On December 22, 2017, the President signed the Tax Cuts and Jobs Act (the “Act”), which makes sweeping changes to the existing United States Internal Revenue Code (the “Code”). These changes include a major overhaul to Section 162(m) of the Code (“Section 162(m)”), which greatly expands the scope of the deduction limitation under Section 162(m) for compensation in excess of $1 million. Below is a summary of the key changes to Section 162(m) implemented by the Act.
Section 162(m) limits deductions by publicly held corporations issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) for compensation paid to its “covered employees” to the extent that the employee’s compensation for the taxable year exceeds $1 million. A corporation’s “covered employees” in a particular tax year include its chief executive officer and the three next highest compensated officers other than the chief financial officer, in each case, as of the close of the year. The Section 162(m) deduction limit does not apply to payments made on a commission basis or to so-called “qualified performancebased compensation.” In general, qualified performance-based compensation is compensation paid solely on account of the attainment of one or more objective performance goals pre-established by a compensation committee comprised solely of two or more outside directors. In order for a director to be considered an “outside director,” among other things, the director must not have been an officer of the corporation and must not receive any compensation other than as a director. In addition to the foregoing requirements, to constitute qualified performance-based compensation, the material terms of the performance goal under which the compensation is to be paid must be disclosed to and subsequently approved by the shareholders of the corporation.
Changes to Section 162(m)
Expansion of Applicable Employers. The Act expands Section 162(m)’s coverage to include companies with any class of securities registered under Section 12 of the Exchange Act and companies required to file reports under Section 15(d) of the Exchange Act (e.g. companies with publicly traded debt).
Elimination of Exceptions to $1 Million Deduction Limit. The Act eliminates the commission and performance-based compensation exceptions under Section 162(m). This change essentially means that all compensation paid to covered employees, including compensation attributable to the exercise of stock options, will be subject to the $1 million deduction limitation (other than compensation paid under grandfathered arrangements).
Expansion of Covered Employees. The Act expands the definition of “covered employee” to include a company’s chief financial officer and to include all individuals who were covered employees in any prior year beginning after December 31, 2016, regardless of whether their compensation level or position would cause them to be a covered employee in the applicable year. In addition, remuneration attributable to a covered employee that is includible in the income of, or paid to, a person other than the covered employee (including to a beneficiary after a covered employee’s death) will be subject to the $1 million deduction limitation.
Grandfathered Arrangements. The amendments to Section 162(m) made by the Act will not apply to remuneration payable pursuant to a written binding contract which was in effect on November 2, 2017 and which was not modified in any material respect on or after such date.
Effectiveness. The changes to Section 162(m) would take effect for tax years beginning after December 31, 2017.
- Companies should consider whether it would be advantageous to accelerate the accrual of deductions into 2017 for cash bonuses payable in 2018 or to accelerate the vesting and payment of compensation (subject to any potential restrictions on such acceleration due to Section 409A of the Code) that may be deductible in 2017, but would be subject to the $1 million deductibility limit in or after 2018. For example, payments by private companies with publicly traded debt, and/or payments to individuals, such as principal financial officers, who are not currently subject to Section 162(m).
- Public companies often take great pains to structure executive compensation arrangements in a manner intended to meet the qualified performance-based compensation exception to Section 162(m). Therefore, companies subject to the deduction limitations imposed by Section 162(m) should begin to consider what if any changes to their existing compensation arrangements may be desirable going forward, given that this exception will no longer be applicable for tax years beginning after December 31, 2017 (taking into account prior proxy disclosures, shareholder approval requirements of the applicable stock exchange and any potential reaction from the company’s shareholders and shareholder advisory firms). For example, companies may want to consider:
- Allowing for the exercise of “positive” discretion by the compensation committee in determining final bonus amounts;
- Reconsidering the use of “umbrella plans” that are designed to fund a maximum potential bonus amount for covered employees (with negative discretion);
- Adding subjective performance criteria to bonus programs;
- Amending employment agreements or other arrangements to allow for bonuses for the year of termination to be paid out at “target” or some other guaranteed level; or
- Removing or revising individual award limits.
- Companies should review their existing arrangements to identify which would be considered grandfathered arrangements to which the transition rule applies and ensure that these arrangements are not materially modified in a way that would impact on the grandfathered status of the applicable arrangements.