This is the fourth article in our series covering the various employee benefits-related changes contained in the Tax Cuts and Jobs Act signed by the President on December 22, 2017.
In addition to the changes we have already discussed in this blog, the Act made significant changes to the taxation of executive compensation arrangements through its amendment of Section 162(m) of the Internal Revenue Code (“Section 162(m)”). These changes, summarized below, will require publicly held employers, and certain other companies not previously subject to Section 162(m), to revisit their executive compensation arrangements and make appropriate adjustments in 2018 and beyond.
Expansion of Application of 162(m) Limitation and Repeal of Performance-Based Compensation Exclusion
An employer generally may deduct reasonable compensation for personal services as an ordinary and necessary business expense, however, Section 162(m) limits the deductibility of compensation paid to a covered employee of a publicly held corporation to no more than $1 million per year.
Prior to the Act, there was an exception to this rule permitting the deduction of compensation in excess of $1 million in certain cases, including where the compensation was performance-based within the meaning of Section 162(m). The Act has eliminated this exception.
In addition, the Act has expanded the definition of “publicly held corporation” for purposes of the $1 million deductible compensation limitation to include additional securities registrants and has expanded the definition of “covered employee” to include an employer’s chief financial officer and any individual who was previously a covered employee (so that the deductibility limitation continues to apply to payments made to former covered employees or their estates, even after their death).
The Act does contain a transition rule that exempts from these changes remuneration provided pursuant to a written binding contract that was in effect on November 2, 2017 and that was not modified in any material respect on or after such date.
Employer Action Items
Although the performance-based exception has been eliminated, this change presents publicly traded employers with new flexibility to be more creative in structuring their performance-based executive compensation arrangements. For example, such employers will no longer be constrained by strict requirements under the eliminated performance-based compensation exception in setting and approving performance goals and can make adjustments to performance goals at the conclusion of a performance period that increase compensation payable where appropriate.
Moreover, employers who previously granted stock options and stock appreciation rights to ensure compliance with the performance-based compensation exception may now consider replacing such awards with other forms of incentive compensation.
Employers will also need to reevaluate their performance metrics to take into account the impact of the reduction of the corporate tax rate to 21%. In some cases, performance metrics affected by this reduction may be permitted or required to be adjusted.
Additionally, employers will now have more flexibility to provide for acceleration of the payment of performance-based compensation regardless of whether performance conditions have been satisfied, such as in the case of certain involuntary terminations.
Publicly traded employers will need to conduct an inventory of their executive compensation arrangements and compensation committee charters in 2018 and thoughtfully consider, with assistance from their tax and legal counsel, what revisions may be required or appropriate given the changes made by the Act. And certain companies that have publicly traded debt and some foreign private issuers, which were not previously subject to Section 162(m), will need to determine whether the amended Section 162(m) applies to them.
Finally, employers will need to take precautions to ensure that any pre-November 2, 2017 grandfathered arrangements intended to comply with the performance-based compensation exception under Section 162(m) are not materially modified in a way that will cause them to lose their grandfathered status.