Tax reform (Tax Cuts and Jobs Act) made significant changes to the taxation of executive compensation, which may increase the cost of certain arrangements. Publicly traded companies as well as those companies who must file reports with SEC for other reasons (such as by virtue of their publicly traded debt) should review their executive compensation arrangements, adjust internal procedures to avoid reporting and late payment penalties, and determine whether to adjust any arrangements to avoid the higher cost now imposed by tax reform.
What has changed?
For years, Section 162(m) of the tax code has limited the ability of public companies to take a tax deduction for payments of compensation in excess of $1 million to certain “covered employees.” In the past, this limit included important exceptions, which meant that payments of certain performance-based compensation and commissions could be fully deducted even if they exceeded $1 million. Tax reform has generally eliminated these exceptions and expanded both the types of companies and the employees covered by the $1 million limit. The details of the new rules are discussed below.
What companies are covered by the revised limit?
Essentially, the revised $1 million limit continues to apply to companies with publicly traded stock, and now also applies to companies with publicly traded debt. Specifically, the revised limit applies to:
- Companies whose securities are required to be registered under Section 12 of the Securities Exchange Act, and
- Companies that are required to file reports under Section 15(d) of the Securities Exchange Act.
Which employees are subject to the revised limit?
The “covered employees” subject to the $1 million limit now include anyone who, in any taxable year beginning after December 31, 2016, was:
- The company’s principal executive officer (i.e., CEO),
- The company’s principal financial officer (i.e., CFO), or
- One of the company’s three highest compensated officers.
Importantly, the list of covered employees is now cumulative. Anyone who becomes a covered employee will remain a covered employee forever, and that status will not go away upon termination of employment or even death.
When does the revised limit begin to apply?
The short answer is that the revised $1 million limit applies now (to taxable years beginning after December 31, 2017). However, there is an important grandfathering rule—the revised limit does not apply to compensation that is provided pursuant to a written binding contract in effect on November 2, 2017, that has not been modified in any material respect on or after that date.
Companies should be careful in determining which arrangements are grandfathered. It is not enough that a compensation arrangement was set forth in a valid writing on November 2, 2017; it must meet other requirements to qualify for grandfathering. While the exact scope of this grandfathering rule will need to be clarified by the IRS, it appears to mean payments that would have been tax deductible under the old rule as performance-based compensation or commissions will continue to be deductible if they are made pursuant to a contract that satisfies the grandfathering rule. Presumably, it also means the revised limit will not apply to payments under such contracts that are made to employees who would not have been covered employees under the prior rule, regardless of whether they would have fallen under the prior exception for performance-based compensation or commissions.
What should companies do now?
- Consider what financial, accounting, or other impact the revised $1 million limit might have on your company.
- Ensure that your company has a process for tracking its covered employees. This is especially important if your company was not covered by the prior rules, but even if your company was covered in the past, it will still need to change the way it tracks covered employees given that the list of covered employees is now cumulative from year-to-year.
- When making compensation decisions, consider whether any items of compensation (e.g., one-time bonuses) might inadvertently cause an employee to become a covered employee. Remember that once an employee is a covered employee, the limit will apply to him or her forever.
- Think about ways to prevent compensation from exceeding the $1 million limit. For example, your company might consider structuring an executive’s compensation so that more of it is deferred until future tax years and is paid out over time when it is less likely to exceed the $1 million limit.
- Evaluate your existing compensation arrangements to determine which ones qualify for the grandfathering rule, and develop a process to track these arrangements.
- Consider whether any of your company’s non-grandfathered compensation arrangements or practices should be changed to better align with the company’s needs now that they will no longer need to satisfy the requirements for an exception to the $1 million limit.
To avoid additional pitfalls, particularly those arising from Section 409A of the tax code, organizations should always consult with counsel before changing the terms of an agreement or deferred compensation plan.