Executive Pay at Public Corporations After Code §162(m) Changes

Internal Revenue Code §162(m) imposes limitations on the deductibility of executive pay by public corporations. The new tax law, Public Law No. 115-97 (the “Tax Cuts and Jobs Act” (TCJA)), makes a number of changes in Code §162(m). These changes generally take effect for taxable years commencing after Dec. 31, 2017 (exceptions noted below). This post discusses these changes, how the changes might impact on different forms of executive pay and some of the steps public corporations need to take in light of these changes.

Part I. Code §162(m) Before and After TCJA

A. Pay Subject to the Deduction Limitation

Prior to TCJA. Since its enactment in 1993, Code §162(m) has imposed a limit of $1 million per taxable year on the deductibility by a “publicly held corporation” of remuneration paid for such year to each “covered employee.” (“Covered health insurance providers” have been, and continue to be, subject to special provisions under Code §162(m) that are not covered in the following discussion.)

Prior to its amendment, Code §162(m) excepted from the deduction limit remuneration that constituted “qualified performance-based compensation.” See pre-TCJA Code §162(m)(4)(C) and Treas. Reg. §1.162-27(e). (It also excepted “commissions,” which are not covered in the following discussion.) For this purpose, Treasury regulations have treated stock options and stock appreciation rights (SARs) as if they were qualified performance-based compensation, whether or not they are subject to performance targets, provided that such stock options and SARs meet the requirements of Treas. Reg. §1.162-27(e)(2)(vi).

After TJCA. TCJA removes the exception just noted for qualified performance-based compensation, making it subject to the $1 million deduction limit for taxable years commencing after Dec. 31, 2017. (It also removes the exception for “commissions” which, as noted, are not included in the following discussion.)

B. “Covered Employees”

Prior to TCJA. Under Code §162(m), as previously in effect, “covered employee” meant any employee (i) who, as of the close of the taxable year, was the chief executive officer (CEO) of the corporation (or was an individual acting in such capacity) or (ii) whose compensation was “required to be reported to the shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the 4 highest compensated officers for the taxable year” (other than the CEO). (In its Notice 2007-29, the Internal Revenue Service reduced the number of executives required by clause (ii) from 4 to 3 and excluded the chief financial officer (CFO) for purposes of determining the executives in clause (ii) as modified. This notice no longer applies due to the changes discussed in the next paragraph.)

After TCJA. TCJA modifies the definition of “covered employee” to include any employee (i) who at any time during the taxable year was the “principal executive officer” or “principal financial officer” of the corporation (or was an individual acting in such capacity); (ii) whose compensation “is required to be reported to the shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year” (other than any individual described in the preceding clause (i)); or (iii) who “was a covered employee of [the corporation] (or any predecessor) for any preceding taxable year beginning after December 31, 2016.” As a result of this new definition, over time the number of individuals included in the “covered employee” group will expand.

C. “Publicly Held Corporation”

Prior to TCJA. A “publicly held corporation” meant an issuer of equity securities required to be registered under §12 of the Securities Exchange Act of 1934 (the Exchange Act).

After TCJA. TCJA extends the definition of “publicly held corporation” to include any corporation that is (i) an issuer of securities required to be registered under §12 of the Exchange Act or (ii) an issuer required to file reports under §15(d) of the Exchange Act. This new definition includes not only corporations with publicly traded equity (as previously) but now includes those with publicly traded debt. The Joint Explanatory Statement of the Committee of Conference for the tax bill that became the TCJA states that this new definition also includes “foreign companies publicly traded through ADRs” and that it “may include certain additional corporations that are not publicly traded, such as large private C or S corporations.” (Quoted language in the preceding sentence appears at page 344 of the Joint Explanatory Statement.)

D. TCJA’s “Grandfather” Clause

TCJA provides that the new provisions described above do not apply to “remuneration which is provided 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.” Grandfathering should apply to future awards if they are made pursuant to a “written binding contract” (e.g., an employment agreement) in effect on Nov. 2, 2017. (See discussion in Part III.B. below on protecting the “grandfathered” status of certain arrangements in effect on Nov. 2, 2017.)

Part II. Potential Impact of Code §162(m) Changes on Executive Pay

A. Short-Term Pay

(1) Salary. It is unlikely that public companies will shift, to any significant degree, from performance-based pay to salaries as a result of the §162(m) changes. Some large U.S. public corporations may have kept salaries of their top executives lower than those salaries might have been, relative to other components of such executives’ pay, in order to maximize the amount of pay (performance-based awards, stock options, etc.) eligible for the former exemption under Code §162(m). Some of those employers now may increase the salary levels of such executives to make them more proportionate to the other elements of such executives’ pay.

(2) Annual Bonus. Payouts under most senior-level annual bonus programs of public companies will continue to be tied to achievement of performance targets. In part, this is because the plans pursuant to which such awards are made contain provisions requiring performance targets in order to qualify for the former exemption under Code §162(m). (These provisions should be carefully reviewed, as noted in Part III.A. below, by public companies to determine whether they want to continue provisions previously required to qualify for the §162(m) exemption.)

It is likely that many annual bonus programs will be revised (subject to shareholder approval if required by the applicable plan) to provide Compensation Committees (as to grants made after 2017) with discretion to adjust bonus payments from those based strictly on the performance targets. Before the enactment of Code §162(m), public company annual bonus programs generally provided such discretion to Compensation Committees.

B. Long-Term Incentive Awards

(1) Performance-Based Awards. For purposes of this discussion, a “long-term performance-based award” means an award as to which payout is conditioned upon the achievement of one or more pre-determined long-term performance targets. A performance period of three years is typical. (This definition of “long-term performance-based award” is not the same as the definition of “qualified performance-based compensation” contained in Treas. Reg. §1.162-27(e). That regulation, issued pursuant to pre-TCJA Code §162(m)(4)(C), contains the technical requirements that must have been met in order for performance-based compensation to be excepted, as previously provided, from the deduction limit under Code §162(m).)

It is expected that public companies will continue to use long-term performance-based awards as a major part of their executive pay programs.

Some public companies may consider giving the Compensation Committee discretion to adjust payouts from those that would result from performance based strictly on pre-determined long-term performance targets. Careful attention should be given to the accounting consequences that might follow from giving Compensation Committee such discretion. These consequences may differ according to the nature of the award and other circumstances.

(2) Stock options and SARs. As discussed in Part I above, stock options and SARs, like performance-based awards, previously were exempted from the $1 million deduction limit under Code §162(m), provided they met the requirements of Code §162(m) and regulations thereunder. Due to accounting changes, adverse stock markets and other factors, the use of stock options and SARs declined in the 2000s. The changes in Code §162(m) are not likely to cause significant further reduction in the use of stock options and SARs.

(3) Restricted Stock/Restricted Stock Units (RSUs). Public companies may shift to some extent from long-term performance-based awards to restricted stock/RSUs as a result of the changes in Code §162(m). Restricted stock involves less complexity in design and administration than performance shares or other performance-based awards. Employers that shift to restricted stock may extend the vesting period for future grants of restricted stock. The intention of extending time vesting for a longer period for future awards would be, as a corporate governance matter, to counterbalance the elimination of performance risk.

C. Deferred Compensation

Some companies, if faced with non-deductibility because of the $1 million cap under Code §162(m), may choose to defer a portion of compensation otherwise payable currently in order to bring annualized amounts below the $1 million cap.

D. Severance Pay

As just noted in connection with deferred compensation, in order to bring annualized amounts below the $1 million cap, some companies may extend severance payments over a period longer than that over which they might otherwise be paid.

Part III. Other Considerations

A. Need to Review Documentation of Executive Pay Arrangements and Summaries in Proxy Statements of Those Arrangements

Careful attention should be given to current documentation of executive pay arrangements to be sure such documentation is consistent with changes in Code §162(m). References to Code §162(m) may, in some cases, have been intended to comply with the §162(m) requirements for exemption from the $1 million deduction limit and are not applicable to grants made in taxable years commencing after 2017. Care must be taken not to make changes in documents (including awards themselves) that, as noted in Subpart B. below, could “de-grandfather” a plan or award. (As noted above, an amendment to a plan may require stockholder approval.)

In addition to review of documents embodying plans, programs and awards, proxy statements must be reviewed to determine whether changes need to be made in descriptions of the arrangements noted. These include changes that may be needed in proxy statement references to Code §162(m). Employers generally will want to continue references to pre-existing §162(m) provisions applicable to previously granted awards as to which grandfathered status applies.

B. Protecting Grandfathered Status of Certain Agreements/Awards in Effect on Nov. 2, 2017

The exemption from the $1 million deduction limit under Code §162(m) will continue to apply, as noted in Part I.D. above, to written binding agreements in effect on Nov. 2, 2017 provided they are “not modified in any material respect on or after such date.” Careful attention should be given to any modification that might cause loss of grandfathered status. For example, extending the term of an award could result in loss of its grandfathered status. In the case of plans, it may be advisable to adopt a new plan rather than modify an existing one. Presumably these points will be covered in rulings and/or regulations to be issued by the Treasury.

C. Avoiding Adverse Consequences Under Other Sections of the Code

Besides the potential loss of grandfathered status, a modification of a plan or award may trigger adverse consequences under another Code provision. For example, Code §409A has complicated provisions regarding deferred compensation that must be complied with in order for such compensation to be “qualified” under that section. Failure to comply with these requirements could result in a 20 percent excise tax and other penalties being imposed on the service provider.