While certain aspects of tax reform remain frustratingly ambiguous to corporate tax departments, the provisions around the deductibility of executive compensation awards are becoming clearer.
The bad news for corporate taxpayers is that the employer deductions with respect to performance-based compensation are looking just as elusive as the legislative language initially suggested. Recent guidance from the U.S. Treasury and the Internal Revenue Service also suggests companies will need to take some new measures to assure they accurately track and report tax liabilities with respect to their highest-paid executives.
The IRS recently issued Notice 2018-68 to provide initial guidance on how it interprets provisions of the Tax Cuts and Jobs Act that revise Section 162(m) of the Internal Revenue Code, which made significant changes to the rules regarding deductibility of executive compensation. The amendments ended the near free pass companies have long enjoyed on performance-based compensation for their highest-paid executives and expands the scope of executives who must be tracked as “covered employees” subject to deductibility limitations.
Companies have long built compensation plans based heavily on performance-based awards not only to incentivize executive performance, but also to leverage rules permitting liberal deductions for such awards. Before the 2017 year-end tax reform legislation, companies were generally limited to $1 million of salary compensation that was deductible for covered employees, but could deduct performance-based compensation that went beyond that $1 million cap.
The Tax Cuts and Jobs Act eliminated that deduction, but also provided a grandfathering provision that said plans governed by a written, binding contract on Nov. 2, 2017, would retain their pre-legislation deductibility. Questions flew about how to qualify for that provision, especially what would constitute a written, binding contract. Corporate taxpayers were hoping for a generous interpretation that would preserve deductibility for many of their current plans.
“The guidance pretty much suggests if you have discretion to eliminate compensation under a grandfathered outstanding arrangement, you likely are not going to be able to avail yourself of the grandfather rule.”
Edward Hauder, Senior Advisor, Exequity
No such luck, says Edward Hauder, lead consultant and senior advisor at compensation consulting firm Exequity. “It dashes hopes more than anything else,” he says.
It’s common for compensation plans to retain for the compensation committee some discretion about performance-based awards, says Hauder. Plans that contain such discretion, even “negative discretion,” or the ability to withhold awards, can be regarded as non-binding, he says.
“The guidance pretty much suggests if you have discretion to eliminate compensation under a grandfathered outstanding arrangement, you likely are not going to be able to avail yourself of the grandfather rule,” says Hauder.
Application of the grandfathering provisions was perhaps one of the more burning questions corporate taxpayers had in the early days after enactment of the tax reform legislation, says Robert Delgado, principal-in-charge of a compensation and benefits group in the Washington national tax practice at KPMG. “Now companies are going back to their legal counsel to review their arrangements and determine whether they have written, binding contracts, irrespective of the negative discretion provision,” he says.
Companies need to carefully identify which of their compensation plans are grandfathered and treat them differently going forward, says Delgado. Any material modifications to those plans for any reason could disqualify them for the grandfather treatment, he says. “We’re seeing companies maintain those plans separately from new plans going forward,” he says.
The recent IRS notice also provided some clarity regarding who is considered a “covered employee” under the deductibility rules of Section 162(m), and the news is not terribly friendly to taxpayers either. “The guidance expands the definition probably even further than people anticipated the statute would take it,” says Jeff Martin, a partner in the Washington national tax office of Grant Thornton.
Amendments to the Definition of Covered Employee
Section 162(m)(3) defines the term “covered employee” for purposes of identifying employees whose remuneration may be subject to the deduction limitation under section 162(m)(1). Before the amendments made by section 13601(b) of the Act, section 162(m)(3) defined the term “covered employee” as any employee of the taxpayer if (A) as of the close of the taxable year, such employee is the chief executive officer of the taxpayer or is an individual acting in such capacity, or (B) the total compensation of such employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the four highest compensated officers for the taxable year (other than the chief executive officer). Section 13601(b) of the Act amended the definition of “covered employee” in section 162(m)(3) to mean any employee of the taxpayer if (A) such employee is the principal executive officer (PEO) or principal financial officer (PFO) of the taxpayer at any time during the taxable year, or was an individual acting in such a capacity, (B) the total compensation of such employee for the taxable year is required to be reported to 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 subparagraph (A)), or (C) such employee was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016.
Section 13601(c) of the Act also added flush language to section 162(m)(3) providing that the term “covered employee” includes any employee who would be described in section 162(m)(3)(B) if the reporting described in such subparagraph were required as so described. The legislative history to section 13601 of the Act explains that the term “covered employee” includes “officers of a corporation not required to file a proxy statement but which otherwise falls within the revised definition of a publicly held corporation.” House Conf. Rpt. 115-466, 489. Furthermore, the legislative history provides that the term “covered employee” includes “officers of a publicly traded corporation that would otherwise have been required to file a proxy statement for the year (for example, but for the fact that the corporation delisted its securities or underwent a transaction that resulted in the nonapplication of the proxy statement requirement).”
Companies have long understood the rules apply to their CEO, CFO, and three additional highest-paid executives as listed in their proxy statements. The amendments, now clarified by the IRS, tell companies to look at reporting rules of the Securities and Exchange Commission to identify those individuals. That may make things complicated for companies where executives may have left mid-way through a year, says Martin. Under SEC rules, even employees terminated part way through a year might qualify as among the highest paid, especially if they received some kind of severance package.
The guidance also reiterates what the statute says, that once an individual is regarded as a covered employee for Section 162(m) purposes, he or she is always a covered employee. That means any future payments to covered employees even after they depart—for example if they should receive payments in future years or if they should return to company employment at a later date—are subject to Section 162(m) deductibility limits.
“There are going to be instances where an executive officer terminates during a year and receives a lot of money,” says Martin. “They may be higher paid than the three reported in the proxy.” Companies will have to develop a way to keep track of such scenarios, he says.
Carlisle Toppin, senior manager at BDO USA, says companies should take a number of steps to assure their compensation practices reflect the recent tax law changes and IRS interpretations beginning with identifying all grandfathered arrangements and assuring there are no material modifications to those. “Avoid accelerating, deferring, or supplementing the payments,” he says. That includes any changes to severance provisions associated with those plans that are tied to a multiple of base salary, he says.
Companies also need to identify all of their covered employees based on the new criteria and establish a process for tracking covered employees going forward, as the list will only grow over time, says Toppin.
Unlike other areas of the tax reform legislation where questions persist, the guidance around executive compensation is clear enough now that most companies should be able to report the effects in financial statements, says Catherine Creech, principal in the national tax compensation and benefits group at EY. That means they should be able to make more specific assertions under the SEC’s Staff Accounting Bulletin No. 118 in their next quarterly filing, she says.
“For most of our clients, they now understand what the IRS and Treasury view of the world is on the grandfathering rule, so to the extent there was uncertainty about that, we don’t have that any longer,” Creech says.
The changes to tax law also raise questions about whether companies may modify their executive compensation strategies going forward. Steve Seelig, executive compensation counsel at Willis Towers Watson, says tax law has certainly driven a great deal in terms of how compensation plans are built today, but shareholders and proxy advisory firms have also had a big hand in driving performance-based compensation trends.
“The performance-based incentive under the tax code is going away, but we don’t think that is going to change anything anytime soon,” says Seelig. “Companies seek to pay for performance, and performance-based compensation is still the way to do that.”