The election is over, the votes have been counted, and the consensus is that Joe Biden – from the Democratic Party ticket – has won the presidency. Control of the House of Representatives will remain with the Democratic Party, and a special election in Georgia will decide the fate of the Senate majority in early January. Even if the Democratic Party does not gain control of the Senate, President-Elect Biden will be keen to push his policies and priorities through Congress once he becomes the 46th President of the United States on January 20, 2021. This includes his tax plan, which calls for numerous changes to the tax system, including changes impacting the taxation of executive compensation.
With respect to such executive compensation, the Biden tax plan takes the following two-fold approach for increasing taxes on individuals who earn more than $400,000 per year:
• The top federal income tax bracket would be increased from 37% to 39.6% for high earners; and
• A brand new 12.4% Social Security tax would apply on certain wages (and earnings from self-employment) for high earners.
The 39.6% federal income tax rate is fairly simple to follow, in that, it basically represents a reinstatement of the top tax bracket that applied prior to the Trump tax cuts in 2018.[1] Under the Biden tax plan, however, this 39.6% rate would apply on income above $400,000.
The new Social Security tax is far more complicated, because it basically imposes a new “doughnut hole” tax regime on a high earner’s wages (and earnings from self-employment). Under Biden’s tax plan, this “doughnut hole” would apply as follows:
• The existing 12.4% Social Security tax would remain unchanged for wages (and earnings from self-employment) up to the regular Social Security wage base ($142,800 for 2021) – incidentally, this is how the Social Security tax laws currently operate;
• There would be no Social Security tax for wages (and earnings from self-employment) between the regular Social Security wage base (noted above) and $400,000 – this limited amount of wages (and earnings from self-employment) is the “doughnut hole” that is exempt from Social Security taxes; and
• A brand new 12.4% Social Security tax would be triggered for all remaining wages (and earnings from self-employment) that exceed $400,000 – this is a major departure from how Social Security taxes have applied in the past.
Note that this 12.4% Social Security tax would be split 50/50 for any high earners who are employees. Under this 50/50 split, the employee and employer would each be responsible for a 6.2% Social Security tax (which adds up to 12.4%). Self-employed individuals, however, remain responsible for the entire 12.4% tax.
To put all of this in context, the new top rate and “doughnut hole” tax regime basically result in a new 15% tax (i.e., 12.4% + (39.6% – 37%)). This new 15% tax applies on all applicable executive earnings that exceed the $400,000 amount described above. For instance, for every $500,000 an executive earns in excess of this $400,000 amount (i.e., after taking into account all applicable tax deductions, exclusions, etc.), an additional $75,000 tax will be triggered as follows:
• $13,000 in additional federal income taxes will apply to the executive under the new top rate;
• $31,000 in additional Social Security taxes will apply to the executive under the new “doughnut hole” tax regime; and
• $31,000 in additional Social Security taxes will apply to the executive’s employer or the executive under the new “doughnut hole” tax regime, depending on whether the executive is an employee or self-employed, respectively.
Ultimately, it remains to be seen if the new top rate and “doughnut hole” tax regime ever become law. The momentum behind enacting the Biden tax plan may stall if the Democratic Party does not gain control of the Senate in January’s special election. However, the Trump tax cuts will sunset at the end of 2025, and both political parties usually have an interest in preserving tax cuts for the middle class. Thus, even if the Senate does not come under Democratic Party control, it is possible that the new top rate and “doughnut hole” tax regime find their way into bipartisan tax legislation that seeks to preserve (and fund) the Trump tax cuts for the middle class on a permanent basis. A similar scenario played out in 2012 with the fiscal cliff negotiations (i.e., the sunset of the Bush tax cuts) involving the Obama administration and Republican congressional leaders in late 2012, so history could repeat itself with respect to the sunset of the Trump tax cuts at some point in the next 5 years.
Whenever taxes are expected to increase, employers often look for ways to mitigate the effects of the tax increase on their executives. This typically involves employers seeking to amend or enter into new executive compensation arrangements with their executives. In either event, the employer’s goal is to pay compensation amounts at a time when the tax increase does not affect the executive. Often, this involves employers accelerating the payment of amounts under existing bonus and incentive compensation programs prior to the time the tax increase takes effect. In other cases, employers implement arrangements (either as new or amended arrangements) that seek to delay the payment of compensation to a future year, such as a year when the executive might be in a lower tax bracket (e.g., after the executive’s retirement).
It should be noted, that taking the above actions is not without risk. The employer must ensure these actions comply with the detailed provisions of Section 409A of the Internal Revenue Code, which were enacted in the wake of the Enron scandal. Failure to comply with Section 409A triggers costly tax penalties, most of which are imposed on the executive. As a result, employers often lean heavily on their lawyers, consultants and accountants when the above actions are under consideration.
This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.
[1] These Trump tax cuts are set to expire at the end of 2025, meaning that the 39.6% tax rate is eventually set to return, regardless of whether the Biden tax plan becomes law.
