For starters, the Internal Revenue Code (IRC) limits the deductibility of compensation given to some “covered workers” of publicly listed firms to $1 million per year. Section 162(m)(3) defines “covered personnel” as the company’s chief executive officer, chief financial officer, and anybody who served in either job during the taxable year, as well as three additional highest-paid workers. Individuals who were covered employees for a tax year starting after December 31, 2016, will continue to be covered employees for all future taxable years, according to the guidelines. This effectively means that an employee’s status as a covered employee will never end, even if she or he no longer works for the company or is no longer among the company’s five highest paid employees, and any compensation, including post-termination compensation, paid by the company to the individual in excess of $1 million per year will not be deductible and will be subject to the corporate tax of 21%. (i.e., current corporate tax rate). For tax years starting after December 31, 2026, the American Rescue Plan Act (P.L. 117- 2, 3/11/21) amended the phrase “covered workers” to include an additional five of the highest paid employees.

Eversince the implementation of the Tax Cuts and Jobs Act (“TCJA”) in 2017, qualified performance-based compensation, which was previously excluded from the deduction limits, has been included in the remuneration subject to the $1 million deduction limit. However, the TCJA has a provision that permits some written contractual employment agreements in place on November 2, 2017, to be grandfathered under the previous system provided they have not been considerably amended or renewed since then. Accurate recordkeeping is essential for monitoring and substantiating payments to workers under grandfathered agreements from year to year until retirement, ensuring that such payments may be deducted in excess of the $1 million cap.

Nonqualified deferred compensation (“NQDC”) arrangements are governed by IRC section 409A. If a nonqualified deferred compensation plan fails to fulfill the requirements of section 409A at any point during a taxable year, the law states that any pay deferred under the plan must be included in the employee’s or service provider’s taxable income for the year, plus a 20% excise tax. There may also be late payment penalties and interest on the taxable amount, all of which are due by the deferred compensation recipient. Section 409A is complicated and broad, affecting the design of benefit programs, severance compensation arrangements, and employment contracts, to mention a few.

It is necessary to grasp the concept of constructive receipt in order to fully understand section 409A. The employee’s income is taxed at the time of his or her constructive receipt. The compensation must be exposed to a high risk of forfeiture to prevent constructive receipt. In other words, “entitlement to the amount is contingent on the execution of substantial future services by any person or the occurrence of a condition relevant to a compensating purpose, and the risk of forfeiture is significant.” [IRC Reg §409A-1(d)(1)] Compensation is considered vested when there is no longer a significant danger of forfeiture. Deferred compensation, on the other hand, is pay earned in one year but paid out later, i.e., an employee or service provider has a “legally binding right during a taxable year to compensation that, pursuant to the terms of the plan, is or may be payable to (or on behalf of) the service provider in a later taxable year.” [IRC Reg §1.409A-1(b)(1)].

There are certain exceptions, including one for short-term deferrals [IRC Reg §1.409A-1(b)(4)]. The primary distinction between qualified and nonqualified plans is that qualified programs [IRC §401(a)] , including as 401(k) plans, are designed to offer benefits to a wide range of workers. A qualifying plan requires the creation of a trust, which is supported by contributions from either the employer or the employee. An unfunded NQDC plan, on the other hand, does not have its own separate trust established, and the funds for deferred compensation are mixed in with and paid out of the employer’s general assets, which have little to no protection from the employer’s general creditors and would be subject to a creditor’s claim in the event of the company’s insolvency. NQDC plans are a useful method for distinguishing CEO salary from that of normal workers. In comparison to qualified plans, a company has more freedom in designing NQDC plans. Corporations may choose which of its workers are eligible to enroll in such plans, and deferrals from contributions to NQDC plans are limitless. Employer-owned life insurance policies and supplementary executive retirement plans, or SERPs, are examples of NQDC plans.

The income tax obligation for remuneration earned under a NQDC plan that conforms with the rules of section 409A may be delayed to a later date. These are the specific provisions:

– The plan must be written down.

– The plan document(s) must state at the time an amount is deferred: the payment amount,  the payment plan; and the event(s) that will cause payment to occur.

– Before the year in which the compensation is received, the employee must make an irreversible option to postpone compensation. There are usually no possibilities for early withdrawal, and payment cannot be accelerated.

While income tax is postponed until the funds are given to the beneficiary (constructive receipt), employment tax (such as social security and Medicare) is due at the time of vesting. However, since nonqualified deferred compensation plan members are often highly paid workers, their incomes are typically substantially over the social security pay base, therefore, the Medicare tax may be the only employment tax that applies during the year of vesting.

Employers may not claim a current deduction on their contributions to NQDC plans until the benefits are given out to participants and the participants are taxed on them, in the same way that income tax is postponed for participants. Furthermore, rather than compounding tax-deferred, all investment returns under the programs are taxed immediately to the employer.

Stock-based compensation, such as restricted stock units, phantom stock, and the like, is also subject to section 409A because it represents an unencrypted, unfunded guarantee by the employer to grant a set number of shares of stock or pay the cash equivalent to the employee or service provider upon the fulfillment of set performance criteria. If the exercise price of nonqualified stock options (“NSOs”) or stock appreciation rights (SARs) is less than the fair market value, they are called NQDC. They must comply with the requirements of Section 409A outlined above to avoid taxes at the time of grant. Stock rights, including stock appreciation rights, do not allow for income deferral since they are not subject to a considerable risk of forfeiture as defined by Reg 1.409A-1.

To put things in perspective, section 409A was enacted in 2005 in response to years of corporate mismanagement of deferred compensation programs, most notably in the instance of Enron, which saw its leaders’ deferred compensation payouts accelerated on the eve of the company’s implosion. Section 409A attempted to address the then-common practice of firms giving workers stock options that were already “in the money,” or options having a strike price lower than the FMV of the underlying shares at the time of issuance, in addition to banning unethical payment acceleration. For example, if a firm’s stock is worth $10 but the corporation offers an option to purchase it for $8, the employee receives $2 in value right away, which the government will wish to tax. The exercise price of a stock option must be set at or above FMV for it to be considered as a tax-free event for a firm’s workers, and the corporation must establish that the FMV used is fair [IRC Reg §1.409A-1(b)(5)(iv)(B)].

The FMV of a stock may not be simply determinable for privately owned corporations whose stock is not regularly traded. When private firms provide equity rewards to its workers, including founders, a valuation is necessary to establish the right exercise price for an option. In the past, a corporation would determine on its own what price they thought was reasonable. A correct value is necessary after section 409A, which requires considerable supportable evidence. If there has been a change in the company that might have substantially altered the corporation’s worth, an updated valuation must be acquired every twelve months or sooner. Determining if a major change has occurred that may have made a company’s present value outdated may be a difficult task, therefore organizations should obtain legal advice and proper valuation skills. The infusion of additional cash is perhaps the most typical occurrence that affects a startup’s value. Other occurrences, such as the introduction of a new product, macroeconomic developments (for example, as a result of COVID), or the unexpected entrance into a substantial contract, may need a fresh valuation analysis for a firm.

According to the regulations, valuations must be performed by a qualified independent appraiser with “at least five years of relevant experience in business valuation or appraisal, financial accounting, investment banking, private equity, secured lending, or other comparable experience in the line of business or industry in which the service recipient operates.” [IRC Reg §1.409A-1(b)(5)(iv)(B)(2)(iii)]

Certain statutory stock options, such as incentive stock options (“ISOs”), are exempt from Section 409A. Stock options must meet the conditions of section 422, which include, but are not limited to:

– Only workers may be given the option.

– The price of an option (exercise) cannot be less than the stock’s FMV at the time it is given (110% of FMV if granted to employees who are 10%  shareholders).

– The FMV of options vesting in a calendar year cannot exceed $100,000 (all additional options vesting will be classified as NSOs).

Employees are given favorable tax treatment by ISOs. When an ISO is granted or exercised, no compensation is recorded, and the employer does not obtain a tax deduction for the compensation. While there is no income tax on the option grant or exercise, the difference between the FMV and the exercise price is considered income for the purpose of computing the employee’s alternative minimum tax.

When it comes to executive compensation, ISOs are less common than NSOs due to the $100,000 cap. In a qualified disposal, the whole gain on sale may be taxed as long-term capital gains provided the holding period criteria are fulfilled (i.e., the employee retains shares for at least two years from the date of award and one year from the date of exercise). Compensation is deemed wages and is deductible by the employer in a disqualifying disposition if the holding time criteria are not fulfilled. Section 409A does not apply to stock options given via an employee stock purchase plan, just as it does to ISOs (ESPP). This article will not dig deeper into the mechanics of ESPPs since their objective is to promote employee ownership of company shares on a larger level and is less relevant for executive compensation. Employment taxes (such as FICA, FUTA, and FITW) do not apply to the exercise of an ISO or ESPP option, regardless of whether the exercise was a qualifying or disqualifying disposition. [Notice 2002-47]

Section 83(b) allows the receiver of property (such as restricted stock) to elect to pay taxes on the complete FMV of the restricted shares at the time of award rather than upon vesting. If made, a section 83(b) election must be made within 30 days of the restricted stock award date.[IRC §83(b)(2)]

In essence, if the value of the stock is likely to grow in future years, a section 83(b) option allows the recipient to pay ordinary income tax on a low valuation. This also permits the recipient to begin the long-term capital gains holding period sooner, allowing any appreciation between the grant date and the vesting date to be taxed at the capital gain rate rather than the ordinary income tax rate. However, if the value of the stock drops in future years or the stock is forfeited, the employee may suffer financial consequences. If the restricted stock is forfeited later, the forfeiture is viewed as a sale of the shares for no compensation. In addition, the recipient is not entitled to a deduction or credit for taxes paid as a consequence of the section 83(b) option or the property’s subsequent forfeiture. [IRC §83(b)(1), IRC Reg §1.83-2(a)]

The final point to examine is executive compensation under section 280G, also known as “golden parachute payments” because of the high payouts. Compensation made to ineligible people in connection with a change in control of the company, including severance payments, (accelerated) stock compensation, and any other sorts of benefits (i.e., change in the ownership of effective control or of a substantial portion of the assets of the corporation). Shareholders, corporate executives and directors, and highly paid persons who offer services for the business are all disqualified. [IRC §280G(c)]

Section 280G is activated if parachute payments reach three times yearly includible compensation for a base period, or base amount.  The business will lose its tax credit for the extra amount, and the disqualified person would incur a nondeductible 20% excise tax on the “excess parachute payment.” Annualized includible pay, as defined by Section 280G, is the average yearly compensation paid by the company to the employee for the previous five years (as reported on Form W-2). The amount by which combined parachute payments surpass the basic amount is known as the excess parachute payment. Simply stated, any amount of an executive’s parachute payments in excess of his or her base salary is normally liable to a nondeductible 20% excise tax after Section 280G is activated.

Evidently, invoking Section 280G restrictions may be very costly for both the company and its personnel. Companies may incorporate gross-up clauses in their severance agreements, or they may adopt such measures in preparation of a deal, from a planning standpoint. Bulk up provisions, on the other hand, may be costly and result in extra non-deductible expenditures since they effectively compel companies to gross up parachute payments in order to offset the tax impact on the CEO. There are also laws that provide shareholders an advisory vote on the topic, which will undoubtedly attract public and shareholder attention. Base amount planning, which involves exercising stock options or accelerating stock awards within the base period to effectively boost the base amount. Executives should be careful not to unintentionally trigger the 20% excise tax under Section 409A in certain situations.

It’s not every day that you encounter someone who seems to be wanting to pay extra taxes on purpose. Musk, as the company’s chief executive officer, has consistently received a minimum wage base income, according to the company’s proxy statement for 2021. He never took the monetary remuneration, and the corporation finally did away with it at his request. Musk’s salary at Tesla has always been equity-based and connected to the company’s success. The shares in question were awarded as performance-based stock option awards in 2012 and are slated to expire in 2022.

Musk beneficially held 244,018,640 shares (or 23.1%) of the company’s common stock as of June 30, 2021, according to the company’s proxy statement declarations. This includes outstanding common stock, common stock with options, and other convertible instruments.

Although Musk is not your usual CEO and his compensation package is clearly unique, executive compensation has soared to previously unheard-of levels in recent years. How many of us can imagine receiving millions, if not billions, of dollars in compensation?