Changes to the $1 Million Section 162(m) Compensation Deduction Limitation
By Jim Swanick
The Tax Cuts and Jobs Act of 2017 (TCJA), enacted on December 22, 2017, made significant changes to Section 162(m) of the Internal Revenue Code (“IRC”). The following blog summarizes the prior rules as well as the changes made under TCJA , which are effective for years beginning after December 31, 2017. Section 162(m) Compensation Deduction Limitation
Section 162(m) Before the Tax Cuts and Jobs Act of 2017
Under IRC Section 162(m) of 1986, the deduction for a publicly held corporation for otherwise deductible compensation paid to a covered employee was limited to $1 million per year. For purposes of IRC Section 162(m), compensation generally means the aggregate amount allowable as a deduction for the taxable year (determined without regard to IRC Section 162(m)) for remuneration for services performed by a covered employee, regardless of when the services were performed.
A publicly-held company subject to these rules was defined as any corporation issuing any class of common equity securities required to be registered under, and subject to the reporting obligations of, section 12 of the Securities Exchange Act of 1934. Regulations under IRC Section 162(m) provided that this determination was to be made as of the last day of the taxable year. Thus, in certain cases, short tax years ending with mergers where the acquired company is not required to comply with the Exchange Act’s executive compensation disclosure rules for the short tax year were exempt from the IRC Section 162(m) annual limitation.
A “covered employee” was defined as an employee who, on the last day of the company’s fiscal year, was either the CEO or one of the highest three paid officers, other than the CEO or CFO, whose compensation was required to reported in the summary compensation table of the company’s proxy.
Commission-based compensation and qualified performance-based compensation were excluded from the $1 million deduction limit. As a result, publicly-held employers typically spent considerable time and effort ensuring that a substantial portion of the compensation paid to their covered employees qualified as IRC Section 162(m) performance-based compensation, which maximized the company’s compensation-related tax deductions. Generally, performance-based compensation had to meet each of the following requirements:
- The compensation was contingent on the attainment of one or more pre-established, objective performance goals.
- The performance goals were set by the corporation’s compensation committee consisting solely of two or more outside directors.
- Before payment, shareholders in a separate vote approved the compensation terms, including the applicable performance goals and the maximum amount payable to any covered employee.
- Before payment, the compensation committee certified in writing that the performance goals and any other material terms were in fact satisfied.
Changes Under TCJA
The Act made significant changes to IRC Section 162(m), including the following, which are effective for years beginning after December 31, 2017:
The companies which are subject to the new IRC Section 162(m) rules are expanded to include entities required to file reports under Section 15(d) of the Securities Exchange Act of 1934, including non-public companies that register debt or equity securities with the Securities and Exchange Commission, like foreign companies publicly held through American depositary receipts (ADRs). How the new rules will affect certain tax periods (such as after an acquisition, initial public offering or a spin-off) is currently unclear. Companies that are in such a period will want to monitor any future guidance provided by the Internal Revenue Service that might impact how the new rules will apply to these situations.
A “covered employee” is now defined as any employee who is:
- the principal executive officer (e.g., CEO) or principal financial officer (e.g., CFO) at any time during the year,
- any employee whose total compensation is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of being among the 3 highest paid officers for the year (other than the CEO or CFO), or
- any employee who was a covered employee of the taxpayer (or any predecessor) for any preceding year beginning after December 31, 2016.
Under the prior rules, if an individual terminated employment prior to the last day of the year, he or she was no longer a “covered employee”. Thus, compensation paid for the year of termination was considered fully deductible. Under the new rules, the “last day” rule was eliminated. Thus, going forward, any person who is the CEO or CFO during any part of the tax year will now be treated as a covered employee, even if they leave prior to year-end. However, since this rule applies to years beginning after December 31, 2017, the last day rule should still exempt a CEO who terminated prior to the last day of 2017. Likewise, since the CFO was not a covered employee under pre-tax reform rules, he or she will not automatically be considered a covered employee in post-tax reform years, unless the CFO continues in the CFO role in years beginning after 2017, and then only to the extent he or she receives compensation that is not grandfathered as discussed below.
Under the new rules, since an individual never loses his or her status as a covered employee, all compensation paid to that individual will be subject to the $1 million annual deduction limit, unless grandfathered as described below. Employers will need to start tracking any employees, and their compensation arrangements, who were considered “covered employees” for any tax years beginning after December 31, 2016.
Unless grandfathered as described below, commission-based and performance-based compensation is no longer exempt from the $1 million deduction limit. Thus, commissions and performance-based compensation paid to a covered employee will now be subject to the $1 million annual deduction limitation.
Under transition rules, the changes described above do not apply to compensation paid to a covered employee that is provided pursuant to a written binding contract that was in effect on November 2, 2017, and which is not modified in any material respect on or after such date. Thus, payments to a covered employee that would have been previously deductible under IRC Section 162(m), such as payments made under performance-based compensation arrangements that comply with IRC Section 162(m), will remain deductible if they are paid under a written binding contract in effect on November 2, 2017.
Currently, there is little guidance about what constitutes a written binding contract or what is considered a material modification to such contract, particularly in cases where the compensation committee retains discretion to reduce the amount of an award or not pay an award. Based on similar grandfathering rules that applied when IRC Section 162(m) was first passed, an arrangement will not be grandfathered as of the date that it could be amended or terminated by the employer, or as of the date of renewal if either the employer or employee can elect not to renew. Under those same rules, an arrangement was considered materially modified if it was amended to increase compensation, or if it was amended to accelerate or delay payments (subject to certain exceptions).
With respect to the new rules, we will need to await Internal Revenue Service guidance before final determinations can be made as to what constitutes a binding contract or a material modification of such contract. In the meantime, companies will need to inventory their written binding contracts in effect as of November 2, 2017 and closely monitor any proposed modifications to ensure compensation related to those contracts remains deductible in 2018 and beyond. A modification, if considered material, could cause the arrangement to lose its grandfathered status, subjecting the compensation payable under that arrangement to the $1 million annual deduction limit.
The above transition rules appear to shield the following from the $1 million annual limitation, to the extent of compensation paid under non-modified binding contracts in effect on November 2, 2017:
- performance-based compensation
- CFO compensation
- Post-employment compensation
- Compensation paid by entities that were not previously treated as publicly-held
How to Move Forward
From a tax accounting perspective, companies will need to consider the following items:
- Will the company be considered a publicly-held company under the new rules?
- Which employees will be considered covered employees? How to track those covered employees each year due to the “once covered always covered” rule? (this may require additional processes and controls to properly track this information).
- For interim tax provision purposes, companies will need to determine an estimate of the annual compensation deduction for covered employees which is nondeductible under IRC Section 162(m) and consider that amount in the determination of their Annual Effective Tax Rate.
- Will existing deferred tax assets more likely than not be realized in future periods under the new rules? This could involve the following considerations:
- Will future deductible temporary differences be covered by the transition rules discussed above and thus exempt from the annual limitation?
- Monitoring of all compensation plans in existence as of November 2, 2017 to ensure they continue to qualify for the transitions rules;
- If deferred taxes for future deductible compensation are not expected to be realized, what is your company’s policy regarding the ordering of the reversal of their accrued but unpaid compensation to determine which amounts are expected to be paid in excess of the $1 million deduction limitation? (i.e., disallow cash-based compensation first or stock-based compensation first, or pro-rata portion of each)
- When projecting future taxable income for valuation allowance purposes, the projected disallowance of executive compensation should be included in such projections
The new rules under IRC Section 162(m) have added a substantial level of additional complexity to the corporate tax provision and compliance process. Companies will need to develop enhanced processes and controls to track compensation paid to an increased number of covered employees for many years into the future as well as tracking all existing compensation arrangements related to those employees to determine which arrangements qualify for the transition rules. Detailed projections will need to be performed of the estimated future compensation deductions for each covered employee to determine the realizability of future deductible temporary differences.
The interim provision process will also need to be modified to include a projection of nondeductible compensation in many cases. Varying interpretations of the transition rules and what constitutes a binding contract or material modification will cause confusion until additional guidance is issued. Companies will need to get ahead of this analysis as early as possible to avoid unexpected results in their tax provisions and returns.
We hope this post was helpful as you assess the impact of tax reform on your business. GTM will be publishing regular posts highlighting key features and developments of tax reform. Visit our tax reform page for the latest U. S. tax reform updates.