The new tax laws have created opportunities for private businesses—reducing tax rates and creating investment incentives; however, there are a few challenges. This article will review the complexities for planning executive compensation for owner executives of private companies after the Tax Cuts and Jobs Act (Tax Act).
Tax Rate Planning
The corporate tax rate applicable to C corporations (C Corps) has been reduced from 35% to 21% and the corporate alternative minimum tax (AMT) has been repealed. Individual tax rates have also been reduced but not as significantly (from 39.7% to 37%). This disparity in the effective tax rates creates some interesting challenges for planning executive compensation.
Tax Act impact on C Corps: With individual rates so much higher than corporate rates, C Corps who have owner executives may desire to leave the profit in the C Corp (and pay the corporate tax on earnings) rather than distributing out the profit in the form of bonuses (reducing
corporate earnings) and paying the tax as individuals. By doing so, the overall annual tax burden may be reduced. The company can retain profits with a lower 21% tax rate compared to the higher 37% income tax rates on individuals.
Note: Bonuses may only be deducted by a C Corp to the extent the compensation is reasonable based on the value of services delivered. Also, C Corps paying bonuses to its shareholders must consider the amount of the bonuses in relation to the ownership of the stock.
However, paying bonuses remains the more efficient way to distribute earnings from the C Corp when compared to paying dividends. The C Corp gets a deduction for bonuses paid and the owner executive pays ordinary rates up to 37% plus employee Medicare taxes up to 2.35% and employer Medicare taxes of 1.45%. Thus, the total burden is about 41%. If the company paid non-deductible dividends, the tax load would be 21% on the company plus the 20% individual tax on qualified dividends and the HCA tax of 3.8% on the dividends for a total of almost 45% tax. Note these relative costs (41% versus 45%) are much closer than they used to be!
Illustration: Personal service businesses often choose to be a C Corp and manage the corporate income to low levels by paying the owners bonuses each year. Under the prior rates, taking a tax deduction in the C Corp at 35% was offset with an individual tax of up to 39.7%….not a big difference. With the new tax rates, C Corps may retain profits at a much lower tax rate, 21%, while owner executives avoid paying tax on the income at up to 37%. Rather than bailing out the earnings each year in the form of bonuses, the annual tax burden may be reduced by having the C Corp retain its profit. Bonuses could be paid in future years, if desired, as long as the compensation is reasonable based on the value of services delivered that year. Pursuing this strategy will place more importance on the company’s buy sell agreements including the valuation of the business. If significant amounts of compensation are foregone, an exiting owner executive would expect the value of his or her stock to be greater reflecting the value of the foregone compensation.
Tax Act impact on S Corps and LLCs: Life has gotten really complicated for owner executives of pass through organizations. New IRC Section 199A has introduced a 20% deduction for qualified business net income of pass through entities and sole proprietorships. The deduction is designed to lower rates on business income of pass throughs similar (at least in philosophy) to the rate relief provided C Corps. A pass through owner in the 37% tax bracket who receives the 20% deduction would pay a 29.6% tax on the pass through income. The complication is in the rules which define and limit the amount of the 20% deduction. A detailed discussion of these rules is beyond the scope of this article. Suffice it to say, the rule makers were concerned about tax planning strategies whereby personal service providers would “convert” personal service income to qualified business income taxed at the lower tax rates.
Under the tax rules before the recent Tax Act, owner executives generally paid the same rate of tax on wages as distributable business net income. One difference is in the payroll taxes…Medicare taxes of 1.45% (2.35% when wages exceed $200,000) apply to wages but not necessarily to distributable net income. This provides some incentive to minimize wages. Based on our experience, owner executives still pay themselves competitive levels of wages, at least sufficient to optimize qualified plan contributions and benefits.
Going forward, when S Corp and/or LLC owner executives are eligible for the 20% deduction, the difference in marginal rates will provide an even greater incentive to minimize wages in favor of a larger share of distributable net income. This must be weighed against other important factors including 1) optimizing the value of any qualified plan deductions and benefits, and 2) recognizing the appropriate value for services rendered by each of the owner executives who may have different levels of ownership and hold different jobs (with different values).
When S Corp and/or LLC owner executives are not eligible for the 20% deduction (such as when it phases out based on taxable income levels), there should be no difference in tax rates on wages (versus the distributable share of net income) other than the Medicare taxes. Compensation planning will likely proceed as it did prior to the Tax Act, for pass through organizations. There should be no significant incentive to minimize wages in order to receive a larger share of distributable net income.
Nonqualified Deferred Compensation Planning
Many private companies have created nonqualified deferred compensation plans (NQDCPs) for their executives. These plans serve different objectives such as delivering supplemental retirement income, providing retention incentives and/or aligning business owners and non-owner executives through long term compensation such as phantom stock. NQDCPs allow an executive to defer income tax on deferred wages under prescribed rules by requiring the employer to defer the related tax deduction. Prior to the recent Tax Act, the tax rates on business income have been close to the individual tax rates. Thus, the value (benefit to the executive) of deferring the compensation has been closely matched by the value (cost to the company) of postponing the deduction on the deferred compensation. The lower rates on business income under the Tax Act have reduced the cost of these plans to employers making them more cost efficient.
The original Tax Act proposals would have eliminated nonqualified plans altogether. Thankfully, wiser heads prevailed in Congress. Since these plans have come to play a critical role in attracting, retaining and rewarding executive talent in private companies, eliminating deferred plans as a tool for business owners would have created significant HR challenges.
In C Corps, delivering nonqualified deferred compensation is pretty straight forward. The C Corp is a taxpayer. It provides the deferred compensation and bears the cost of deferral through paying taxes on the amounts retained to pay future deferred liabilities. With the lower tax rate assured under the Tax Act, the cost of deferrals is lower. The plan designs are typically supplemental retirement benefits, long term incentive arrangements or phantom stock. Under the Tax Act as passed, these plans should proliferate.
Equity Compensation Planning
The Tax Act left intact most of the rules on taxation of stock transfers in connection with the performance of services under IRC Section 83; therefore, equity tax planning for private company executives should not change significantly. The Tax Act introduced a tax deferral opportunity for eligible stock delivered to qualified employees. The tax deferral opportunity is only available when private companies make broad based (to greater than 80% of employees) stock or option transfers. Given the restrictions, we do not expect widespread use of this tax deferral opportunity.
The Role of Compensation Philosophy
Companies should plan their executive compensation consistent with their overall philosophy on delivering compensation. This generally means paying competitive base salaries and incentives that are delivered in a tax effective manner. Such a philosophy can also serve companies and their owner executives. Executive compensation decisions which are motivated solely based on tax results should be avoided.
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Findley Perspective, Human Capital