House GOP Tax Bill Repeals Performance-Based Pay Exception, Severely Limits 409A, Options

November 03, 2017

After much anticipation and several delays, the House GOP unveiled its comprehensive tax reform bill, which includes a full repeal of the performance-based pay exception of section 162(m), a substantial modification of nonqualified deferred compensation that effectively eliminates stock options, and various other employment-related provisions.  Both provisions have been long demonized by Democrats.  Section 162(m) is often branded as "taxpayer funded" executive compensation.  Meanwhile, section 409A is one of the most frequently criticized tax code provisions due to its association with the Enron scandal and its inordinate complexity.  The GOP's tax bill specifically would:

  • Repeal the performance-based pay exception of section 162(m):  Currently, companies are allowed to deduct compensation expenses for select top executives, including the CEO and three most other highly paid executives in excess of $1 million, so long as the compensation is "performance-based," with stock options specifically named as per se performance-based.  The GOP's tax bill repeals this provision, along with the exception for commission-based compensation, and includes the CFO as an executive subject to the limitation.  If adopted, this would effectively cap executive compensation and commission-based pay employee compensation corporate deductions for these individuals at $1 million per employee.

  • Replace 409A with new nonqualified deferred compensation scheme in 409B:  The tax bill repeals section 409A, which provides a restrictive framework for nonqualified deferred compensation, replaces it with the 409B—a new nonqualified deferred compensation scheme—and instructs the IRS to implement the provision via rulemaking.  The GOP's tax plan would effectively subject all nonqualified deferred compensation to same-year taxation unless the compensation is subject to a "substantial risk of forfeiture" in that the individual's right to the pay is conditioned on "future performance of substantial services by any person."  Thus, stock options and stock appreciation rights would be taxed at the vesting date, regardless of whether the options or SARS have been exercised.  The provision expressly excludes non-compete agreements in severance arrangements from the conditions which would satisfy the "substantial risk of forfeiture."  If the provision becomes law, how broadly or narrowly it applies will depend upon IRS rulemaking.
The fact that Republicans have included each provision in their first draft of the tax bill foreshadows considerable debate and the potential demise of both provisions—if a bill can actually pass through Congress. 

In exchange for a lower corporate tax rate, the House bill would also repeal business deductions for employer-provided child care facilities and referral expenses, employee transportation and parking benefits, and the work opportunity tax credit for employers who hire and retain veterans and individuals with significant barriers to employment.  Importantly, aside from repealing Archer medical savings accounts primarily used by small employers and the self-employed, the House bill would not make any changes to the tax treatment of employer-provided health care benefits.