While opinions on the Tax Cuts and Jobs Act (the “Act”) vary, one thing everyone can agree on is that it is a game changer in many areas of law and business. An example of that is how the Act affects executive compensation arrangements of publicly traded companies. The Act has amended Internal Revenue Code Section 162(m) so that if a public company pays more than $1 million in compensation to a “covered employee” in 2018 or later, that company generally will not be able to deduct the amount over $1 million. Amounts paid under agreements that were effective on or before November 2, 2017, however, may still be able to be deductible under a transition rule (assuming that the agreements are not materially modified). To manage the loss of this deduction, public companies should consider taking the following actions with respect to their executive compensation plans.
- Reevaluate the design and administration of their plans.
- Implement measures to track covered employees because once an executive is a covered employee under Code Section 162(m), that person remains a covered employee forever (including after termination of service and even after he or she is deceased).
- Encourage covered employees to consider deferring larger amounts of compensation until termination of employment or later, when compensation may be less than $1 million.
- Review their proxy statement disclosures and make any appropriate updates to reflect the changes that the Act made to Code Section 162(m).
This post will discuss these issues in greater detail below.
Overview of Changes
Before discussing how to respond to the changes to Code Section 162(m), it will be helpful to first understand what those changes are. Historically, Code Section 162(m) prohibited a public company from recognizing a tax deduction with respect to compensation paid to covered employees in excess of $1 million. If compensation qualified as “performance-based,” however, such amounts were excluded from the $1 million limit and were still deductible. The regulations under Code Section 162(m) added procedural requirements that companies needed to follow to qualify compensation as performance-based. As mentioned previously, the Act eliminates the performance-based exception. That means that beginning with payments of compensation for tax years beginning on and after January 1, 2018, any amounts (whether performance-based or not) in excess of $1 million generally will not be deductible.
The Act makes other changes as well. One is that it broadens the definition of covered employee to include the company’s CEO, CFO, and any of the next three highest paid executive officers. Previously, the CFO generally was excluded from the covered officer definition. Additionally, anyone who fits into one of these categories for any taxable year beginning after December 31, 2016, remains a covered employee for all future years, including after termination of employment or death. Previously, terminated (and deceased) employees ceased being covered employees. Finally, entities that are subject to Code Section 162(m) now include companies that are required to file reports under Section 15(d) of the Securities Exchange Act, even if they are not required to register their securities under Section 12 of the Exchange Act.
The Act includes a transition rule that essentially grandfathers future compensation paid to employees from the changes to Code Section 162(m) if the compensation is paid under a written binding contract that was in effect on November 2, 2017, so long as the terms of such contract are not materially modified on or after that date. Such contracts would continue to be governed by Code Section 162(m) as it existed before the changes made under the Act. The conference agreement under the Act adds that the fact that a plan is “in existence” on November 2, 2017, is not enough to qualify for the transition relief. Amounts must be payable under binding contracts to qualify for the relief. Further, a contract that is “renewed” after November 2, 2017, will be treated as a new contract and lose grandfathered status.
While somewhat limited, the transition rule should still provide some relief. More guidance from the IRS and Treasury is necessary to determine the extent of that relief.
Planning Considerations and Next Steps
The question that follows from the changes that the Act makes is what should public companies do to mitigate the lost tax deduction? There are at least four broad actions these companies should consider taking, as described below.
- Incentive Plan Design and Administration. The first action companies should take is to review the design and administration of their current incentive plans. Such a review should include the following actions:
- Reconsider what types of results to reward. Before the Act, many performance measures and goals were designed to comply with the performance-based qualification requirements under Code Section 162(m). Those requirements may not have always provided for the most efficient plan design from a business standpoint. Members of Congress had commented that these requirements led to excessive stock option grants, for example. Many companies also used “umbrella” plan designs to try to comply with the performance-based requirements. Such designs should no longer be necessary in the future. Instead, companies can consider both the objective and subjective measures that are most appropriate for them. Additionally, companies should consider the cost of such plans given the loss of the tax deduction for amounts in excess of $1 million and also the lower corporate income tax rate.
- Take an inventory of agreements that were in effect on or before November 2, 2017, and determine whether they qualify for grandfathered status. If there is any desire to amend these agreements, consult with legal counsel to determine whether such an amendment could cause a loss of grandfathered status.
- Implement Measures to Track Covered Employees. Companies will need to identify their covered employees and keep track of them in future years. Remember, under the Act, the rule essentially is once someone is a covered employee, that person always remains a covered employee. Therefore, the $1 million deduction limit continues to apply to payments to these individuals after they have terminated service and to their beneficiaries after they are deceased.
- Nonqualified Deferred Compensation Plans. To mitigate the impact of the lost tax deduction, companies should consider encouraging covered employees to defer amounts in excess of $1 million until termination of service. Compensation paid after termination of service that exceeds $1 million still would not be deductible, but such payments would not be aggregated with salary and other payments that typically are made while employed. As such, a larger portion of these amounts could fall under $1 million than they would if they were made while still employed. Additionally, postponing the cash payments could provide general cash flow benefits to companies. Of course, companies should make sure that such deferrals satisfy the requirements of Code Section 409A.
- Proxy Statement Disclosures. Most public companies have disclosed in their proxy statements the extent to which they have considered the performance-based requirements of Code Section 162(m) when designing their compensation plans and awards. These companies should explain that the deduction for such awards will no longer qualify for a tax deduction. Additional discussion may be needed depending how much Code Section 162(m) was addressed in the past and the extent to which the changes to Code Section 162(m) will change the company’s compensation philosophy and plan design. If companies are changing the designs of their plans and awards, they also should consider how these changes will be reflected in the various compensation tables in the proxy statement.
As mentioned previously, we are expecting more guidance from the IRS and Treasury to provide more clarity about the scope of the transition rule. Additionally, we would not be surprised if ISS and the listing standards updated its standards for best practices regarding performance-based compensation. In the meantime, public companies can better prepare for the lost tax deduction by acting proactively to change their compensation programs.