The tax bill proposed by the Committee on Ways and Means of the U.S. House of Representatives would, if enacted into law in its current form, replace Section 409A of the Internal Revenue Code and tax non-qualified deferred compensation once the service provider’s right to receive the compensation is no longer subject to a substantial risk of forfeiture.
The law would apply to non-qualified deferred compensation attributable to services performed on or after January 1, 2018. In addition, non-qualified deferred compensation attributable to services performed prior to January 1, 2018 would be taxed upon the later of the last taxable year beginning before 2026 and the taxable year in which such amounts are no longer subject to a substantial risk of forfeiture. According to the Joint Committee on Taxation, the provision would raise $16.2 billion of revenue from 2018 through 2027.
If this law passes as is, plan sponsors and employers may have to take steps to alert participants of the impact this legislation may have on them and their funds. Amounts will be considered subject to a substantial risk of forfeiture only if the service provider’s right to the compensation is contingent on the future performance of substantial services, which is far narrower than the Section 409A definition.
The Bill defines non-qualified deferred compensation broadly to mean any plan, agreement or arrangement that provides for a deferral of compensation other than:
- Plans qualified under Code Section 401(a), Section 403(b) plans, Section 403(a) annuities, SEP IRAs, SIMPLEs and governmental plans;
- Any bona fide vacation leave, sick leave, compensatory time, disability pay or death benefit plan; and
- Any other arrangement defined by the IRS.
Most notably, the Bill specifically includes as non-qualified deferred compensation:
- A right to compensation based on the value of or appreciation in the value of a specified number of equity units of the service recipient whether paid in cash or equity; and
- Stock appreciation rights and stock options.
This broad language would appear to include stock options, stock appreciation rights, phantom equity and other equity-based compensation arrangements. However, the inclusion of incentive stock options as deferred compensation is not entirely clear as the Bill makes minor changes to the incentive stock option rules under Code Section 422, rather than repealing them.
On the other hand, transfers of property under Code Section 83 — other than stock options — are not deferred compensation. Consequently, grants of restricted stock would not be considered deferred compensation. It appears that restricted stock units that are not settled at vesting would be considered deferred compensation but this also is not entirely clear.
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Non-qualified deferred compensation would exclude amounts that are paid no later than two and a half months after the end of the service recipient’s tax year in which the service provider’s right to the payment is no longer subject to a substantial risk of forfeiture.
However, because the definition of substantial risk of forfeiture is limited to service-based vesting and does not include vesting based on the performance of the service recipient or the attainment of liquidity events such as an initial public offering, many arrangements that historically would not be considered non-qualified deferred compensation under Code Section 409A would be considered non-qualified deferred compensation under the Bill and taxed at vesting.
For example, absent relief provided by the IRS, the Bill would treat as non-qualified deferred compensation severance payments that are payable more than two and a half months following the service recipient’s tax year in which the service provider is terminated.
In addition, Section 457 plans maintained by tax-exempt employers are not excluded from the Bill’s definition of non-qualified deferred compensation and would also be subject to its requirements.
Because it is far too early to know with any degree of precision what any final law might actually include, employers need not abandon stock options and SARs today. However, it is not too early to start thinking about the impact of this proposed legislation.
For example, employers that are in the process of soliciting deferral elections for their non-qualified deferred compensation plans may wish to notify participants of this proposed legislation so they can take the legislation into account in deciding whether to make a deferral election — that they may be unable to defer taxation of any amounts beyond 2025.
