A series of tax reductions passed by the Bush administration was set to expire at the end of 2010, leaving many companies considering moving up executive compensation payouts previously planned for 2011 or later.
Political observers were doubtful Congress would extend the entire package of Bush tax cuts, and continued relief for high earners was viewed as especially unlikely. The Obama administration has called for extending present tax rates for middle-class earners only, and reinstating the top two pre-Bush era marginal income tax rates of 36 and 39.6 percent, starting with adjusted gross incomes of more than $250,000 for joint filers and $200,000 for individuals. The current top rates are 33 and 35 percent.
Absent congressional action, tax changes effective in January 2011 would include:
• Increasing the top income tax rates from 33 and 35 percent today to 36 and 39.6 percent.
• Increasing the top dividend tax rate from 15 percent to 39.6 percent
• Increasing the top capital gains tax rate from 15 percent to 20 percent.
• Increasing the estate tax from 0 to 55 percent (with $1 million exclusion).
• Reinstating the full phase-out of personal exemptions.
• Reinstating the full phase-out of itemized deductions.
A number of dividend-paying companies are considering making larger dividend payments before the end of 2010 (in effect, moving up payments that would otherwise be made in 2011) so that shareholders are taxed no more than 15 percent under the current rate. Similarly, a number of companies are weighing whether to accelerate executive compensation that otherwise would be paid to high earners in 2011.
“The questions I’ve been hearing are whether compensation should be accelerated to the extent possible into 2010, and whether compensation deferrals into the future should cease,” said Liz Buchbinder, a compensation and benefits consultant with Ernst & Young LLP, during a July 2010 webcast by her firm. She addressed a number of possible opportunities along with concerns for employers and their compensation committees to keep in mind.
Accelerating compensation into 2010 in many cases will be something for employers to consider, Buchbinder noted. “But there are other considerations beside taxes. You have to look at the economic or opportunity cost associated with accelerating the income into 2010, particularly when you consider higher tax rates on dividends and capital gains in the future that will erode after-tax investment returns on the compensation that’s accelerated. It’s not a given, necessarily, that accelerating deferred cost is the best way to go, particularly if the deferral period is long.”
Should all possible compensation be accelerated into 2010?
Factors to consider:
• Opportunity costs involved with paying taxes on distributions in 2010 as opposed to at a future date (albeit at a higher future tax rate), leaving less money to invest otherwise.
• Impact of paying taxes on dividends, interest and capital gains on after-tax investments vs. deferred compensation.
Early Exercise of Stock Options
If the decision is made to accelerate compensation, one opportunity is the early exercise of nonqualified stock options in 2010. The advantage: It might trigger compensation income at a lower stock value, to be taxed at lower 2010 income tax rates. That income could then be reinvested and the subsequent appreciation would be taxed in the future at the capital gains rate—which will be higher than current capital gains rates but still lower than future income tax rates.
“The conventional wisdom is to exercise a stock option toward the expiration of its term, which is typically 10 years,” Buchbinder said. “Clearly, if the stock value goes up after the holder has triggered income at a lower stock price and paid a lower tax rate, there is a benefit there.”
But there could be a price to pay for the early exercise of a stock option as well, she explained. “You basically sacrifice the option value, which is the ability to share in the upside potential of the stock without fully assuming downside risk—which makes stock options desirable in the first place.”
Also, she noted, cash flow considerations shouldn’t be overlooked, because the option holder would have to come up with the money to pay taxes on that income in 2010.
Accelerated Restricted Stock Vesting
Another opportunity is to alter restricted stock vesting provisions, which typically require an employee to work for a number of years or to meet performance-related goals before becoming fully vested.
“An employer could determine that it wanted to accelerate vesting of restricted stock into 2010, particularly if it’s near the end of the vesting period,” Buchbinder said. But releasing vesting restrictions “can have a big impact on the ‘golden handcuff’ aspects of the restrictions to begin with,” meaning the use of restricted stock to keep executives from jumping to a competitor. Corporate governance issues also are involved with early vesting.
Another opportunity is to accelerate payment of 2010 bonus compensation. Often, discretionary annual bonuses for a given year are paid within 2½ months after year end. To the extent the company has a good idea of the results for the year and can pay earlier, and if the compensation committee can act before the end of the year to approve it, “this would be one way to accelerate compensation into 2010,” Buchbinder said.
However, here, too, there are points to consider. “If you are a public company, you have to be cognizant of tax code section 162(m) relating to so-called “covered employees”—the CEO and the next three highest paid officers, she related. Performance-based compensation can be paid only to covered employees after related performance goals for the year have been certified by the comp committee or else those payments are not deductible under 162(m).
Certifying 'Near Final Results
Michael S. Melbinger, the lead partner and global head of law firm Winston & Strawn’s employee benefits and executive compensation practice, writes on his Executive Compensation blog:
Public companies seeking to preserve the deductibility of annual bonus payments to their named executive officers (NEOs) under code Section 162(m) need to deal with requirement that the compensation committee certify the attainment of the performance goals before payment (in order to qualify for the performance-based compensation exception). This they should be able to do, with a little advance planning. For example, if final financial results are not available, the compensation committee could certify "near final results" and pay most of the expected annual bonus on December 31, 2010, or certify that portion of the performance goals that have been achieved, in either case, with an additional "true-up" payment to be made in early 2011. [Note that this change in bonus payment policy might require the company to file a Form 8-K.]
Stopping or Accelerating Deferrals
“To the extent you’ve already deferred compensation in 2010, you’re pretty much stuck with it” because of restrictions in tax code section 409A relating to deferred compensation elections, Buchbinder explained. Section 409A was enacted in 2004; it limits the time of payment for deferred compensation severely. “Basically, once you’ve deferred comp to a particular event such as separation from service, there are very limited opportunities to either re-defer it further out or to accelerate it to an earlier date.”
For those who violated section 409A by making an impermissible acceleration, the distribution is not only taxed as current income but also subject to a 20 percent additional income tax and potentially to a premium interest tax.
“If you want to terminate and actually liquidate the plan and make distributions, there are also severe limitations on doing that” under Section 409A, Buchbinder said. “The only way to do this is if you terminate all plans of the same type and make distributions within a 12- to 24-month window following plan termination. Basically, if you terminate a plan now, you wouldn’t be able to distribute for at least 12 months, and you’re already into 2011. So it’s not a practical solution.”
Grandfathered Deferred Comp Plans
There is an opportunity, however, for deferred compensation that was grandfathered under section 409A, Buchbinder said. Section 409A applies only to compensation that was earned or vested after 2004, “so to the extent you have deferred comp that was earned and vested before 2005, that compensation does not fall under section 409A restrictions and there is an opportunity to potentially accelerate that deferred compensation.”
She advised, however, that “it’s a one-time chance, because if you materially modify a grandfathered plan, such as by accelerating the payment of deferred compensation, you then fall under section 409A.”
While such a move is a viable opportunity, she said, “it, too, has corporate governance considerations,” including Securities and Exchange Commission disclosure ramifications. And there are section 162(m) implications, because most plans defer compensation until separation from service. "If you pay it now, while the covered employees are still executive officers," she noted, "you could have a deduction disallowance.”
Concluded Buchbinder, “there are lots of pros and cons on all of these opportunities,” with the result that accelerating payment of executive comp “is not a decision to be made lightly.”
Upcoming Medicare Tax on High Earners Poses
Planning Challenges, Too
Along with the anticipated expiration of the Bush tax cuts, the new Medicare tax on high earners enacted as part of the health care reform legislation signed into law in March 2010 means big changes in personal financial planning and executive compensation for these employees.
Single taxpayers who earn more than $200,000 and married taxpayers with combined income of more than $250,000 will face the new 3.8 percent Medicare tax on their investment gains starting in 2013. The tax will apply to investment income including interest, dividends, rents, royalties, annuities and capital gains. As a result, high earners may have to rethink their short and long-term financial strategies.
"Employers can provide clarity through financial education to help prepare highly compensation employees for these changes," says Lynn Pettus, national director of employee financial services at Ernst & Young LLP. "Offering year-end planning seminars or webinars can provide clarification and ease stress," she advises. "If employees receive objective guidance and a better understanding of the impending tax environment, both the employer and the workforce benefits."
Stephen Miller is an online editor/manager for SHRM.
Employers in U.S. Start Bracing for Higher Tax Withholding, Bloomberg, October 2010
Companies Should Consider Early Bonus Payments, Vorys Legal Counsel, October 2010
Interactive Graphic: How the Fight over Tax Breaks Affects Your Bottom Line, Washington Post, August 2010
Upper-Income Taxpayers Plan for Hike, Wall Street Journal, August 2010
On Wall Street, a Jump on Bonuses, Wall Street Journal, August 2010
Planning for the Expiring Bush Tax Cuts: Here Today, Gone Tomorrow, SHRM Online Legal Issues, October 2010
IRS Releases Section 409A Correction Program for Nonqualified Plan Document Failures, SHRM Online Benefits Discipline, January 2010
Executive Comp Reminder: Amend for Section 162(m), SHRM Online Compensation Discipline, October 2009
Code Section 409A Imposes New Requirements, SHRM Online Compensation Discipline, November 2007
Analysis of Final Section 409A Regulations, SHRM Online Benefits Discipline, April 2007
Options to Stock Options, HR Magazine, April 2006
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