During his campaign for President, Joe Biden proposed a number of tax policy changes that, if enacted as proposed, would result in a significant increase in the federal income and employment taxes paid by certain executives and other high-earning employees. Although enacting such policy changes as proposed would not be without (potentially significant) challenges, uncertainty over future tax rates has prompted executives and employers to evaluate potential changes to their executive compensation programs and to consider accelerating compensation, including retirement income, into 2020. This alert:
- briefly summarizes a number of the Biden tax proposals bearing on executive compensation,
- discusses in more detail alternatives to accelerate income into 2020,
- notes pitfalls that employers should consider before implementing such strategies, and
- outlines several executive compensation design choices to consider going forward.
Biden Tax Proposals Impacting Executive Compensation
- Rollback of top tax bracket and reinstatement of 39.6% as top marginal tax rate. Taxable incomes above $400,000 would be subject to the pre-Tax Cuts and Jobs Act (TCJA) rate of 39.6%. Currently the top marginal rate is 37%, and this applies to income in excess of $622,051 (indexed) for joint filers.
- Increase capital gains tax rate to ordinary income tax rate for high earners. On income over $1 million, capital gains and dividends would be taxed at 39.6% rather than 20%.
- Subject income over $400,000 to Social Security payroll tax. Under current tax law, there is a 12.4% Social Security payroll tax—paid 50/50 by the employer and executive—on taxable compensation earned up to Social Security wage base, which for 2020 is $137,700. The Biden tax plan would also impose the 12.4% Social Security payroll tax on taxable compensation earned above $400,000.
- Increase the corporate income tax rate from 21% to 28%. This would represent a partial rollback of the TCJA’s reduction of the corporate tax rate from 35% to 21%.
- Impose a new corporate alternative minimum tax on corporations. Corporations with book profits of at least $100 million would pay the greater of their regular corporate income tax or the 15% minimum tax (while still allowing for net operating loss and foreign tax credits).
Employer Actions to Accelerate an Employee’s Income
Employers consistently face pressure to ensure good employee morale, particularly during the pandemic. There are several strategies to accelerate income into 2020 and take advantage of current tax rates, such as:
- Paying annual bonuses in December. Many employers pay annual bonuses in the first calendar quarter following year-end. For employers that can readily forecast financial performance and may be able to complete annual performance reviews prior to year-end this would be one clear way to accelerate income into 2020 annual bonuses for executives.
- Accelerating equity awards. Employers accelerating the vesting of restricted stock can accelerate the tax timing of income and employment/FICA taxes into 2020. Similarly, accelerating vesting and settlement of restricted stock units (“RSUs”) into 2020 can achieve this outcome, although care should be taken to avoid impermissible acceleration of RSUs subject to the deferred compensation restrictions of Section 409A of the Internal Revenue Code (“Code”). In addition, Accelerating the vesting of options would afford an executive the ability to exercise such awards in 2020.
- Triggering FICA taxes on deferred compensation earlier. Employers generally have little to no flexibility to accelerate the payment of previously deferred amounts under a nonqualified deferred compensation (NQDC) plan due to the limitations under Section 409A. By contrast, accelerating the vesting (but not the payment timing) of unvested employer contributions in a NQDC plan or unvested deferred RSUs generally does not pose a problem under Code Section 409A. Accelerating the vesting of currently unvested NQDC in 2020 would require such amounts to be subject to FICA taxes, but not federal income taxes, in 2020. Moreover, if an employee has already exceeded the 2020 Social Security wage base at the time of such accelerated vesting, then the NQDC amounts would only be subject to the uncapped Medicare portion of FICA taxes (2.9%, paid 50/50 by the employer and executive), plus the Additional Medicare Tax of 0.9% on income above a certain threshold ($250,000 for joint filers).
Pitfalls and practical tips
- Administrative hurdles and tight timing. Where annual bonuses are determined in whole or in part on achieving financial targets, the board of directors or compensation committee may not be willing to rely on a forecast in order to determine achievement before year-end. Existing performance review processes may not lend themselves to change easily. For bonuses and equity awards granted under a shareholder-approved plan, plan terms need to be consulted to verify such acceleration is permitted. As we are already in November, a company may also face a steep hurdle obtaining necessary director consent to any changes before year-end.
- Acceleration may undermine retention goals. Companies should weigh the impact of accelerating vesting on retention goals against the possible benefit afforded to an executive seeking to lock in current tax rates. A company may find itself faced with the prospect of needing to grant more awards in later years in order to retain an executive or a loss of leverage during a termination scenario.
- Practical tip: A way to mitigate this retention risk would be to impose a clawback on accelerated awards (and shares issued on exercise/settlement) on a voluntary termination or termination for cause.
- Disclosure. As with all variances made from pre-established plan designs, a public company that is considering altering its executive compensation programs should consider the rationale for such changes and whether such changes would trigger any current reports. However, bonuses are generally required to be included in the summary compensation table for the year to which they relate (rather than the year in which they are paid), and, therefore, acceleration of bonuses should not have any meaningful impact on a company’s summary compensation table or CEO pay ratio.
- Section 409A violation could overtake possible tax savings. Accelerating the payment of pre-scheduled bonuses and other NQDC can result in a violation under Code Section 409A. Section 409A violations are subject to a 20% additional tax and premium interest, and California also imposes a separate 5% state-specific Section 409A penalty.
- Practical tip: It’s not always obvious when an arrangement is subject to Section 409A. Thus, it’s best to consult with outside counsel before accelerating the payment timing of a pre-existing arrangement.
- Section 162(m) grandfathered status. Care should be taken to ensure that any contemplated changes would not jeopardize any amounts from otherwise continuing to qualify as Code Section 162(m) grandfathered amounts (and being deductible as performance-based compensation, despite the $1 million limit that applies to covered employees).
- More valuable deductions if corporate tax rates increase. If corporate tax rates increase in 2021 or later, the deduction for bonuses and other payments accelerated into 2020 for cash-basis taxpayers and certain accrual-basis taxpayers may be less valuable for the employer.
- Location, location, location. The Biden tax plan also proposes to remove the limits on state and local tax deductions that were imposed by the TCJA. For some executives located in states with high personal income tax rates, accelerating income into 2020 may result in a higher state and local tax bill than if paid in a later year if the TCJA limits on state and local tax deduction limits are rolled back.
Accelerating Capital Gain and Increasing Tax Basis through Open Market Trading
In anticipation of a higher capital gains tax rate, executives and other employees who hold large amounts of appreciated public company stock may also consider selling their shares in order to lock in the current lower capital gains tax rate. Another strategy some are considering is to sell such shares on the open market and repurchase the same number of shares on or around the same day, which both accelerates taxation of capital gain into 2020 and causes a step up in tax basis.
Whether or not these strategies would be financially beneficial to any particular individual is a highly personal assessment and dependent on the relevant stock price. The issues described below are particularly acute with respect to the sale and repurchase strategy and are being raised to highlight that such risks may likely outweigh any personal benefit achieved:
- Section 16 disgorgement. If an executive is a Section 16 officer or director, a sale and any purchases within six months before or after the sale could create matchable transactions for purposes of Section 16 of the Securities Exchange Act of 1934 (the Exchange Act).
- Form 4 requirements. Such sales and repurchases would trigger Form 4 filings for Section 16 officers and directors, resulting in disclosure of the sale and purchase, as well as, if applicable, any disgorgement of profits. The investor relations department should be prepared to answer questions relating to these types of trades.
- Insider trading matters. Executives should always consider insider trading issues prior to any transaction in their company’s securities. Many insider trading policies prohibit or otherwise discourage short-term transactions in company securities. In addition, blackout periods sometimes begin prior to the end of a quarter, which means that trades at or shortly before year-end may be prohibited under a particular insider trading policy. Finally, an executive should always consider whether they are in possession of material nonpublic information prior to any transaction involving their company’s securities.
- Stock ownership guidelines. The company should consider the impact of these transactions on the individual’s compliance with any stock ownership guidelines.
In-Plan Roth Conversion
If allowed under the company’s 401(k) plan, an executive may elect to convert within the plan all or a portion of his or her non-Roth amounts in the 401(k) plan into an after-tax Roth account (referred to below as an In-Plan Roth Conversion). A 401(k) plan may allow an In-Plan Roth Conversion for an executive’s pre-tax 401(k) deferrals, employer contributions, and non-Roth after-tax contributions. Making this election in 2020 causes such converted amounts to be subject to income tax in 2020 (provided the conversion is completed no later than December 31, 2020).
Prior to making an In-Plan Roth Conversion, an executive should consult with his or her professional tax or financial advisor to understand the impact on his or her personal finances, including the following:
- Taxes triggered need to come out of pocket. The executive will need to have available cash to pay the taxes due on an In-Plan Roth Conversion, especially with the conversion of a large account balance. The taxes due will be based on the market value of the converted amounts on the date of the conversion.
- Quarterly estimated tax payment. The executive may need to make a quarterly estimated tax payment for the fourth quarter of 2020 to avoid an underpayment penalty.
- The conversion is irrevocable. Once the conversion election is made, it cannot be revoked.
- 5-year holding period. In order for the converted amounts to be treated as a “qualified distribution” when paid from the 401(k) plan, and thus exclude the earnings on the Roth amounts from federal (and in most cases state) income taxes, the converted amounts and earnings cannot be distributed until a 5-year holding period is met. Failing to meet the 5-year holding period results in the earnings being taxable and potentially a 10% additional penalty tax if the executive is not age 59½ or older on the distribution date. As a result, an In-Plan Roth Conversion in 2020 may be less attractive to executives who may want to access their 401(k) plan account sooner than five years after making the election.
- Practical tip: If the executive is age 59½ or older and is concerned about satisfying the 5-year holding period, if permitted under the plan the executive could elect to take an in-service withdrawal of all or a portion of his or her vesting account (depending on the terms of the 401(k) plan). While the funds would not continue to accumulate pre-tax, if the withdrawal is completed in 2020 these amounts would be taxed in 2020.
Looking Forward—Design Considerations in Anticipation of Future Tax Hikes
Many of the tax cuts under the TCJA are subject to a sunset—namely, the top marginal tax rate will revert to 39.6% as of January 1, 2026. So regardless of whether a Biden administration is successful in enacting sweeping tax policy changes, employers and executives may wish to plan ahead when designing new compensation arrangements now and in the coming years assuming that Congress chooses not to prevent the sunset.
Incentive compensation design
- Equity choice program. Some companies offer employees a choice of the types of equity awards for their annual grant to provide flexibility and address the different preferences of employees in a multi-generational workforce. Typically the choice is between options and RSUs, often at set percentages (such as 100% options or RSUs, or a 50/50 or 75/25 split). Options have the benefit of a longer term and the ability of executives to control when they are taxed on awards based on when they exercise.
- Switch from RSUs to restricted stock awards that can be taxed at grant. RSUs tend to be favored by public companies over restricted stock awards due to administrative ease. However, with restricted stock a recipient can choose to accelerate the tax event from vesting to the date of grant by making a so-called Code Section 83(b) election within 30 days of grant.
- Incentive stock options. Incentive stock options (ISOs), which are especially popular with start-up and pre-IPO companies, are not currently subject to FICA at exercise or on the sale of shares purchased on an ISO exercise. Moreover, gain on the “spread” at an ISO exercise is not subject to ordinary income tax—rather, the spread is an adjustment item that may trigger alternative minimum tax (AMT). AMT has a maximum rate of 28%. And if the executive ends up paying AMT due to an ISO exercise, he or she will receive AMT credits that can be used to offset regular income in future tax years. Gain on the sale of ISO shares is also taxed at capital gains rates if the shares were held more than one year following exercise and more than two years following the option grant date.
- Practical tip: ISOs are probably less useful for large equity awards to executives covering stock with a high value because they are subject to strict limits on the value of the shares—if the fair market value (determined at grant) of the option shares that first become exercisable in a calendar year (usually at vesting) exceeds $100,000 in value, the option shares in excess of this $100,000 limit will be treated as a nonstatutory stock option (NSO). Moreover, if an employee meets the ISO holding periods noted above, the company does not receive a tax deduction. But even a public company may want to consider combining the use of ISOs with NSOs and RSUs to provide opportunities for tax planning and incremental tax savings.
- Performance criteria review. A company that typically uses formulaic performance goals which would be impacted by an increased corporate tax rate may consider:
- Ensuring the compensation committee has authority to adjust performance outcomes to neutralize the impact of increased corporate tax rates. Any such adjustment provisions should be tailored to avoid being viewed as discretionary rather than performance-based, both for disclosure purposes and to satisfy the proxy advisory firms and institutional investors.
- Using performance metrics that would not be impacted by a change in the corporate tax rate, such as relative TSR or EBITDA.
Implementing or enhancing deferred compensation arrangements
NQDC plans that are designed to permit executives to delay payment of deferred amounts until after termination or retirement, when their tax rates may be lower, may become more attractive in the coming years. Such NQDC plans include, among other arrangements, salary deferral arrangements, sometimes with employer matching contributions; deferred bonus plans or deferred RSUs; supplemental executive retirement plans/SERPs; and excess benefit plans, which provide benefits to executives subject to deferral limits under the company’s 401(k) plan or other qualified retirement plan.
To state the obvious, to take advantage of the 2020 tax rates executives and employers will have to act before December 31, 2020 to accelerate (where available) compensation into 2020. The comments in this alert are based on high-level tax policy summaries put forth by the Biden team. As indicted above, whether and to the extent these tax policy proposals ultimately become law will turn on a number of factors, many of which we will not fully appreciate until 2021 and later.
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