Although the key feature of the Emergency Economic Stabilization Act of 2008 (Act) is the establishment of the Troubled Assets Relief Program (TARP) to restore liquidity and stability to the financial system, the Act as signed into law also contains many important tax provisions. In this alert, members of Foley’s Tax & Employee Benefits Practice summarize the key tax provisions of the Act, as interpreted by United States Department of the Treasury in Notice 2008-94.
Tax Treatment of Executive Compensation for Participating TARP Entities
The Act includes rules that modify the tax treatment of executive compensation paid by institutions that participate in TARP. These tax provisions are in addition to direct restrictions on executive compensation paid by such participants and apply only if the taxpayer (hereinafter, “a participating institution”) is a member of a controlled group of corporations or commonly controlled businesses that sells (in the aggregate) more than $300 million of troubled assets to the government. In determining whether a controlled group has reached the $300 million threshold, the Act excludes direct sales to the government; however, this exclusion only applies if direct sales are the only means by which the group’s troubled assets are acquired by the government.
Limits on Deductibility of Compensation
The Act expanded Section 162(m) of the Internal Revenue Code (Section 162(m)), which generally places a $1 million limitation on the deductibility of compensation paid by publicly held corporations to their chief executive officers and their four highest paid officers. Under the amendment, a participating institution is disallowed a deduction for annual compensation (including deferred compensation) in excess of $500,000 that it pays to a “covered executive” in respect of services performed in any year during the term of the Act.
The Act applies the $500,000 limitation in a substantially different manner than the general $1 million limitation under Section 162(m). Ordinarily, the Section 162(m) limitation applies only to publicly held corporations and does not apply to commission- or performance-based compensation (or to certain grandfathered compensation arrangements). By contrast, the $500,000 limitation added by the Act applies to both privately and publicly held entities and permits no exception for commissions, performance-based compensation, or grandfathered compensation.
Another difference relates to the manner in which the limitation is calculated. The general $1 million limitation under Section 162(m) is calculated on the basis of total compensation paid during the year (other than excepted compensation) regardless of when the compensation was earned. By contrast, the $500,000 limitation is calculated with respect to the year in which the compensation is earned, not the year it is paid, and amounts attributable to the growth in deferred compensation for the passage of time such as an increase for interest or investment returns, fully count against the limitation. Thus, deferred compensation allocable to services performed in a year covered by the Act (including a growth factor) may not be deducted when paid in a later year to the extent that it causes the total compensation for the services performed in the earlier year to exceed $500,000.
According to Notice 2008-94, deferred compensation paid during a year is “allocable” to services performed in an earlier year if the executive possessed a “legally binding right” to such remuneration based upon a formula that relates to services performed in the earlier year. For example, if an executive acquires a legally binding right to receive remuneration that is tied to the amount of compensation earned during a particular year, the deferred compensation is allocable to the services performed in such year. Notice 2008-94 indicates that an executive does not have a legally binding right to future remuneration for this purpose if the employer has discretion to reduce or eliminate the compensation unilaterally after the services are performed, unless the employer’s right is exercisable only on a condition or the employer’s discretion “lacks substantive significance.” It also indicates that a “risk of forfeiture,” that is, a condition that makes payment of the deferred compensation dependent on the performance of future services, does not prevent the right to the compensation from being “legally binding.” Rather, in this situation, the compensation generally must be allocated pro rata over the period of time the employee is required to perform such services.
The $500,000 limitation does not apply to (1) compensation for services performed in years prior to the first year the employer becomes subject to the limitation as a result of its participation in TARP, or (2) compensation earned in a year after the term of the Act. The Act is due to expire on December 31, 2009, but can be extended. Accordingly, a participating institution (or any institution that may become one during the term of the Act) will need to track the years to which deferred compensation relates.
For purposes of the tax provisions of the Act, a “covered executive” includes the chief executive officer (CEO), chief financial officer (CFO), and any employee (other than the CEO and CFO) who is one of the three most highly paid executives (determined under the proxy disclosure rules, whether or not such rules apply) during any portion of a taxable year in which the Act is in effect. Once an individual is determined to be a covered executive, he or she will remain a covered executive for the duration of the term of the Act and afterward with respect to deferred compensation. Thus, an executive who is one of the three most highly paid executives in a year covered by the Act remains a covered executive in later years covered by the Act, even if he or she ceases to be one of the three most highly paid executives in such years.
The Treasury Secretary is authorized to prescribe guidance, rules, or regulations necessary to carry out the purposes of these provisions, including to cover the case of any acquisition, merger, or reorganization of a participating employer.
Tax Treatment of Severance Payments
The Act also amends Section 280G of the Internal Revenue Code (Section 280G) to treat severance payments by a participating institution to covered executives (i.e., the CEO, CFO, and their highest paid executives) as “parachute payments.” Under the revised Section 280G, if the present value of the severance payments to a covered executive equals or exceeds three times the executive’s average annual compensation during the base period (the “base amount”), then the excess of such payments over the base amount will be nondeductible. Additionally, the covered executive will be subject to a 20-percent excise tax under Section 4999 of the Internal Revenue Code on the same amount.
The provision only applies if the severance occurs during the term of the Act and as a result of the involuntary termination of the executive or in connection with any bankruptcy, liquidation, or receivership of the employer. Thus, unlike the rest of Section 280G, it applies in the absence of a change of control of the employer. Whether a payment is made on the account of the employee’s “severance” is determined in the same manner as under present law. Thus, a payment should not be considered a severance payment if the payment would have been made at that time without regard to the termination of employment, or if the payment would have been made with respect to a voluntary termination.
Several of the exceptions that enable taxpayers to avoid Section 280G do not apply to severance payments by a participating institution to a covered executive. For example, under the amendment, the small business corporation exception does not apply to severance paid by a participating institution to a covered executive and, consequently, the $500,000 limitation applies to entities that are not normally subject to the golden parachute payment rules such as S corporations and corporations eligible to be S corporations. Similarly, a participating institution cannot escape Section 280G by obtaining shareholder approval of the severance payment. Additionally, the amendment does not provide an exclusion for reasonable compensation for services provided prior to or after the date of severance. Consequently, payments attributable to a post-severance non-competition agreement will be treated as severance benefits.
Noticeably absent from the Act are definitions of “severance” and “involuntary termination.” The meaning of the latter term is critical, since both the participating institution and the covered executive have an incentive to characterize any termination as a voluntary termination. In Notice 2008-98, the Internal Revenue Service (IRS) provided some preliminary guidance on the meaning of involuntary termination. Under Notice 2008-98, an executive will be deemed to undergo an involuntary termination if his or her employment is terminated unilaterally by the employer notwithstanding the executive’s willingness and ability to continue providing services. Thus, an involuntary termination can include the employer’s failure to renew the executive’s employment contract if the executive was willing to remain employed under substantially the same terms and conditions. Notice 2008-94 suggests, however, that an employer’s termination of an executive may not be involuntary if it is due to the executive’s “implicit or explicit request” to be terminated. Notice 2008-94 also states an executive’s termination for “good reason,” due to a material negative change in the executive’s relationship with the employer, constitutes an involuntary termination. In addition, an apparently voluntary termination of employment can be an involuntary termination if the facts and circumstances indicate that the employer would have terminated the executive and the executive had “knowledge” that he or she would be terminated.
Both participating institutions and their executives should pay careful attention to the precise language used in any contractual provisions relating to limits on parachute payments or providing for tax gross-up payments by the employer. Many such provisions are active only upon a change of control of the business and, therefore, may not apply to severance covered by this amendment.
In the case where an actual change of control occurs, the normal Section 280G rules apply without regard to the amendment. Through a quirk in the drafting of the definitions, however, the severance rules may still apply to an actual change of control if the participating institution is an S corporation.
The Treasury Secretary is authorized to prescribe guidance, rules, or regulations necessary to carry out the purposes of these provisions, including to cover related corporations and personal service corporations.
Nonqualified Deferred Compensation From Tax-Indifferent Parties
The Act makes another change to the treatment of compensation that is unrelated to TARP. This change concerns deferred compensation arrangements maintained by non-U.S. taxpayers who are indifferent to the availability and timing of a deduction for the deferred compensation. Although existing Section 457(f) accelerates recognition of deferred compensation income not subject to a substantial risk of forfeiture if the service recipient is a governmental body or a Section 501(c)(3) or other tax-exempt entity, it does not apply if the service recipient is foreign. The Act adds a new Section 457A to the Code to fill this gap. New Section 457A supplements, but does not replace, Section 409A and other provisions of the Code and regulations governing deferred compensation.
Acceleration of Deferred Compensation
Under the new Section 457A, compensation deferred by a service provider under a “nonqualified deferred compensation plan” that is covered by Section 457A must be included in income as soon as the compensation is no longer subject to a substantial risk of forfeiture, unless such compensation is paid within 12 months after the end of the taxable year of the service recipient during which the right to such compensation is no longer subject to a substantial risk of forfeiture. Where the amount of the deferred compensation is not “determinable” at the time it is first no longer subject to a substantial risk of forfeiture, taxation continues to be deferred until it is determinable. However, the service provider incurs a steep price for this additional deferral in the form of an additional 20 percent tax on the deferred compensation, plus interest (at the underpayment rate, plus one percent). The circumstances under which deferred compensation is not determinable are yet to be defined in regulations.
Section 457A does not apply to compensation paid by a foreign entity that would have been deductible by such foreign entity against income effectively connected with a U.S. trade or business if the compensation had been paid in cash on the date that the compensation ceased to be subject to a substantial risk of forfeiture. It also does not apply to a deferred compensation plan of a foreign entity if the compensation is payable to an employee of a domestic subsidiary of such entity and is reasonably expected to be deductible by the subsidiary under Section 404(a)(5) when such compensation is includible in income by such employee.
Nonqualified Deferred Compensation Plan
Whether compensation is deferred under a nonqualified deferred compensation plan for Section 457A purposes is generally determined in accordance with the same standards that apply under Section 409A. Thus, Section 457A does not apply to incentive stock options or options granted under an employee stock purchase plan, nor does it apply to a nonqualified stock option with a strike price that is not less than the fair market value of the underlying stock on the date of grant, or to a transfer of property to which Section 83 applies (such as a transfer of restricted stock), provided the arrangement does not include a deferral feature. However, any other arrangement under which compensation is based upon the increase in value of a specified number of equity units of the service recipient (regardless of exercise price) is a nonqualified deferred compensation plan covered by Section 457A. Thus, for example, Section 457A applies to stock appreciation rights.
Section 457A applies only if the nonqualified deferred compensation plan is maintained by a nonqualified entity, defined to include any foreign corporation unless substantially all of its income is effectively connected with a U.S. trade or business (and therefore taxable in the United States) or subject to a “comprehensive foreign income tax.” Income of a foreign corporation is deemed to be subject to a comprehensive foreign income tax only if the foreign corporation (i) is eligible for the benefits of a comprehensive income tax treaty between the foreign country imposing the tax and the United States or (ii) demonstrates to the satisfaction of the Treasury that the foreign country has a comprehensive income tax. Significantly, Section 457A does not impose any requirement with respect to the timing of any compensation deduction under the foreign tax law.
The term nonqualified entity also includes any partnership unless substantially all of its income is directly or indirectly allocated to persons other than (i) foreign persons with respect to whom such income is not subject to a comprehensive foreign income tax and (ii) tax-exempt organizations. Literally, this means that the admission to a partnership of foreign partners not subject to a comprehensive foreign income tax will subject deferred compensation from the partnership to Section 457A, even if the income allocated to the foreign partners is effectively connected with a U.S. trade or business (and therefore subject to U.S. tax). Section 457A should not impact investment partnerships or funds with domestic tax exempt entities as investors as long as the tax exempt entities use one or more blocking C corporations to own their interests.
Under Section 457A, aggregation rules similar to those that apply under Section 409A will apply for purposes of determining whether a deferred compensation plan sponsor is a nonqualified entity. The legislative history indicates, however, that the aggregation rules should not cause Section 457A to apply to a nonqualified deferred compensation plan of a foreign corporation that is not a nonqualified entity on a standalone basis, but is a member of a controlled group that includes nonqualified entities, to the extent of deferred compensation expenses that are properly allocable to such corporation.
“Substantial Risk of Forfeiture”
For purposes of new Code Section 457A, compensation is subject to a substantial risk of forfeiture only if the rights to such compensation are conditioned upon the future performance of substantial services. However, the Treasury is authorized to expand the definition of substantial risk of forfeiture to cause compensation based solely upon gain recognized on the disposition of an investment asset to be treated as subject to a substantial risk of forfeiture until the date of disposition of that asset. For this purpose, an investment asset is any single asset (other than an investment fund or similar entity) (1) acquired directly by an investment fund or similar entity, (2) with respect to which neither such entity nor any person related to such entity participates in the active management of such asset (or if such asset is an interest in an entity, in the active management of the assets of such entity), and (3) substantially all of the gain on the disposition of which (other than the nonqualified deferred compensation) is allocated to investors of such entity. The legislative history indicates that for this purpose, active management includes participation in the day-to-day activities of the asset, but does not include the election of directors or other voting rights exercised by shareholders.
The exception for deferred compensation based upon gain with respect to an investment asset applies only if the compensation is determined solely by reference to the gain upon the disposition of the investment asset. Thus, for example, it does not apply in the case of an arrangement under which the amount of the gain upon which the deferred compensation is based is reduced for losses on the disposition of any other asset.
Section 457A is effective for deferred amounts that are attributable to services performed after December 31, 2008. However, deferred amounts that are attributable to services performed before January 1, 2009 are generally includible in an individual’s gross income in the later of (i) the last taxable year of the individual beginning before 2018 or (ii) the taxable year in which there is no substantial risk of forfeiture of the rights to such compensation, if not included before then. Earnings on deferred amounts that are attributable to pre-2009 services are subject to Section 457A only to the extent that the amounts to which such earnings relate are subject to Section 457A.
Energy Tax Provisions
A package of energy tax incentives was added to the Act at the last moment to sweeten the Act for several members of Congress. The incentives include key extensions of expiring credits for renewable energy investments, provisions that have had broad bipartisan support but have been in political limbo for many months as they were attached and then removed from several bills over the past year. The Renewable Electricity Production Tax Credit (PTC) and the Energy Investment Tax Credit (ITC) have been key to the development of green power in the United States in recent years. Their expiration at the end of 2008 would have resulted in a loss or postponement of billions of dollars of new investment in renewable energy resources. The latest iteration of the extension of the energy tax incentives was in the proposed Energy Improvement and Extension Act of 2008. A variation of this bill became Title B of the Act.
Renewable Energy Incentives
One-Year Extension and Modification of the PTC. The key and most costly provision of the bill was an extension of the last day for placing in service property eligible for the PTC to December 31, 2009 for wind and refined coal, and to December 31, 2010 for all other qualifying sources (including open and closed-loop biomass, hydropower, geothermal, small irrigation, solar, and municipal solid waste from landfill gas facilities). The PTC also was expanded to include new biomass facilities and marine renewables (waves and tides) placed in service after October 3, 2008.
Long-Term Extension of the ITC. The other key provision for the renewable energy industry was an eight-year extension of the 30-percent ITC for solar energy property and qualified fuel cell property and the 10-percent ITC for microturbines and geothermal facilities, through December 31, 2016. The Act increases the ITC cap for qualified fuel cell capacity from $500 per one-half kilowatt hour to $1,500. The Act also expands the 10-percent ITC to include combined heat and power systems, qualified small wind property (capped at $4,000 per taxpayer) and geothermal heat pump systems. The energy ITC can now be claimed by public utilities under the Act, and the energy ITC will be allowed to offset the alternative minimum tax (AMT).
Long-Term Extension and Modification of the Residential Energy-Efficient Property Credit. The Act extended through 2016 the 30-percent income tax credit for residential solar property and eliminated the current $2,000 cap on the credit, effective for solar electric energy property placed in service after December 31, 2008. It also expanded the credit to cover small wind systems and qualified geothermal heat pump property. The residential credit will be available for offset against the AMT for tax years beginning after 2007.
Other Tax Provisions
In addition to extending and expanding renewable energy incentives, the Act included a number of carbon mitigation and coal provisions, transportation provisions, and energy conservation provisions. Among these tax provisions are:
- A credit for plug-in electric drive vehicles equal to $2,500 plus $417 for each kilowatt hour of traction battery capacity in excess of four kilowatt hours. There are limits on the amount of the credit ranging from $7,500 for vehicles under 10,000 pounds to $15,000 for vehicles over 26,000 pounds.
- Extension through 2009 of the biodiesel PTC for small biodiesel producers and the credit for diesel fuel created from biomass. The biodiesel credit also was modified to eliminate the disparity between biodiesel and agri-diesel, and to eliminate the requirement of a certain production process.
- A new 50-percent bonus depreciation allowance for qualified reuse and recycling property placed in service after August 31, 2008.
- Extension of the lifetime income tax credit of up to $500 for qualifying energy-saving improvements to a personal residence through 2009 and addition of energy-efficient biomass fuel stoves to the list of qualifying property (subject to a $300 credit limit).
- Extension of the energy-efficient buildings deduction through 2013 and extension of the credit for energy-efficient improvements to new homes through 2009.
- Extension through 2010 of the credit for energy-efficient appliances and modification of the amount of the credit.
- Provision for accelerated depreciation as 10-year property of smart electric meters and qualified smart electric grid systems (previously 30-year class life property).
- Treatment of qualified bicycle commuting reimbursements as qualified fringe benefits for tax years beginning after December 31, 2008.
To offset part of the cost of the energy incentives, the Act includes several revenue offsets. Three of the offsets are addressed primarily to oil companies — limiting the Code Section 199 deduction for oil and gas producers to three percent for tax years beginning after 2009; eliminating the different treatment of foreign oil and gas extraction income and foreign oil-related income; and increasing the per-barrel rate of contributions to the Oil Spill Liability Trust Fund. Another offset is a one-year extension of the 6.2 percent federal unemployment tax rate on payroll through 2009, after which it will revert to six percent.
Other Changes and Extenders
The Act provides temporary AMT relief by increasing the exemption amounts. The new AMT exemption amounts are $69,950 (from $66,250 in 2007) for married couples filing joint returns and $46,200 (from $44,350 in 2007) for individual filers.
The Act also loosens the limitations on unused minimum tax credits to allow the credit to be claimed over a two-year period (rather than five years), and eliminates the adjusted gross income phase-out in connection with the credit.
The Act provides relief for individuals with AMT income attributable to the exercise of incentive stock options (ISOs). Any underpayment of tax, penalties, and interest attributable to the pre-2008 exercise of ISOs is abated. Individuals who already paid such amounts will receive a refund in the form of a credit spread over the years 2008 and 2009.
The Act also extends the application of a variety of nonrefundable personal tax credits to 2008.
Brokers Reporting of Basis on Form 1099
Brokers who file a Form 1099 will be required to include the taxpayer’s adjusted basis and whether the gain or loss is short-term or long-term. Generally, the default method of determining basis will be first-in first-out unless the taxpayer indicates otherwise to the broker. The basis of such securities generally will be determined on an account-by-account basis. Exceptions for wash sales apply. This rule becomes effective January 1, 2011 for most stock and January 1, 2013 for most other financial instruments.
Issuers of any share of stock, note, or bond in a corporation as well as issuers of a commodity contract or financial instrument must report changes in basis to taxpayers after certain transactions (i.e., stock splits, mergers, and acquisitions) that impact the taxpayers’ basis. This rule is phased-in similarly to the broker rule above.
For banks, small business investment companies, business development corporations, depository institution holding companies, and certain other financial institutions, the sale of Fannie Mae or Freddie Mac stock is treated as ordinary income (loss) instead of capital income (loss).
Tax Return Preparer Penalty
The general standard for imposing preparer penalties has been changed from “more-likely-than-not” to “substantial authority” so that the same standard that applies to tax filers now also applies to tax return preparers.
The New Market Tax Credit has been extended through 2009, and the research credit was extended until January 1, 2010. The latter extension applies retroactively to research costs incurred since December 31, 2007.
The Act extends the tax-free treatment of qualified charitable distributions from traditional or Roth Individual Retirement Accounts (IRAs) for tax years 2008 and 2009. Thus, taxpayers age 70 ½ or older may exclude up to $100,000 of IRA distributions per year that are paid directly to a qualified charitable organization.
The Act extends the mortgage forgiveness exclusion to January 1, 2013. This provision is an exception to recognition of income on the cancellation of indebtedness. Any income from the discharge (in whole or in part) of qualified principal residence indebtedness is excluded from gross income (but applied to reduce the adjusted tax basis of the residence).
Special rules that increase corporate charitable deductions for donations of certain property (computer property and food inventory that will be used for the care of ill, the needy, or infants) also have been extended by the Act.
Section 512(b)(13) of the Internal Revenue Code subjects certain payments from a subsidiary to a parent exempt organization to the unrelated business income that would otherwise be excluded. The special exception applies for certain contracts entered into before August 17, 2006 is extended to December 31, 2009.
The Act implements a number of disaster area relief provisions, including waiver of the 10-percent of adjusted gross income (AGI) limit on personal casualty losses for federally declared disasters for tax years 2008 and 2009, and permission for the expensing, rather than capitalizing, of qualified disaster expenses and increases the expensing for qualified disaster assistance property under Section 179 of the Internal Revenue Code. In addition, the Act includes a number of temporary tax relief provisions specific to the Midwestern disaster area, which generally includes areas declared by the president where a major disaster occurred (e.g., Wisconsin, Illinois, Michigan, Minnesota, and Indiana). These temporary provisions include items such as rehabilitation credits and extended net operating loss carryback periods.
Legal News Alert is part of our ongoing commitment to providing up-to-the-minute information about pressing concerns or industry issues affecting our clients and colleagues.
If you have any questions about this alert or would like to discuss the topic further, please contact your Foley attorney or:
John B. Palmer III
Timothy L. Voigtman
Michael H. Woolever