On February 26, 2014, U.S. Congressman Dave Camp released a comprehensive tax reform proposal that includes several provisions intended to limit or restrict executive compensation. Congressman Camp’s proposal includes the elimination of tax deductions for commission payments and qualified performance-based compensation under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”); the narrowing of the “substantial risk of forfeiture” concept as applied to nonqualified deferred compensation under Code Section 409A; the imposition of a penalty excise tax on the payment of “excess” compensation and certain golden parachute payments to service providers of tax-exempt organizations; and the denial of corporate tax deductions for stock transferred pursuant to incentive stock option plans.
New Regulations Regarding Nonqualified Deferred Compensation; Repeal of Code Sections 409A and 457A; Replacement of Code Section 457(b) Rules for Tax-Exempt Organizations
The proposal would repeal Sections 409A and 457A of the Code regarding non-qualified deferred compensation of taxable entities and “nonqualified entities” (e.g., certain foreign corporations and partnerships not subject to comprehensive foreign income tax), respectively, and eliminate the special deferred compensation rules for Code Section 457(b) plans for tax-exempt organizations. In place of these existing deferred compensation rules, Congressman Camp proposes to create a new Code Section 409B to regulate deferred compensation arrangements for all entities, whether taxable, nonqualified or tax-exempt.
Section 409B would require that any compensation deferred under a nonqualified deferred compensation plan be included in gross income when there is no “substantial risk of forfeiture” on that compensation; however, amounts paid within six months of the end of the tax year of the service recipient during which the payment was no longer subject to the substantial risk of forfeiture would not be considered “deferred” under Congressman Camp’s proposal.
Under the proposed Code Section 409B, a “substantial risk of forfeiture” would only exist if a person’s rights to the compensation are conditioned upon the future performance of substantial services by the individual. As a result, Code Section 409B would essentially limit the ability to defer any compensation not tied to future services, for example, compensation tied to the achievement of future performance and/or satisfaction of a restrictive covenant. By contrast, Code Section 409A provides that compensation may be subject to a “substantial risk of forfeiture” if payment is conditioned upon either performing future services or a condition related to the purpose of the compensation (i.e., a performance-based condition), while Code Section 83 governing transfers of property provides a broader concept of “substantial risk of forfeiture” that could, depending on the facts and circumstances, cover a forfeiture restriction tied to not only performance-based conditions, but also from refraining from future services (e.g., a non-competition clause).
Expansion of Limitation on Deductibility of Executive Compensation
The proposal would significantly expand the scope of Code Section 162(m). In general, Code Section 162(m) limits the deductibility of compensation paid in excess of $1 million to a publicly traded company’s chief executive officer and its three other highest compensated officers (other than its chief financial officer) serving as of the end of the prior fiscal year. Under Code Section 162(m), however, commission payments and amounts that meet the requirements for “qualified performance-based compensation” are not subject to these limitations and may be deductible by the paying corporation.
Congressman Camp proposes to:
- Eliminate the existing Code Section 162(m) exceptions for commission payments and qualified performance-based compensation;
- Expand the scope of covered employees under Code Section 162(m) to include any employee of the company that was its chief executive officer or chief financial officer at any time during the taxable year, regardless of whether he or she is employed at the end of the prior fiscal year and regardless of his or her compensation levels, and to require that once an employee is a Code Section 162(m) “covered employee” for a tax year beginning after 2013, the individual will always be a Code Section 162(m) “covered employee”; and
- To clarify that amounts paid to a covered employee’s beneficiary fall within the scope of Section 162(m), even after the death of the covered employee.
“Excess” Tax-Exempt Organization Executive Compensation
Congressman Camp’s proposal would impose a 25% excise tax on compensation paid by tax-exempt organizations to covered employees (other than excess parachute payments) in excess of $1 million and on any “excess parachute payments” (regardless of the amount) paid by tax-exempt organizations to covered employees.
For these purposes, a tax-exempt corporation’s “covered employees” would include its five most-highly compensated employees in any given taxable year, as well as any current or former employee who was a “covered employee” for any tax year beginning after 2013. In addition, “excess parachute payments” for these purposes would generally include payments contingent on an employee’s termination that equal or exceed three times the employee’s “base amount,” as determined in a manner similar to the rules under Code Section 280G(b)(3) relating to “excess golden parachute payments.”
This 25% excise tax is higher than the 20% excise tax that applies to “excess parachute payments” under Code Section 280G. In addition, the excise tax on “excess” compensation is much more punitive than the denial of a tax deduction on “excess” compensation paid to covered employees under Code Section 162(m).
Tax Deductions for Stock Transferred Pursuant to Incentive Stock Options
Finally, the proposal would codify the IRS position that employers cannot deduct stock transferred pursuant to incentive stock option plans or employee stock purchase plans as ordinary and necessary business expenses under Code Section 162(m) or otherwise.
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Although it is unlikely that Congressman Camp’s proposal will become law, it highlights the increasing scrutiny placed on executive compensation in recent years. Indeed, the portion of the proposal regarding Code Section 162(m) closely mirrors a recent bill introduced in the U.S. Senate last August, as discussed in an earlier blog post available here.
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IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this document is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any transaction or matter that is contained in this document.