Except for special rules that apply to public companies, the reasonable compensation of all employees is fully deductible as an ordinary and necessary business expense. Before this year the compensation deduction of a covered employee in a public company was generally capped at $1 million, except for commissions and performance compensation. A public company could deduct a covered employee’s commissions and performance-based compensation. To be deductible, performance-based compensation had to be attributable to a written, objective performance standard, established by the company’s independent compensation committee on or before the 90th day of the service period, and approved by a separate shareholder vote. The amount of the performance-based compensation had to be reduced to a formula, although the employer could retain the discretion to reduce or eliminate (but not increase) the compensation awarded.
Typical of deductible performance-based compensation was the grant of stock options and stock appreciation rights awarded by a compensation committee to pay a covered employee the increase in value of the stock after the date of the grant or award.
Beginning in 2018, the $1 million limit on the compensation deduction for a covered employee of a company will be harder to avoid, because the commission and the performance-based exceptions to the cap are being phased out, the type of companies subject to the new limit is being expanded, and a greater pool of covered employees is now affected.
The companies affected by the new rules are:
- Publicly held corporations, the securities of which must be registered under §12 of the 1934 Securities Act, or
- Companies required to file reports under §15(d) of the 1934 Securities Act.
Included are all domestic, publicly traded companies and all foreign companies that are publicly traded through American depository receipts. The expanded definition, now including §15(d) filers, could include certain large private C or S corporations.
The new rule now applies to a broader group; those who at any time during the tax year were a CEO or CFO, or one of the three highest paid officers for the year reportable on the proxy. A person who ever was a covered employee for any taxable year beginning after 2016 remains a covered employee for the deduction cap, even if no longer employed with the company or deceased. Compensation paid to the covered employee’s beneficiary is also subject to the deduction cap. For example, severance and deferred compensation payable to a beneficiary after the death of the covered employee can be subject to the deduction limit.
A transition rule survived, however, allowing a public company to take advantage of the prior exception for commissions and performance-based compensation, provided that the company had a written, binding contract in effect on November 2, 2017 that has not been modified. The transition rule does not apply to contracts renewed after November 2, 2017, and to arrangements that can be terminated unilaterally without the consent of the other party.
Actions to Take Now
Public companies should make a list of the covered employees affected by the new rule, and prepare to track those employees over time.
In addition, public companies should take an inventory of every written arrangement in effect on November 2, 2017 affecting covered employees to determine whether compensation awarded under the arrangement is potentially exempt from the deduction cap. IRS guidance is needed in this area to determine what arrangements are subject to grandfathering, but the following may qualify:
- Stock options issued at fair market value;
- Stock appreciation rights;
- Severance pay earned after performance conditions are met;
- Non-qualified deferred compensation plans; and
- Any other special, performance-based compensation arrangement for covered employees.