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Tax Cut and Jobs Act Eliminates Performance Based Compensation; Expect Changes to Proxy Statements and the Executive Pay Process

02.01.18

The Tax Cut and Jobs Act created a new corporate income tax rate of 21%, down from 35%. One of the trade-offs for the lower rate is the elimination of a deduction for certain compensation paid to executive officers. The new law will affect proxy statement disclosure beginning in 2018 and raise new considerations for the executive compensation process. 

Prior Law

Since 1994, Section 162(m) of the Internal Revenue Code has limited the ability of a publicly traded corporation to deduct compensation paid to certain executive officers above $1 million. Most corporations have been able to work around this cap by utilizing an exemption for “performance based compensation.” To do this, they have designed their cash bonus and stock incentive programs to fit within the restrictions of Section 162(m).

The prior law applied only to corporations with registered equity securities. All other companies have been exempt from the $1 million deduction limit. 

Public corporations are well-accustomed to 162(m) compliance. Proxy statements almost universally disclose 162(m) compliant performance targets and rewards for executive officers. Most proxy statements also include a statement that compensation programs are designed to satisfy the performance based compensation exemption.

Changes to 162(m)

The new law eliminates the exemption for performance based compensation and commissions paid by public corporations. Compensation paid to “executive officers” (as now defined) above $1 million is now non-deductible. Moreover, the $1 million limit applies to many more corporations and captures payments to more officers than before.

Broader definition of public corporation. Going forward, the $1 million deduction limit applies to:
 
  • Corporations with any type of publicly traded securities. 
  • Corporations required to register securities or file reports under the Securities Exchange Act, even if their securities are not publicly traded.
Broader definition of executive officer. The deduction limit now applies to compensation paid to anyone who would be or has ever been a “named executive officer” or “NEO” under the proxy disclosure rules of the SEC. This includes:
 
  1. The principal executive officer (usually the CEO);
  2. The principal accounting officer (usually the CFO);
  3. The three highest compensated officers other than the principal executive and accounting officers; and
  4. Anyone who was an NEO of the corporation in 2017 or later.
This means the deduction limit can apply to payments to former NEOs following retirement and death, such as payments from executive deferred compensation programs.

What to do Now?

The new law is effective for years beginning after December 31, 2017. Going forward, the following should be considered:
 
  1. Proxy disclosure revisions. Proxy statements typically include information tied to Section 162(m) compliance, and most include a statement that executive incentives are designed to take advantage of the deduction for performance based compensation. For 2018, these statements should be revised to reflect the elimination of this deduction in Section 162(m).
     
  2. Consider shareholder approval of performance based compensation. Section 162(m) requires that shareholders approve, at a minimum, the business criteria that are used to set performance goals each year. New approval is required every five years. While we see no reason to abandon existing incentive compensation plans that were designed to comply with Section 162(m), there is no need to continue to request shareholder approval every five years, unless there are reasons under state law – see Item 3 below.
     
  3. Caveat: monitor state income tax changes. Many state income tax systems have mirrored the federal Section 162(m). Some states may automatically mirror the change in Section 162(m). But some may, for a period, retain the right to deduct performance based compensation from the state income tax burden.
     
  4. Take a deduction limit inventory. The change in 162(m) captures many payments that have been outside of 162(m) for many years, such as SERP payments to former executive officers.
     
  5. Identify and maintain grandfathered contracts. The law has a carve out for any “binding contract” that was in effect on November 2, 2017 and has not been “materially” modified. Examples may include deferred compensation plans and outstanding stock awards. Arrangements that make payments to NEOs should be reviewed and considered for grandfather status. The term “modification” is likely to be very broad, and may include annual contract renewals. 
     
  6. Review executive compensation policy. Executive pay has been driven in part by the performance based compensation exemption. Some elements in this exemption were inflexible and can now be reevaluated. For example, only objective business criteria, approved by shareholders, could be considered in measuring performance. Subjective considerations could not be included as a performance goal. There were also timing requirements for making and paying awards and strict restrictions on modifications during a performance period. Going forward, a company may:
     
    a. Include subjective as well as objective elements in incentive compensation. 
    b. Consider mid-year adjustments when needed to account for extraordinary events. 
    c. Specify performance periods that do not necessarily track the fiscal year.
     
  7. Review executive compensation committee membership. A bright spot in the new law is that the confusing standards for identifying “independent directors” under 162(m) no longer apply. Section 162(m) standards were different than those under SEC rules and those applied by the national securities exchanges. Populating a compensation committee has been difficult and directors have often been disqualified who were otherwise “independent” under every other applicable standard. This should simplify the board committee assignment process.
     
  8. Consider reducing shareholders. Some corporations that are subject to SEC reporting do not have an active market for their equity securities. Community banks, for example, often encourage broad stock ownership to develop ties with customers and the community. Section 162(m) may encourage some to reduce the shareholder count through stock buy-backs, cash mergers or reverse stock splits to eliminate SEC reporting requirements and thereby escape Section 162(m).
For additional information, please contact James Bristol or any member of Waller’s Tax or Executive Compensation practices.

The opinions expressed in this bulletin are intended for general guidance only. They are not intended as recommendations for specific situations. As always, readers should consult a qualified attorney for specific legal guidance.

 

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