Impact of Tax Cuts and Jobs Act: Part IV – Changes to the Section 162(m) Deduction Limitation for Executive Compensation
Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades. We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance. In Part I of this series, we covered potential changes to employer-provided benefits, and in Part II, we addressed entertainment expenses and other fringe benefits. In Part III, we discussed the Bill’s potential impact on various retirement provisions. In this Part IV of the series, we address proposed changes to the deduction limitation for executive compensation under Code section 162(m). Currently, Code section 162 allows as a deduction all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. This includes a deduction for reasonable compensation for personal services actually rendered. However, Code section 162(m) limits the deduction of any publicly held corporation with respect to compensation paid to a “covered employee” to $1 million. However, certain types of compensation—such as qualified performance-based compensation and commissions—are not subject to the deduction limitation. Covered employees are defined to include the chief executive officer (“CEO”), as of the close of the taxable year and the officers whose compensation is required to be reported to shareholders by reason of being among the three most highly compensated officers for the taxable year (other than the CEO). Section 3802 of the Bill would amend section 162(m) in three key ways: (1) it would eliminate the exceptions for qualified performance-based pay and commissions; (2) it would extend the deduction disallowance to a broader array of companies; and (3) it would amend the definition of covered employee to more closely align with current SEC disclosure requirements and make covered employee status permanent. Repeal of Exceptions to Deduction Limitation. Many public companies pay covered employees primarily in the form of performance-based compensation to avoid the effect of the deduction limitation. This exception applies to many forms of equity-based compensation— most stock options, stock appreciation rights, restricted stock, and restricted stock units—and many annual and long-term cash incentive compensation plans. The Bill would repeal Code sections 162(m)(4)(B) and (C), removing the exceptions for performance-based compensation and commissions. It is unclear whether the repeal of the performance-based pay exception will reverse the trend toward performance-based compensation, given that many shareholders and shareholder advocates believe that performance-based compensation can align shareholder and executive interests. Expansion of Deduction Limitation to Additional Corporations. Currently, the deduction limitation applies only to corporations that issue a class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (the “’34 Act”). The Bill would amend Code section 162(m)(2) to apply the limitation to any corporation that is an issuer under section 3 of the ’34 Act that (1) has a class of securities registered under section 12 of the ’34 Act or (2) is required to file reports under section 15(d) of the ’34 Act. This would extend the deduction limitation to corporations beyond those with publicly traded equity securities to include those are required to file reports solely because they issue public debt. Change to the Definition of Covered Employee. Code section 162(m)(3) defines covered employee to include the CEO (or the individual acting in such capacity) as of the last day of the tax year and the four officers whose compensation is required to be disclosed to shareholders because the officer is one of the four most highly compensated officers for the tax year. However, because of a change to the cross-referenced section of the ’34 Act, the IRS interpreted the limitation as applying to only the principal executive officer (generally, the CEO) and the three most highly compensated officers other than the CEO and CFO in Notice 2007-49. Compensation paid to the CFO was not subject to the deduction limitation regardless of how much he or she was paid. The Bill would amend the definition of covered employee to align it more closely with current SEC disclosure rules. Under the Bill, covered employees would include employees who, at any time during the tax year, were the principal executive officer or principal financial officer, and the three officers whose compensation is required to be disclosed to shareholders because they are the three most highly compensated officers during the tax year (other than the principal executive officer). As a result, the deduction limitation could apply to a variable number officers for any given tax year depending upon whether more than one individual serves as either the principal executive officer or principal financial officer during the tax year and whether the principal financial officer is among the three most highly compensated officers during the tax year. The Bill would also add a third category of covered employee: individuals who were covered employees of the employer (or any predecessor) for any preceding tax year beginning after December 31, 2016. Accordingly, the Bill has the effect of making covered-employee status permanent. Under current law, employees (and former employees) who are no longer officers of the employer as of the last day of the tax year are not covered employees. As such, the deduction for compensation that is deferred until a date after the employee is no longer a covered employee is not subject to the limitation under Code section 162(m). The Bill would eliminate this strategy for avoiding the deduction limitation. Moreover, the Bill specifies that covered-employee remuneration that is includible in the income of, or paid to, someone other than a covered employee, such as a beneficiary of a covered employee after the covered employee’s death, remains subject to the deduction limitation. Given the changes to the taxation of nonqualified deferred compensation in the Bill (and discussed in Part III of our series), the utility of this strategy for avoiding the deduction limitation would have been greatly reduced even without this amendment. The amendments to Code section 162(m) would be effective for tax years beginning after December 31, 2017.
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