Massive changes in tax law with respect to executive compensation may give public companies reason to rethink how they pay their top brass.
The Tax Cuts and Jobs Act eliminates longstanding provisions around executive compensation that will make executive pay checks subject to far more taxation, both for companies and the executives themselves. The sting of that increased taxation is considerably softened by the massive cut in the corporate tax rate from 35 percent to 21 percent. The changes also remove the shackles companies have long borne in planning their executive compensation arrangements.
“We’re going to see companies looking for more efficient ways to do things,” says John Lowell, a partner with retirement services firm October Three Consulting. “Now people are going to pay what’s appropriate—whatever the right mix of base pay and incentives comes out to be.”
Companies have long structured executive compensation packages based on tax rules, and those rules under Section 162(m) of the Internal Revenue Code have long placed limits on how much of the top five executives’ paychecks at public companies is deductible from income for tax purposes.
Until the Tax Cuts and Jobs Act, the rules limited to $1 million the amount of base pay the company could deduct for its five highest paid executives. Any compensation above that $1 million could be deductible only if it met a handful of criteria that would base the compensation on performance.
That has incentivized companies to structure their executive pay packages with the tax rules in mind, says Taylor Wedge French, a partner at law firm McGuireWoods and co-chair of its employee benefits and executive compensation group. “For years we have advised companies on how to set up compensation arrangements to take advantage of performance-based compensation rules that would allow them to deduct amounts over $1 million,” he says.
Now the new tax legislation says once an executive has been identified as a “top five” for purposes of the deductibility rule, that status remains on that person for life, even after termination or into retirement.
The two most common approaches are equity-based compensation and annual bonuses predicated on some kind of performance metrics, says Eric Keller, a partner at law firm Paul Hastings. In the equity area, stock options are a common approach, where compensation amounts are based on increases in the stock price.
Equity awards also can be made through restricted stock units or performance share units, where compensation is not solely based on stock appreciation but also the attainment of other performance measures. “It can be based on a combination of factors,” says Keller. “There’s no one size fits all.”
Annual bonuses can also be structured around any number of performance criteria, says Keller, such as various measures of earnings, shareholder return, revenue, internal rates of return, and others. As long as the pay is based on performance and it’s properly governed by a compensation committee and approved by shareholders, such plans usually enable deductibility well beyond the $1 million cap on base pay.
A second important change in the Tax Cuts and Jobs Act is to the provision limiting the $1 million cap to the five highest paid executives in a given company. With changes in staffing or compensation, that list of the five highest paid executives can change over time.
Now the new tax legislation says once an executive has been identified as a “top five” for purposes of the deductibility rule, that status remains on that person for life, even after termination or into retirement. “Once you’re a covered employee, you’re always a covered employee for purposes of this $1 million deduction limitation,” says French. “That will increase the number of individuals who are subject to this cap.”
That has huge implications, both for companies and executives, around deferred compensation arrangements. Companies often structure pay so some of an executive’s compensation is payable after they leave their post, extending the deductibility of certain portions of executive pay packages into post-employment.
Another important aspect of the new tax rules for companies to study is a provision to grandfather arrangements that are considered “binding” as of Nov. 2, 2017, making them subject to the old deductibility rules, says says Helen Morrison, a principal in EY’s national tax department focused on compensation and benefits. Companies need to sort through which of their existing arrangements are eligible for the grandfathering provision and which will be subject to the new deductibility rules.
Assessing executive compensation post Tax Cuts and Jobs Act
Margaret Engel, founding partner at Compensation Advisory Partner, suggests 10 steps companies should take with respect to executive compensation in light of the changes under the Tax Cuts and Jobs Act:
Take an inventory. Make a list of outstanding compensation arrangements and awards to determine which may continue to be deductible going forward. These would include contractual benefits and other awards made under written binding contracts in place on or before Nov. 2, 2017.
Double check your assessment with tax counsel. Make sure internal resources and outside advisors agree with your analysis and conclusions.
Determine administrative processes needed to capture tax deductions going forward. For example, achievement of the goals of a grandfathered performance share award must be certified by the compensation committee prior to payment to comply with current Section 162(m) rules.
If contractual arrangements and awards will continue over time, continue to seek re-approval of the material terms of incentive plans every five years. Shareholder approvals of metrics, maximum awards and the class of participants are required to comply with current law.
Be wary of making changes. Modification to awards or arrangements in effect on or before Nov. 2, 2017 could result in the loss of valuable tax deductions.
Determine which executives appear in the proxy and become covered employees under amended Section 162(m).
Do your best to limit new entrants into the proxy disclosed group. Once an executive becomes subject to amended Section 162(m), the limits on deductibility become permanent.
Prepare a pro forma showing current law and amended law to review with the compensation committee. Committee and senior management briefings are important to avoid surprises and understand the magnitude of lost deductions.
Review your proxy disclosure. Determine how best to address the issue of tax deductibility in the CD&A.
Follow case law as it develops. Without a doubt, companies will test the amendments and new thinking will develop. You will benefit if you track the issue as it is tested in the marketplace.
That has rapid implications for the financial reporting consequences of the new tax law. Public companies are required under Accounting Standards Codification Topic 740 on income taxes to reflect changes in tax rules in the period in which the relevant legislation is enacted. Because the Tax Cuts and Jobs Act was signed into law in late December, companies must reflect it in their fourth-quarter financial statements.
With respect to executive compensation, companies will need to assess deferred tax assets on their balance sheet and determine where they have been wiped out by the change in deductibility rules, says Morrison. “Companies are looking to see whether their plans and award agreements in place are subject to the transition rule,” says Morrison.
Based on the way companies typically structure many of their performance-based awards, Morrison expects many companies will find many of their arrangements will still be deductible. Questions will arise often, however, for contracts that give compensation committees authority called “negative discretion,” which allows the committee to reduce or eliminate payments under certain circumstances. Such discretion can be viewed as producing a contract that is not binding, and therefore not subject to the grandfathering provisions, says Morrison.
While the accounting and reporting rules would suggest companies should work quickly through those assessments, they have some additional time, courtesy of the Securities and Exchange Commission. Soon after the Tax Act was signed into law, the SEC staff issued Staff Accounting Bulletin No. 118 to give companies some relief from the massive reporting exercise that would involve, given how extensive the changes in tax law are and how close enactment fell to the end of the reporting period.
SAB 118 tells companies they must report the effects of the tax law where they are able, but they may develop estimates or provisional amounts where they are not able, and they can use historic numbers if even estimates are impossible. They must supplement that accounting with plenty of disclosure, and they must update provisional amounts and historic numbers each quarter, wrapping up the transitional reporting within a year.
In the longer-term view, key changes to the taxation of executive compensation could give companies new license to rethink how they compensate their top executive team, but it’s too soon for predictions, says Lowell. “I don’t think anyone really knows for sure what the general trends are going to be,” he says. “We’re all guessing.” He surmises proxy advisory firms may soon begin weighing in with ideas that could become influential across capital markets.
The prevailing view for the moment is that pay packages will become more based on economics and what the market demands than on compliance with tax rules, says Lowell. “There will be ideas on whether companies should continue to align pay with performance or whether it is not such a big deal anymore,” he says. “I’m guessing it will be.”
French agrees companies are likely to experience some continued demand for performance-based pay structures as a good governance practice. “Prior to tax reform, there was agreement that the rules created some artificial, market-distorting pay practices,” he says. “But investors demand pay for performance, so that will always be a key component of executive pay programs.”
Another short-term project for companies to take up, says French, is a review of their proxy disclosures ahead of proxy season. Those disclosures typically contain a statement about executive pay as it relates to taw law, so companies will want to review and revise that language. “What may have been a sleepy corner of proxy statement disclosure should be revisited and updated,” he says.