The most sweeping tax reform in decades is now on the brink of being signed into law. It may materially alter the way most public companies have been structuring executive compensation for the past twenty years under Section 162(m). Here’s a quick summary of the changes and what committees may consider before year-end to maximize deductions of compensation at this 11th hour.
If passed, what are the Section 162(m) Changes?
Effective as of January 1, 2018:
- The “performance-based compensation” exception under Section 162(m) will be eliminated, resulting in all compensation paid to a “covered employee” in excess of one million per year becoming non-deductible. However, any performance-based compensation arrangements entered into under a “binding written contract” in effect on November 2, 2017 will be grandfathered.
- The scope of “covered employees” will be expanded to include:
- The CFO (who, under a technical glitch, has been excluded for nearly ten years); and
- Anyone who has been a covered employee since 1/1/17, even if terminated (formerly, once an individual was no longer in the proxy statement at year-end, they could be excluded).
- Corporations covered by 162(m) will now also include those with publicly traded debt and certain foreign private issuers.
In addition to 162(m), there are considerable changes in other areas that will affect executive compensation planning, including reduction of the corporate tax rate to 21% (from 35%) and top income tax brackets reduced to 37% (from 39.6%).
What should compensation committees consider doing before year-end, if anything?
Some companies are taking swift action to accelerate certain payment into 2017 to preserve deductibility under 162(m) while it’s still applicable. However, certain factors should be considered before doing so.
Company Deduction: With corporate tax rates being significantly cut in 2018, so too are company deductions. Therefore, deductions in 2017 are worth more than they are in 2018. Generally, bonus payments made by March 15, 2018 are deductible in 2017 and would not need to be accelerated to take advantage of 2017 deductions. For those bonus arrangements that require employment on date of payment in 2018, companies may accelerate payments into 2017 or establish a minimum bonus liability in 2017 to secure the deduction. Companies are also considering accelerating vesting or payment of equity awards into 2017. If either cash or equity awards are accelerated to 2017, companies must make sure all 162(m) requirements are met (i.e., certification of performance during the period by the committee, if applicable, which may require a special meeting) and ensure not to run afoul of other technical requirements as outlined below.
Executive Deductions: Under the final bill, executives will only be able to deduct state and local income taxes on their federal tax returns up to $10,000 per year. Executives (especially those in high state tax jurisdictions) may want to accelerate taxation from 2018 to 2017 to preserve the full benefit of this deduction at least one more year.
New 162(m) Employees: Now that CFOs will be subject to 162(m) limitations, companies have a good reason to accelerate these employees’ compensation from 2018 to 2017 to the extent companies believe payments will exceed $1 million. In addition, any employee serving as an NEO during 2017 that may not be an NEO during 2018, but whose compensation may exceed $1 million in 2018, should also consider payments accelerated to 2017.
Grandfathering: If compensation will be paid pursuant to a “binding written contract” in effect as of November 2, 2017 (which has not been materially modified), it will still be covered by the performance-based pay exemption even if paid out in 2018. To take advantage of this transition rule, careful consideration must be paid to whether the arrangement has been modified.
Technical Barriers: Acceleration of payments may only be made to awards to the extent permitted in grant documents and shareholder-approved plans, and should not be inconsistent with any company policy or promises made in prior disclosures. In addition, the ability to benefit from deductions and accelerated payments may be limited by accounting and other tax rules (i.e., Section 409A).
What should committees do going forward?
While companies will no longer be jumping through hoops to meet the technicalities of the 162(m) performance-based exception, this is by no means the end of the need to align executive pay and performance in a systematic manner. Clearly, shareholders and proxy advisors will continue to scrutinize programs for pay and performance alignment. However, there will likely be more options for adjustments, performance measures, and positive discretion going forward. From a deduction perspective, time-based restricted stock may become more prevalent as options and performance-based restricted stock will no longer have a deduction preference. On the disclosure front, additional information may be needed in proxies filed in 2019 with respect to the value of lost executive compensation deductions. Outside of plan designs, plan documents and charters will all need to be reviewed and revamped to eliminate 162(m) antiquated hurdles. In short, undoing 162(m) will be a long process which will be addressed over time after the Department of Treasury issues updated regulation at some point in the future.
