Executive compensation planning for owner executives of private business after tax cuts and jobs act

Tax rate planning

The corporate tax rate applicable to C corporations (C Corps) has been reduced from 35 percent to 21 percent. Individual tax rates have also been reduced but not as significantly (from 39.7 percent to 37 percent). Individual tax rates on qualified business net income of pass through entities (S Corps, partnerships and LLCs) have been effectively reduced by 20 percent to 29.6 percent. 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 with 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 percent tax rate compared to the higher 37 percent income tax rates on individuals. 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 or dividends could be paid. 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 owner executive would expect the value of his or her stock to be greater reflecting the value of the foregone compensation.

Note: Paying bonuses remains the more efficient way to distribute earnings from the C Corp when compared to paying dividends, as illustrated in this chart. The total tax cost of paying bonuses is about 41 percent compared to 45 percent when paying dividends. Note these relative federal tax costs are much closer than they used to be … so paying dividends may be a viable strategy for some C corps.

Tax Act impact on S Corps and LLCs: The new Tax Act has introduced a 20 percent deduction for qualified business net income of pass through entities designed to lower rates on business income of pass through entities similar (at least in philosophy) to the rate relief provided C Corps. A pass through owner in the 37 percent tax bracket who receives the 20 percent deduction would pay a 29.6 percent tax on the pass through income.

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 apply to wages but not necessarily to distributable net income. This provided some incentive to minimize wages and increase distributions.

Going forward, when S Corp and/or LLC owner executives are eligible for the 20 percent deduction, the difference in marginal rates will provide an even greater incentive to minimize wages. Doing so must be weighed against other important factors including optimizing the value of any qualified plan deductions and benefits and 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).

The role of compensation philosophy

Companies should plan their executive compensation consistent with their overall philosophy on delivering compensation. This generally means paying base salaries and incentives that are delivered in a tax effective manner.

This philosophy can also serve owner executives. Executive compensation decisions should take into account the tax implications to the corporation and the individual, as an element of their overall philosophy.

• Marc Stockwell is a principal and compensation and rewards practice leader at Findley, a HR and employee benefit consulting firm.