Proposed Tax Bill Would Change the Face of Executive Compensation

Yesterday, Representative Kevin Brady (R-TX), Chair of the powerful House Ways and Means Committee, rolled out the Republican tax reform proposal. And, while no tax bill in my lifetime or likely anyone else's lifetime has made it through the legislative process unscathed, the draft bill fashioned as HR 1 certainly provides an indicator of where we may be headed.

Much seems completely as expected. We knew about the slimming to four tax brackets. We knew about the narrowing of deductions. We knew that some of the more heavily-taxed states would feel the pain of restructuring. What we didn't know and what frankly came as a surprise to me and to others that I know would completely change the face of executive compensation in the US. Honestly, on its surface, these proposed changes look to me as if they they had been constructed by Democrats. It wouldn't surprise me if these changes had been pre-negotiated, but that's entirely speculation on my part.

So, what's the big deal?

There are two extremely significant proposed changes according to my initial reading.

1. The draft would amend Code Section 162(m) (the $1 million pay cap) to eliminate the exemption for performance-based compensation. In addition, that section would be amended to cover the Chief Financial Officer in addition to the Chief Executive Officer. 
2. Code Section 409A would be repealed (you thought that was good news, didn't you?) and replaced with a new Code Section 409B. Essentially, 409B as drafted would apply the much more stringent taxation upon vesting rules that have previously applied generally only to 457(f) plans. 

162(m) Changes

Section 162(m) was added to the Internal Revenue Code by the 1993 tax bill. Widely praised at the time as a way to limit executive compensation, the exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined. Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay (some only very loosely incentive based) without limits while taking current deductions.

That would change. 

My suspicion is that companies would return to paying their top executives as they and their Boards see fit, but with the knowledge that particularly high compensation whether performance based or not would not be deductible. Additionally, so called mega-grants and mega-awards would likely become much rarer as the cost of providing them would no longer be offset by tax savings.

409B

The ability to defer compensation has long been a favorite of high earners. The requirement to defer compensation has also been considered a good governance technique by many large employers (for example, a number of large financial services institutions require that percentages of incentive compensation be paid in company stock and that receipt must be deferred),

Much of this would go away as very few people have the ability or desire to pay taxes on large sums of money before they actually receive that money.

What Might Happen If the Bill Passes

Nobody really knows what might happen. But since this is my blog, I get to guess. Here, readers need to understand that there is no hard evidence that what I say in this section will happen, but it seems as if it could.

The draft of HR 1 appears to keep tax-favored status for qualified retirement plans. That's important because qualified retirement plans are a form of deferred compensation with some special rules and requirements attached. What this means is that to the extent that an individual would like to defer compensation on a tax-favored basis, he would need to do it through a qualified plan.

However, qualified plans need to be nondiscriminatory; that is, they must (not an exhaustive list):

• Provide benefits that are nondiscriminatory (in favor of highly compensated employees)
• Provide other plan elements sometimes known as benefits, rights, and features that are nondiscriminatory
• Cover a group of employees that is nondiscriminatory

There are techniques by which this can be accomplished in a currently legal manner, but they are not simple. It would not surprise me to see more interest in these techniques.

As I said at the beginning, I don't expect this bill to pass as is. But, these particular provisions written by Republicans should not draw ire from Democrats. We'll see where it goes.