P.L. 115-97, popularly known as the Tax Cuts and Jobs Act (“TCJA”), significantly changes an employer’s ability to deduct compensation paid to its top executive employees.
Section 162(m), added to the Internal Revenue Code (“Code”) in 1993, provides that a publicly traded corporation may not deduct more than $1 million in compensation paid to its CEO and next three most highly compensated employees. Section 162(m) included an important exception to the $1 million limitation for commissions and performance-based compensation. The exception for performance-based compensation covered not only many cash bonus plans but also most stock options and stock appreciation rights plans.
TCJA makes the following changes to Section 162(m):
- Eliminates the exception for commissions and performance-based compensation.
- Changes the definition of “covered employee” to include (a) an employee who is the principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year; (b) the next three most highly compensated employees (other than the PEO and PFO); and (c) any employee who was a covered employee for any taxable year beginning after December 31, 2016.
- Expands the definition of an employer who is subject to Section 162(m) to include not only corporations whose stock is publicly traded and registered pursuant to Section 12 of the Securities Exchange Act of 1934 (the “1934 Act”) but also any entity required to file reports under Section 15(d) of the 1934 Act.
- The $1 million limitation will apply to remuneration paid to beneficiaries as well as to employees.
The changes made by TCJA apply for taxable years beginning after December 31, 2017. There is an exception for compensation paid pursuant to a written binding contract that was in effect on November 2, 2017 and was not materially modified after that date.
Any employer affected by the changes should review the impact of the revisions to Section 162(m) on its 2018 executive compensation program. In particular, the elimination of the exception for performance-based compensation will cause significantly more elements of remuneration to be subject to the $1 million limitation on deductibility. Although the changes to the definition of covered employee, which now conforms to the SEC definition for purposes of proxy reporting, is a welcome change, the expansion of that definition to former covered employees who receive severance or deferred compensation may be challenging and will require ongoing monitoring.