article is reprinted with permission from the
November 29, 1993
New York Law Journal.
© 1993 NLP IP Company.
Tax Planning Under OBRA '93
By Joseph E. Bachelder.
TODAY'S COLUMN discusses tax-planning considerations for executive compensation in light of certain changes made by the Omnibus Budget Reconciliation Act of 1993 (OBRA). These changes include:
(a) Increase in the individual marginal income tax rate from 31 percent to 36 percent and introduction of a surtax equal to 10 percent of the income tax on income above a certain level, resulting in a marginal combined rate of 39.6 percent.
(b) Removal of the cap on covered compensation for purposes of the Medicare hospital insurance tax (Medicare tax) (the cap in 1993 is $135,000). The effect of this is a new tax in 1994 at the rate of 2.9 percent on executive compensation above $135,000, 1.45 percent on the employer and 1.45 percent on the executive.
(c) The imposition of a $1 million limit per year per covered executive for the deduction attributable to certain (but not all) compensation that is not "performance based." This limit applies only to the pay of the very top executives of public corporations 1 and, in some cases, their affiliates. 2
In addition to the changes just noted, OBRA
makes a number of changes in the taxation of executives as to
which tax planning considerations will not be discussed in this
* Reduction in annual compensation on which tax qualified retirement plans can be based to $150,000. 3
* Elimination of a deduction for club dues and reduction in the deduction for business meals from 80 percent of the cost to 50 percent of the cost.
* Increase in the Alternative Minimum Tax rate from 24 percent to 26 percent on alternative minimum taxable income up to $175,000 and 28 percent over $175,000.
* Elimination of long-term capital gains from the definition of "investment income" for purposes of the investment interest deduction limitations under Code §163(d)(4).
* Further tightening of the limits on the "safe harbor" rules for purposes of estimated tax payments by individuals.
* Increase in the rate of withholding on supplemental wages. 4
Depending on the tax change there may be end-of-year tax planning considerations as well as longer term tax planning considerations. In some cases, there are open issues that cannot be resolved until the Treasury Department and the Internal Revenue Service (IRS) issue clarifying statements, regulations or rulings. Corrective legislation may be required to resolve some of the issues.
Marginal Tax Rate
1. Increase in the marginal tax rate on individuals to 39.6 percent (for discussion of additional 1.45 percent Medicare tax, see Part 2 below).
1993 Year-End Planning. Since the new rates took effect for tax years beginning after Dec. 31, 1992, a year-end 1993 acceleration is not relevant (but see below as to Medicare tax). It is possible, of course, that income otherwise payable in 1994 might be deferred to a later period5. There is a risk, of course, that tax rates in a later period might be higher than in 1994.
Longer-Term Planning. Consideration should be given to the advantages (and disadvantages) of replacing ordinary income with long-term capital gain in the design of executive compensation. Long-term capital gain continues to be taxable at a rate of 28 percent. Following are two examples of plans designed to achieve long-term capital gains for the participants.
(a) A sale of stock by the employer to the executive for a promissory note, the latter being forgiven by the employer over time, will allow growth in value of the stock to qualify for long-term capital gain treatment. (Forgiveness of the note will result in ordinary income.)
(b) A sale by the employer to the executive of a convertible debenture, assuming it is properly designed so as to be treated as a debenture for tax purposes, will allow the gain in the underlying common stock above the purchase price of the debenture to be treated as long-term capital gain. (The conversion of the debenture would not be taxable; the sale of the underlying stock should be eligible for long-term capital gain treatment when sold.)
The opportunity provided the executive for long-term capital gain on growth in stock value, noted in the two preceding examples, results in a loss of deduction against ordinary income by the employer in respect of such stock gain.
New Medicare Tax
2. Medicare tax (1.45 percent).
1993 Year-End Planning. Among steps that might be taken to reduce the impact of this new tax on compensation above $135,000:
(i) Payments that are due shortly after the first of the year (such as annual bonuses and long-term award payments otherwise payable in early 1994) might be accelerated into 1993.
(ii) Deferred compensation that is not yet vested might be vested before 1993 year end. Deferred compensation, once earned, becomes subject to the Medicare tax when "there is no substantial risk of forfeiture of the rights to such amount." 6
Longer-Term Planning. In view of the applicability of the Medicare tax to deferred compensation whenever paid there would seem to be little further planning of any real substance after the end of 1993. To the extent capital gain opportunities are provided (see discussion in Part 1 above), the Medicare tax would be avoided.
3. $1 million limitation on the deductibility of certain compensation for senior level executives of public companies.
A detailed discussion of this provision, embodied in §162(m)(1) of the Internal Revenue Code of 1986 (Code) as added by §13211(a) of OBRA, was provided in this column Aug. 30. Section 162(m)(1) provides:
In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1 million. This new provision is effective as to compensation otherwise deductible by a corporation in a taxable year beginning on or after Jan. 1, 1994.
Only a handful of the top executives of any public corporation is covered by this new provision. A "covered employee" includes the person serving as chief executive officer "as of the close of the taxable year" and any other employee required to be reported in the proxy statement as a "named executive officer" by reason of "being among the four highest compensated officers for the taxable year (other than the chief executive officer)." 7
Covered remuneration includes "the aggregate amount allowable as a deduction under this chapter for such taxable year (determined without regard to this subsection) for remuneration for services performed by such employee (whether or not during the taxable year)." 8
Obviously such a broad definition of covered remuneration covers a wide spectrum of executive compensation. Among exceptions to covered remuneration are contributions to a qualified retirement plan and benefits available under other tax qualified benefit plans. Also excluded are commissions paid in respect of an individual's own services (such as a salesman's commissions on his own sales).
The most important exception for purposes of the present discussion is that provided for "performance based compensation." This exception, as described in §162(m)(4)(C), is applicable if
(i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of two or more outside directors,
(ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such remuneration, and
(iii) before any payment of such remuneration, the compensation committee referred to in clause (i) certifies that the performance goals and any other material terms were in fact satisfied.
Grandfather date. The new rule exempts "any remuneration payable under a written binding contract which was in effect on Feb. 17, 1993, and which was not modified thereafter in any material respect before such remuneration is paid." 9
Open issues. The legislation leaves open many issues that need to be resolved promptly. It is expected that the Treasury will, before year end, provide a statement as to its position on these issues, which include the following:
(i) Who is a "covered employee"? On Nov. 22, the Securities and Exchange commission voted to adopt amendments to its disclosure rules that expand the definition of "named executive officers." 10 The definition of "covered employee" under Code §162(m) refers to these rules. Under the SEC disclosure rules, as so amended, up to two additional executives who would have been among the four highest paid executives at year end but for their ceasing to serve as executive officers during the year may be required to be included as "named executive officers" required to be included in the "covered employee" definition for purposes of Code §162(m)? 11
(ii) What is a "performance based plan?"
* Who qualifies as an "outside director" for purposes of approving (and later certifying) performance under a "performance-based plan"?
The Conference Committee Report for OBRA limits an "outside director" for purposes of §162(m)(4)(C)(i) to a director who is not a current employee of the corporation (or related entities), is not a former employee of the corporation (or related entities) who is receiving compensation for prior services (other than benefits under a tax-qualified pension plan), was not an officer of the corporation (or related entities) at any time, and is not currently receiving compensation for personal services in any capacity (e.g., for services as a consultant) other than as a director. 12
De Minimis Exception?
If a director receives compensation (other than as a director), is there a de minimis exception? What if the director is a partner in a firm, such as a law firm or an investment banking firm, that receives fees from the employer -- are these fees attributable to the director so as to disqualify such person as an outside director?
* If a stock option plan, as approved by shareholders, provides for a maximum number of shares that can be granted under it, does that meet the requirements noted in the Conference Committee Report that the plan must specify the maximum number of shares that an individual executive can receive under the plan? What if the maximum number of shares is based on an "evergreen" provision (e.g., one that provides a number or a fixed percentage of new shares available for grant each year)?
* Does discretion in the compensation committee administering the plan to adjust an award payout (from what would be paid out based strictly on the performance goals) defeat the §162(m) requirement that the plan be based on "performance goals"? What if the discretion can only be exercised to reduce the payout?
* What if an award payout will be accelerated in the event of a change in control?
(iii) How are the "transition" rules to be interpreted?
* What is a "written binding contract" for purposes of the grandfather provision in §162(m)(4)(D) and when will a modification of the contract or other change in the award payable under the contract result in loss of the grandfather exception?
* Are any awards subject to exception from the new rule by reason of having been granted
* before the date of enactment of OBRA, Aug. 10, 1993, but after Feb. 17, 1993?
* after the date of enactment but before announcement by the Treasury of its clarifications as to application of the transition rules?
* If grants just described are not excepted from the new rule, will they qualify for the "performance based plan" exemption if they are modified (assuming they can be modified) to include provisions required by §162(m)(4)(C) with the approval of (i) a committee of outside directors only or (ii) if (i) is not sufficient for this purpose, the shareholders themselves (e.g., at the first annual meeting following the Treasury's announcement of its position on this issue)?
1993 Year-End Planning. This includes:
* Determine if there are any elements of compensation payable in 1994 or later that cannot be modified to qualify for exemption. (In virtually every such case the exemption in question will be the "performance based plan" exemption.) In such a case, determine whether
* payment of the amount involved can be accelerated into 1993.
* the amount involved can be deferred to a later year (e.g., post-retirement) when the executive will no longer be a "covered employee."
Early 1994 planning. This includes planning to bring plans, including their administration (e.g., outside director requirement), into compliance with the requirements for a "performance based plan." Some of these steps will require clarification by the Treasury in order for an employer to know exactly what to do in order to comply (see discussion of issues above). Following are some of the steps:
* In respect of the "performance based plan" exemption:
* make sure the committee responsible for administering the plan is composed only of "outside directors."
* prepare to submit to shareholders for their approval any plan provision that may be required in order for the plan to qualify for the exemption (e.g., performance based criteria for plans other than stock option plans and, in the case of stock option plans (depending on the Treasury's position, the announcement of which is expected in December), limitation on the number of shares that can be granted to any one executive).
* to make certain the applicable committee of outside directors certifies that the required performance goals have been met prior to payout.
* In respect of "transition requirements"
* make certain that requirements such as those necessary to comply with the "grandfather" rule are complied with.
Longer-term planning. Attention must be given to the overall executive compensation program of an employer, particularly in terms of the most effective design and administration of "performance based plans." Among the considerations are:
* Should future awards be divided between the form of awards to "covered employees" and awards to other executives? In fact, this may be an issue for more immediate planning. For example, in modifying awards already made but not yet paid out (again, assuming they can be modified), should the modification be limited to "covered employees," leaving the remainder of the participants in the award program unaffected? In such a situation, however, care should be taken in determining not to make a modification as to any participant who might, in a later year when payout occurs, become a "covered employee."
* If the Treasury insists there should be no discretion on the part of the administering committee under an incentive plan designed to qualify, to the extent possible, as a performance based plan, should the plan be split up into two parts: (i) a part (for example, 50 percent) that is entirely performance goal based and (ii) a part (the remaining 50 percent) that is discretionary? (This possible course obviously is dependent upon what the Treasury announces with regard to the consequences of the use of discretion).
* On an ongoing basis, employers will need to review;
* should amounts otherwise payable under a remuneration plan be deferred until the executive involved ceases to be a "covered employee"?
* if a "covered employee" is approaching retirement, should retirement be accelerated in order that the executive will cease to be a "covered employee" for the year in question? (As already discussed, until the Treasury clarifies the matter, it may be unclear in particular cases whether termination of employment of a "covered employee" for the year in question? (As already discussed, until the Treasury clarifies the matter, it may be unclear in particular cases whether termination of employment of a "covered employee" will terminate status as a "covered employee" for the year of termination.)
* should a particular stock option award, or other award, be modified to extend the period of exercise, or payment date, beyond retirement (if it does not already so provide) in order that the exercise of the option, or in the case of other plans, the payouts, can occur after the executive ceases to be a "covered employee"?
* as it becomes desirable from time to time to modify contracts entered into on or before February 17, 1993, can the modification be made without jeopardizing the grandfathered status of the contract?
1While the provisions of Internal Revenue Code §162(m) apply only to "any publicly held corporation," a privately held corporation that anticipates going public should also take these provisions into account. Among other things, any awards made while the corporation is privately held that pay out (or, in the case of stock options, are exercised) when it is publicly held will be subject to §162(m).
2 The language of §162(m)(1) is unclear whether compensation paid to a "covered employee" by a subsidiary (or other non-public affiliate) of a public company for services to that affiliate is subject to the cap. (This question exists whether the executive is a covered employee by reason of his employment by the public company or by reason of his having responsibilities at the public company level as an employee of the non-public affiliate.) For a discussion of this issue, see "Recommended Guidance Relating to $1 Million Limitation on Deductible Compensation Under §162(m)," Committee on Nonqualified Employee Benefits and Committee on Qualified Plans, New York State Bar Association Tax Section, at 3 (Sept. 27, 1993).
3 Tax planning in respect of this change is not discussed in today's column because of the complex qualified plan rules that must be taken into account in a complete tax planning analysis. There are, obviously, important planning considerations for executives in areas outside the qualified plan rules. More retirement income for executives will be funded (to the extent funded at all) by non-qualified funding vehicles, such as rabbi trusts. Another issue will be the exemption of so-called "top hat plans" from most of the requirements of ERISA. As more executives become covered by such a plan (as a result of the reduction in qualified plan coverage), the risk increases that the plan may cease to be treated under ERISA as a "top hat plan." For this purpose, "top hat plan" means a plan "maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees." Employee Retirement Income Security Act of 1974 §201(2), 29 USCA §1051(2) (West 1985).
4 Supplemental wages do not include salary but do include bonuses. See generally Treas. Reg. §31.3402(g)-1(a)(1).
5 Generally, the rulings policy of the Internal Revenue Service (IRS) provides that elective deferral of compensation effectively postpone taxation if the election to defer the compensation is irrevocable and is made before the beginning of the period in which the services are rendered for which the compensation is payable. See Rev. Proc. 71-19, 1971-1 C.B. 698. In audits, the practice of the IRS generally is not as stringent as its ruling policy. Whether an election to defer will be effective for tax purposes depends on the particular facts and circumstances involved. For a discussion of elective deferrals, see this column, New York Law Journal (March 30, 1987).
6 IRC §3121(v)(2). Deferred compensation includes not only elective deferred compensation (such as bonuses deferred to a later year) but also supplemental executive retirement plans (SERPs). On the other hand, deferred compensation for this purpose does not include the spread in a nonqualified stock option before its exercise.
7 IRC §162(m)(3).
8 IRC §162(m)(4)(A).
9 IRC §162(m)(4)(D).
10 The amendments adopted by the SEC on Nov. 22 are based on the SEC proposal that appeared in 58 Fed. Reg. 42,893 (August 12, 1993) (proposing amendments to 17 CFR. §229.402 (Item 402 of Regulation S-K)).
11 Under the SEC's amendment to Item 402(a)(3)(i), disclosure is required as to any individual who served as the corporation's CEO at any time during the last completed fiscal year. Id. Section 162(m)(3)(A), however, applies with respect to the employee who was the CEO "as of the close of the taxable year." Section 162(m)(3)(B) includes as a covered employee an employee required to be reported as a "named executive officer" in the proxy statement "by reason of such employee being among the 4 highest compensated officers for the taxable year (other than the chief executive officer)." Thus clarification is needed whether a CEO (or any other executive, as discussed in the text) who is not employed at the end of the year but is one of the four highest paid executives during the year (other than the person who is the CEO at year end) will be included as a "covered employee" under §162(m) as a result of the SEC amendments.
12 H.R. Conf. Rep. No. 213, 103d Cong., 1st Sess. 96 (1993).