Performance-Based Compensation

Introduction

Section 1402(a)(13) of the Internal Revenue Code provides that the distributive share of “limited partners, as such” from a partnership is not subject to self-employment tax.[1]  Managers of private equity and hedge funds are routinely structured as limited partnerships to exclude management and incentive fees from self-employment

COVID-19 has had significant impacts on all aspects of business.  While employers are assessing how to handle immediate employee needs related to sick leave, family leave and benefits claims, employers should also consider the impact that changes in their workforce or economic conditions will have on their compensation plans and programs.

This blog post addresses one of those compensation issues that many companies are currently grappling with – whether a temporary leave of absence or furlough triggers forfeiture, payment, vesting, or other treatment under compensation arrangements.

In following blog posts, we will address other compensation issues, including:

  • Effect of salary reductions on compensation arrangements (including “good reason” triggers);
  • Limitations on amendment of equity awards and performance goals; and
  • Funding and termination of nonqualified deferred compensation plans (“NQDC plans”) and limitations on such actions.

Is a leave of absence or furlough a “termination of employment” or “separation from service”?

Many employment agreements, severance plans, equity awards and other compensation arrangements provide for partial or full vesting or payment of amounts upon an employee’s termination of employment or separation from service.

Although many employees have experienced a significant decline or cessation of work in connection with the COVID-19 outbreak, such employees may not have necessarily had a separation from service or termination of employment under the terms of the applicable compensation arrangement.

As a general matter, employers with compensation arrangements with separation from service or termination of employment triggers who have employees who are being placed on leave, reduced hours or furlough should take the following steps, preferably before or as soon as possible after implementing any workforce changes:

Under both the House and Senate versions of the Tax Cuts and Jobs Act, Internal Revenue Code Section 162(m) would be modified to expand the scope of companies and executive officers subject to the limitation on deductibility of compensation over $1 million, as well as to eliminate the exception to non-deductibility under Section 162(m) for qualified performance-based compensation. The changes would be effective for tax years after 2017, but under the Senate bill, binding contracts in effect on November 2, 2017 would be grandfathered if not materially modified on or after that date).  Each version of the Tax Cuts and Jobs Act would also generally lower the corporate tax rate to 20%.  The House bill reduces the corporate tax rate beginning in 2018 and the Senate reduces it beginning in 2019.

In the early hours of Saturday morning, the U.S. Senate passed the Tax Cuts and Jobs Act (H.R. 1) (the “Senate bill”), just over two weeks after the U.S. House of Representatives passed its own version of the same legislation (the “House bill”).  Members of the House and Senate will next convene in conference to attempt to reconcile the House and Senate versions of the legislation.  Identical versions of the bill must be passed by simple majorities in both the House and the Senate before the bill, and signed by President Trump, before such legislation will become law.

The final Senate bill, although similar to the bill passed by the Senate Finance Committee on November 16, contains several important changes.  We outline some of the most significant changes below, followed by a list of some of the major outstanding points of difference between the House and Senate bills as passed by the respective chambers.  We then discuss in detail some of the most significant provisions of both bills.

Yesterday afternoon, the House of Representatives passed the Tax Cuts and Jobs Act (H.R. 1) (the “House bill”). The House bill is identical to the draft bill approved by the House Ways and Means Committee on November 10. Late last night the Senate Finance Committee approved its own conceptual version of the Tax Cuts and Jobs Act. An initial, descriptive version of the Senate Finance Committee bill (for which actual statutory text is still forthcoming) prepared by the Joint Committee on Taxation (the “JCT”) was released on Thursday, November 9. The Senate Finance Committee subsequently revised the bill significantly, as reflected in the JCT descriptions of the modifications released on Tuesday, November 12, and a further amendment[1] released late last night (as modified, the “modified Senate bill” and generally, the “Senate bill”). The modified Senate bill varies in certain important respects from the House’s bill.

The modified Senate bill introduces significant changes to the Senate bill released last week. Perhaps most significantly, the modified Senate bill would repeal the provision of the Affordable Care Act (ACA) requiring individuals without minimum health coverage to make “shared responsibility payments” (commonly referred to as the “individual mandate”). The modified Senate bill also provides for most changes to individual taxation to sunset after December 31, 2025, including the repeal of the individual AMT, the reduced rate for pass-through entities, the reductions in ordinary income tax rates and brackets, the repeal of itemized deductions, the increased standard deduction, and the expanded exemption for estate and generation-skipping transfer taxes. Notably, the reduced corporate rate cut of 20% (reduced from 35%) effective in 2019 would be permanent.

We have outlined below some of the significant changes in the latest draft of the Senate bill, and summarized the key differences between the modified Senate bill and the House bill. Because the Senate has not yet released legislative text, this summary is based only on the JCT’s descriptions of the Senate Finance Committee’s bill (in its original and modified form) and the November 16 amendment (as published on the Senate Finance Committee website).

IRC Section 162(m) provides that a public company may not deduct annual compensation paid to a “covered employee” in excess of $1,000,000 per year, other than certain “qualified performance-based compensation.” For these purposes, “covered employees” generally include the company’s CEO and its three most highly compensated executive officers (other than the CEO and CFO) identified in the company’s “Summary Compensation Table.”