Performance-Based Compensation May “Die” Under the Tax Cut Legislation

An amusing but telling “obituary” for performance-based compensation by Dan Walter outlines the consequences of doing away with the tax benefits for pay linked to stock price increases.

The proposed tax reform bill of 2017 would eliminate many of the time-tested and successful components of equity compensation, effectively removing one of the three legs of many companies’ three-legged stool of compensation philosophy.

Under the proposed rules:

Appreciation vehicles such as stock options and SARs would be taxed at vesting, instead of at the time of exercise. This would effectively shorten their useful lives from potentially 10 years to perhaps 4 or 5 years. It would also make the use of these tools for pre-IPO or other illiquid companies too risky to be a recommended practice.

Full value vehicles like RSUs, would be taxed much as they are today, but with far less flexibility in deferring income or linking vesting to performance conditions.

Performance vested awards would be taxed immediately, instead of at the time of performance achievement and associated vesting. While these are currently investors’ preferred tool for executive long-term incentives, the change in taxation would make them a punitive form of pay beginning in 2018.

It appears that all outstanding equity would be subject to these rules as of January 1, 2018. This would result in changes for both companies and employees that would include the death of long-term motivation and retention tools, immediate taxation for employees, acceleration of expense associated with all equity-based incentives and much, much more.

Presumably, cash bonuses tied to financial metrics or other performance goals would still be available.