With the elimination of the performance-based compensation exception (and other changes) to Section 162(m), companies that pay more than $1 million in total compensation (cash, equity, etc.) to a “covered employee” in 2018 or later generally will not be able to deduct the amount over $1 million, subject to the transition rule for plans and agreements in place on November 2, 2017.
We may be able to find some small silver lining in the dark cloud of changes to Section 162(m). As readers know all too well, there were several technical requirements to satisfying the performance-based compensation exemption to Section 162(m). Companies will be liberated from the time and expense of complying with these requirements.
- Eliminating the deductibility of performance-based compensation reduces the need for a company to base a substantial portion of its annual compensation on performance factors. However, best practices and the demands of ISS and other investors make it likely that companies will continue to make executives’ compensation heavily performance-based (although recent reports indicate that at least one company did not get the memo!).
- Eliminating the requirement that the performance goals must be established by a compensation committee comprised solely of two or more outside directors will give companies the flexibility to include on their compensation committees board members who would not have qualified as “outside directors” under the requirements of Section 162(m). Again, most companies likely will continue to follow best practices in corporate governance and certainly will follow the independence requirements of the stock exchanges (required by Dodd-Frank Act Section 952) in selecting compensation committee members. Going forward, the independence requirements of the stock exchanges (plus certain ISS preferences) generally will be controlling.
- Eliminating the requirement that the material terms of any performance goals must be disclosed to and subsequently approved by the company’s shareholders before the compensation is paid will give the compensation committee flexibility to select any performance metrics it wants (subject to ISS and investor demands, as noted in #1), and may mean that companies no longer need to put their stock incentive plans and performance metrics up for re-approval by shareholders every five years.
- Eliminating the requirement that the compensation is paid solely because the covered employee has attained one or more pre-established, objective performance goals will give companies and compensation committees flexibility to include subjective performance measures in determining annual and long-term compensation. Compensation committees also will have greater flexibility to adjust the performance goals set at the beginning of the year to reflect unforeseen developments (again, subject to ISS and investor demands, as noted in #1).
- Eliminating the requirement that the compensation committee must certify in writing, before payment of the compensation, that the performance goals and any other material terms were satisfied, will slightly lessen the administrative burdens of boards and committee members and give them more flexibility as to the timing of payments.
Importantly, Delaware courts have held that boards and compensation committees do not have a fiduciary duty to maximize the tax deductibility of compensation, and that the approval and payment of compensation that was not deductible under Section 162(m) did not create liability.