On February 26, 2014, U.S. House of Representatives Committee on Ways and Means Chairman Dave Camp (R-Mich.) released the proposed Tax Reform Act of 2014 (the Camp Proposal). In addition to simplifying the Internal Revenue Code (IRC) and reducing corporate and individual tax rates, the Camp Proposal would fundamentally change the income tax rules that apply to nonqualified deferred compensation arrangements and would further restrict tax deductions available to publicly held corporation when paying named executive officers. It would also impose a new excise tax on employees of certain tax-exempt organizations who receive excessive compensation and certain payments that are contingent upon a change in control. Although unlikely to be enacted this year, the Camp Proposal provides a blueprint for other legislators to propose tax law changes that would significantly impact current executive compensation practices. Given the current political environment and the way tax revenue is estimated by Congress when preparing budgets, it is likely that we have not seen the last of the executive compensation changes included in the Camp Proposal, which makes it important to understand how they work and what they would mean for current executive compensation programs.
On February 26, 2014, U.S. House of Representatives Committee on Ways and Means Chairman Dave Camp (R-MI) released the proposed Tax Reform Act of 2014 (the Camp Proposal), which would simplify the Internal Revenue Code and reduce corporate and individual tax rates. However, to remain revenue neutral, the Camp Proposal would eliminate many important tax incentives and would change the landscape of executive compensation.
Changes to Nonqualified Deferred Compensation
Most significantly, the Camp Proposal would add a new Internal Revenue Code Section 409B under which nonqualified deferred compensation earned after 2014 would be taxed upon the elimination of a substantial risk of forfeiture (typically, upon vesting). Further, under the Camp Proposal, amounts earned before 2015 would generally be includible in income as of the later of: (1) 2022 or (2) the year in which the amounts are no longer subject to a substantial risk of forfeiture. If these provisions are enacted, there would no longer be any tax-advantaged reason to use non-qualified deferred compensation plans and, as a result, there would be an incentive to discontinue them unless they are funded.
Changes to Internal Revenue Code Section 162(m)
Section 162(m) currently limits to $1 million the deduction that public companies may take on the compensation paid to the chief executive officer and the next three highest paid officers. In addition:
- Chief financial officers generally are not subject to Section 162(m) due to a change in SEC proxy disclosure rules in 2007.
- Payments that qualify as performance-based compensation under Section 162(m) are not subject to the $1 million limit.
- The limit only applies to named executive officers in the company’s proxy who are employed by the company on the last day of the company’s fiscal year.
The Camp Proposal would expand the application of Section 162(m) to:
- Cover the chief financial officer
- Eliminate the performance-based compensation exception (so that items like stock options and other performance-based pay would, for the first time, become subject to the $1 million cap)
- Continue to apply the deduction limit to former covered officers and to beneficiaries (which would eliminate the approach of preserving deductions by deferring amounts until Section 162(m) officers terminate employment)
The Camp Proposal’s Section 162(m) provisions remove significant tax incentives to provide compensation in certain types of ways, in particular, to meet the definition of performance-based compensation. While the early consensus appears to be the proposal will not affect the movement toward pay-for-performance for other purposes (e.g., for shareholder “say on pay” votes, etc.), it likely will affect the vehicles and approaches used to implement pay-for-performance. For example, companies may no longer feel compelled to set performance metrics during the first 90 days of a performance period as many companies now do in order to qualify for the existing performance-based exception to Section 162(m).
The Camp Proposal, in its current form, is highly unlikely to be enacted this year. However, these executive compensation provisions (or similar provisions) are attractive revenue raisers that could be used to pay for [...]