It is expected that ordinary income tax rates, dividend income rates and long-term capital gains rates will increase effective January 1, 2011, due to expired tax cuts from the Bush administration. Some companies are considering whether to accelerate payment of certain compensation for their key employees into the 2010 tax year to help those key employees take advantage of lower income tax rates. The purpose of this Post is not to advocate such action, but to provide a summary of certain issues that should be considered when deciding whether to accelerate the payment of compensation.
BACKGROUND
The tax cuts from the Bush administration are scheduled to sunset at the end of the 2010 calendar year. This generally means that if Congress fails to act prior to the end of the year, then effective January 1, 2011, tax rates will likely increase as follows:
- the top ordinary income tax rate would likely increase from 35% to approximately 39.6%;
- the top rate for qualified dividend income would likely increase from 15% to approximately 39.6%; and
- the long-term capital gains tax rate would likely increase from 15% to approximately 20%.
ALTERNATIVES TO CONSIDER
Accelerating taxable income of a key employee into the 2010 tax year could be accomplished through a variety of means, a few of which are discussed below.
- Cash Bonus Programs. The full or partial payment of an annual cash bonus could be accelerated into the 2010 tax year. A key issue to consider is whether any accelerated payment would violate the timing requirements of Section 409A. Additionally, for those annual cash bonus programs that are intended to qualify as performance-based compensation under Section 162(m) of the Internal Revenue Code of 1986, as amended, a few other issues to consider include:
- To maintain qualification under Section 162(m), the amount of money subject to the accelerated payment date would likely need to be discounted to reasonably reflect the time value of money. This discount would likely be a small dollar amount.
- Additionally, and to continue qualification under Section 162(m), the compensation committee must certify the attainment of the stated performance goal prior to any payment. This means an analysis should be performed as to whether the compensation committee could certify preliminary financial results or certify a portion of the financial results attained. Any remaining balance owed to the key employee could then be paid in 2011 pursuant to the normal payment schedule, however, such 2011 payment would not likely qualify as performance-based compensation.
- In lieu of the above, the board or its compensation committee (as applicable) could pay a discretionary bonus to the key employee in 2010. To avoid overpaying the key employee, the normal bonus scheduled to be paid in 2011 could be reduced by a corresponding amount assuming the board or its compensation committee (as applicable) retained negative discretion to reduce such payment.
- Nonqualified Stock Options (“NSOs”). Generally, the holder of an NSO recognizes ordinary taxable income at the time of exercise equal to the difference between the then fair market value of the underlying stock and the exercise price. Due to the optionality of the stock option, the holder could exercise at any time, including within the 2010 tax year (absent a company policy to the contrary). And even if the NSO is subject to a vesting schedule, the board of directors or its compensation committee could decide to accelerate vesting into the 2010 tax year (assuming such discretion was retained); however, keep in mind that accelerated vesting would likely negate the retention attribute that the vesting schedule was intended to create.
- Restricted Stock and Stock Unit Awards. As with cash bonus programs, a key issue to consider is whether any accelerated payment would violate the timing requirements of Section 409A. Also, if the restricted stock award and/or stock unit award is designed to qualify as performance-based compensation under Section 162(m), then the above Section 162(m) analysis would generally apply. However, if such awards are subject only to time-based vesting, then the board of directors or its compensation committee could decide to accelerate vesting into the 2010 tax year (assuming such discretion was retained); though keep in mind that accelerated vesting would likely negate the retention attribute that the vesting schedule was intended to create.
Additionally, the grant date of a restricted stock award could be accelerated provided the board of directors or its compensation committee takes appropriate action. Assuming such award would be subject to a vesting schedule, the key employee recipient could make a Section 83(b) election in order to recognize ordinary taxable income on the date of grant (as opposed to the date of vesting), however, such election would generally have to be made, if at all, within 30 days from the date of grant.
SHAREHOLDER OPTICS
Any proposed action to accelerate the timing of a key employee’s taxable income should be properly vetted to determine the optics from the shareholder’s perspective (which is likely a factually intensive analysis). How shareholders would perceive an accelerated payment is an issue for both public and private companies. However, public companies should also consider:
- Whether an accelerated payment or vesting would be inconsistent with the compensation policies and procedures set forth in the CD&A of the company’s proxy statement.
- Whether and to what extent an accelerated payment would increase the named executive officer’s total compensation as set forth in the Summary Compensation Table of the company’s proxy statement.
- Related to the above, whether an accelerated payment to a key employee would cause a change in the identity of the company’s named executive officers for the fiscal year.
- Whether an accelerated payment would create CD&A optic issues if a named executive officer’s pay for the fiscal year increases when:
- The financial performance of the company decreases. This issue references the provision under the Dodd-Frank Act that would require (when the SEC issues rules) a company to disclose the relationship between the financial performance of the company and the compensation actually paid to its named executive officers (likely disclosed in the form of a graph or pictoral).
- The median total annual compensation of all employees (other than the CEO) is relatively low when compared to the total compensation of the CEO after including the accelerated payment. This issue references the provision under the Dodd-Frank Act that requires a comparison of the CEO’s annual total compensation (as disclosed in the Summary Compensation Table) to the median total annual compensation of all employees (other than the CEO), disclosed in the form of a ratio.
- Whether an accelerated payment would be “material” such that the company would be required to file a Form 8-K.
To conclude this Post, companies should proceed with caution when deciding whether to accelerate the payment of compensation related items for one or more of its key employees.
