EXECUTIVE COMPENSATION UPDATE
Written by Cydni Waldner, Hawley Troxell Employee Benefits Practice Group
The Tax Cuts and Jobs Act of 2017 (“TCJA”) made significant changes to the executive compensation deduction rules under Internal Revenue Code Section 162(m). TCJA expanded the definition of “publicly held corporation,” amended the definition of “covered employee” and eliminated the prior exclusion for performance-based compensation. This blog focuses on the issues around compensation and the grandfather rule.
Background - Code Section 162(m)
Section 162(m) disallows the deduction by a publicly held corporation for employee remuneration in excess of $1,000,000 paid to a “covered employee” in the tax year. Prior to TCJA, Section 162(m) contained an exclusion for “qualified performance-based compensation.” This exclusion meant that many public companies carefully structured a significant portion of their top executives’ compensation to meet the exclusion and be exempt from the $1,000,000 deduction limitation. TJCA, however, eliminated the “qualified performance-based compensation” exclusion, making even performance-based compensation subject to the $1,000,000 deduction limit.
TCJA specifically provided that the amendments to Section 162(m) would apply to tax years beginning after December 31, 2017 but included a specific exception for existing compensation arrangements. The changes made do not apply to compensation payable pursuant to a written binding contract that was in effect on November 2, 2017, and is not materially modified after that date (the “grandfather rule”). On August 21, 2018, the IRS issued Notice 2018-68 to provide additional guidance on this “grandfather rule.” As companies review their tax situation and their executive compensation arrangements for the coming year, the Section 162(m) changes should be considered.
Notice 2018-68 strictly interprets what meets the definition of a “written binding contract.” The company must be obligated under applicable law to pay compensation under the contract if the employee performs required service or satisfies any applicable vesting conditions. Unfortunately, based on the prior requirements, many executive compensation arrangements that were intended to satisfy the performance-based compensation exclusion contained broad negative discretion clauses under which the arrangement set a maximum compensation amount but then allowed the board or the company the discretion to reduce the compensation payable, often to zero. This gave the company maximum flexibility to adjust performance-based compensation under then-existing law. Notice 2018-68 suggests that this negative discretion hampers the company’s ability to claim a “binding contract.” With negative discretion provisions, unless there is a stated minimum, the company is not obligated to pay any amount and thus the compensation is not payable under a binding contract. In these cases, the compensation payable remains subject to the $1,000,000 deductibility cap.
Nonqualified deferred compensation plans are considered written binding contracts. However, just because the plan is in existence on November 2, 2017, that does not mean that all amounts deferred under the plan are excluded from the $1,000,000 deduction limitation. If the company retains the right to unilaterally amend the plan to reduce or eliminate deferrals and/or accruals, as nonqualified deferred compensation plans typically provide, then only the amounts deferred prior to January 1, 2018, would be excluded. This becomes important because of the change under TCJA to the definition of “covered employee,” from those employed in certain positions during the year to a “once covered always covered” approach. Executives often have significant portions of the compensation in nonqualified deferred compensation plans, and much of the time those plans pay out after termination. With the TCJA changes, even payments to long-terminated executives can be subject to Section 162(m), and those payments may not be deductible if the individual was ever a covered employee and more than $1,000,000 is paid to the individual in the tax year.
While tax deductibility is now significantly more limited, plan design parameters are much less restrictive, allowing companies the flexibility to address their own incentives and goals. After TCJA, since companies are not concerned with meeting the “qualified performance-based compensation” requirements, they will be able to design executive compensation programs without necessarily requiring objectively determinable goals and adjustments. Performance goals are no longer required to be established within 90 days of the beginning of the performance period. Perhaps most importantly, companies could now use their discretion to adjust payments up or down based on individual performance or other criteria.
One of the requirements for performance-based compensation under the prior rules was that payment without determination of actual performance upon termination was prohibited, which led to many different work-arounds in severance and employment agreements for no-fault terminations. After TCJA, companies no longer have to abide by this restriction that requires performance-based compensation to be paid only upon achievement of the performance goal. This means companies could now revise severance and employment arrangements to provide for payout of pro rata bonus incentives at target for the year of termination instead of relying on a multiple of salary only or paying pro rata based on actual performance, or any of the other substitute provisions intended to address this issue.
Finally, company policies and plans stating that the plans are intended to qualify as performance-based compensation and/or to preserve the tax deductibility of awards and compensation under the plans should be reviewed and revised appropriately. In addition, compensation committee charters and plan prospectuses should be reviewed with these changes in mind.
For assistance with review of your compensation design, including potential tax issues, or for more information, contact the Tax Group.
Cydni Waldner is a member of Hawley Troxell’s employee benefits practice group. She assists small to large corporations and companies with the nuances specific to ERISA laws and regulations, executive compensation, and employee benefits. Cydni’s active practice allows her to remain at the forefront of ERISA law developments. Her early career as corporate counsel responsible for legal compliance in the employee benefits areas enables her to understand thoroughly the needs of her clients.
A significant part of Cydni’s practice involves advising employers on fiduciary issues and legal compliance with respect to qualified retirement plans, including pension, 401(k) and 457(b) plans. She also assists with IRS and DOL audits of qualified plans and plan operations and corrections and advises employers regarding vendor contracts and employee communications.