if the Biden campaign promise to apply Social Security payroll taxes to earnings above $400,000 is enacted, this 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% would continue to apply to all wages, along with the additional Medicare tax of 0.9% on wages above $250,000.

Divergent tax rules

If such divergent tax rules are enacted, the following principles illustrate how short-term goals might compete with long-term planning:

  • When ordinary income tax rates are set to increase, conventional wisdom would suggest paying out compensation early to avoid that increase.
  • With higher ordinary income tax rates, it often makes sense to defer 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.
  • 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.
  • Those sales may not take place for some taxpayers; however, if those sales raise income for the year of sale, that in turn could push the individual above Biden’s proposed $1 million threshold and into the higher capital gains rate for the following year. This would depend on whether the $1 million trigger is based on prior-year income.
  • 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.
  • Larger deferred compensation balances could encourage an annuity payment regime if that would help reduce income below $1 million for payments made postretirement; 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.
  • 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.

The existing tax code rules do not allow for flexibility in timing compensation payments. Internal Revenue Code (IRC) section 409A requires specific form and timing of payment elections for existing deferrals of compensation, such as excess 401(k) plans and deferred restricted stock units. It also limits changes in distribution form and timing unless done several years in advance.

The 2017 Tax Cuts and Jobs Act (TCJA) made the IRC section 162(m) limit on corporate tax deductions to the first $1 million of compensation paid to any "covered employee" much more difficult to plan around. The TCJA amendment means that anyone who is a “covered employee” for a single corporate tax year will always be a “covered employee,” no matter when compensation is paid, including postretirement and after death. Gone also is the exclusion for qualified performance-based compensation and commissions. A TCJA “grandfather” rule does permit companies to ignore the $1 million pay cap for compensation payments made under a binding written contract in place as of November 2, 2017, but this means those agreements cannot change payment date form and timing without losing that treatment.

Planning for 2021

Companies may want to consider the following actions, assuming that ordinary income tax rates, capital gains rates and corporate tax rates would increase starting in 2022, and that the company has a calendar-year fiscal year:

  1. 01

    Pay annual bonuses before 2021 year-end

    For 2021, companies could pay 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. For executives, this would cause accelerated payments to be taxed at a 37% income tax rate instead of the increased 39.6% rate.

    Processes would need to be in place to avoid overpaying executives before year-end based on actual year-end results evidenced in the audited financials. 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. Companies would need to determine if any footnote or other disclosures in the Compensation Discussion and Analysis are warranted.

    FICA taxes also could 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 could 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.

  2. 02

    Terminate and liquidate NQDC during 2021

    A company could accelerate the payment date of existing NQDC to sometime during 2021 to avoid the ordinary income tax increase; however, 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. Section 162(m) issues would also arise both for grandfathered plans and for the potential lost deduction for immediate payments. The potential corporate tax implications would need to be modeled before a termination/liquidation is undertaken.

  3. 03

    Accelerate vesting and payment of equity during 2021

    Section 409A generally allows early vesting, but a company should consult with shareholders and proxy advisors before moving forward with this alternative.

Expanding NQDC programs for 2022 and beyond

The American Families Plan proposals, if enacted, could make deferrals of future compensation more popular, with the dual benefit 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. (Note: Companies seeking to change NQDC payment terms and timing for existing deferred compensation should remain aware of the restrictions in section 409A and the potential loss of grandfathered treatment under section 162[m]):

  1. 01

    Deferrals could help avoid the net investment income tax on other assets

    Employee deferrals could help those near the $200,000/$250,000 MAGI threshold to stay below those levels to avoid the 3.8% net investment income tax on employee-owned assets.

  2. 02

    Deferrals themselves could avoid the net investment income tax

    Deferring compensation in an employer NQDC could avoid the 3.8% net investment income tax on earnings and dividends.

  3. 03

    Deferrals could help avoid the increased capital gains rate

    Deferring compensation could help employees stay below the “household makes over $1 million” level that would trigger the increased capital gains rate. This would require employees to forecast when they will need to sell capital assets (including company stock), meaning deferral rates could change from year to year. Employees would also need to forecast whether capital gains recognized for a given year would themselves be additive to the $1 million threshold calculation.

  4. 04

    Distribution timing could help avoid the increased capital gains rate in future years

    While deferrals could help avoid the $1 million trigger during an employee’s working years, distribution timing would 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.

  5. 05

    Distribution timing also could help avoid the 162(m) $1 million compensation limit on company deductions

    Delaying distributions could help companies avoid the section 162(m) $1 million pay cap for future payments to “covered employees.” As previously discussed, 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, keeping each of those calculations under $1 million for any distribution year could 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. It might be preferable for these executives to take their NQDC distribution in a lump sum.

  6. 06

    Defer payment of equity grants and/or offer more stock options

    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 above, the new rules taken together suggest it could 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 might not be available under current plan designs.

Going forward

Employers should be prepared to help higher-paid employees with tax planning flexibility within their compensation programs. Employers should also begin considering steps that might be required if these proposed and potential tax law changes become enacted.

Authors

Senior Director, Retirement and Executive Compensation

Senior Director, Retirement and Executive Compensation

Senior Director, Executive Compensation (Arlington)

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