Section 162(m) Prior to the Tax Cuts and Jobs Act
Under prior law, the deduction limit under Code Section 162(m) generally applied (1) only to companies with publicly traded equity securities and (2) to the compensation paid to any employee of a public company who, as of the close of the fiscal year in question, was the company’s principal executive officer (i.e., CEO) or one of the company’s three most highly compensated executive officers other than the principal executive officer and principal financial officer (i.e., CFO). In addition, Code Section 162(m) previously included an exception to the $1 million deduction limit for commission-based compensation and qualified performance-based compensation, including stock options, stock appreciation rights and performance-based equity and cash compensation that met certain requirements. Many public companies have historically taken advantage of the exception for qualified performance-based compensation in order to exclude such amounts from the deduction limitation.
Changes to Section 162(m) Under the Tax Cuts and Jobs Act
Effective for tax years beginning after December 31, 2017, the Act makes the following changes to Code Section 162(m):
- No Exception for Performance-Based Compensation. The Act eliminates the exception to the $1 million deduction limit for commission-based compensation and qualified performance-based compensation. Therefore, all compensation paid to a covered employee will count toward the $1 million deduction limit. This amendment is likely to result in changes to the design and implementation of public company executive compensation plans and programs as discussed in more detail below.
- Anyone Who Serves as CEO or CFO of a Covered Company is a Covered Employee. The Act expands the definition of covered employee to also include a company’s principal financial officer, aligning the definition of “covered employee” with the definition of “named executive officer” under Item 402 of Regulation S-K. In addition, any individual who served as a company’s principal executive officer or principal financial officer at any time during the year is included as a covered employee.
- Once a Covered Employee, Always a Covered Employee. The compensation paid to any person who was a covered employee in any taxable year after 2016 (including years in which a covered company was not required to file reports with the Securities and Exchange Commission (SEC)) will continue to be subject to the $1 million limit for as long as such employee or his or her beneficiaries receive compensation from the company. Companies should review the new covered employee definition and make sure that they understand who will be included in the covered employee group going forward, which may include employees who are covered due to their position or compensation in periods before the company went public as well as individuals who are no longer employed but continue to receive compensation from the company.
- Expansion of Companies Subject to Code Section 162(m) to Include Companies With Registered Debt. The scope of Code Section 162(m) has been expanded to apply to all companies that file reports with the SEC, including any corporation that is required to file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934. Accordingly, companies with registered debt will be subject to the $1 million deduction limit under Code Section 162(m) even if they do not have publicly traded equity.
- Limited Transition Rule. The amendments to Code Section 162(m) will not apply to compensation payable pursuant to a written binding contract in effect on November 2, 2017, provided such contract is not subsequently modified in any material respect after November 2, 2017 (including any renewal of such contract).
As a result of the changes to Code Section 162(m), we recommend that our public company clients take the following actions:
Review Performance-Based Compensation Programs. Given the elimination of the exception to the deduction limit for performance-based compensation, public companies will no longer need to comply with the stringent and complex rules required for performance-based compensation to qualify under Section 162(m) when designing and implementing performance-based compensation programs. For example:
- Companies will no longer be confined to a list of stockholder-approved performance criteria and may use any performance criteria deemed appropriate by the compensation committee.
- In order to meet the requirements for qualified performance-based compensation under prior law, the compensation committee could only have the discretionary ability to make downward adjustments to actual payouts. With the elimination of the exception for performance-based compensation, compensation committees may retain broader discretion to adjust performance-based compensation, including the ability to make upward adjustments.
- Adjustments to performance goals no longer need to be pre-established or objectively determinable.
- The compensation committee need not establish performance criteria in the first 90 days of the performance period.
Although companies will no longer need to comply with the stringent requirements for performance-based compensation under Code Section 162(m), and compensation committees can exercise greater discretion in adjusting performance-based compensation, stockholders and proxy advisory firms are likely to continue to focus on pay-for-performance. Companies should take that into account when designing performance-based compensation programs, and should also consider whether any proposed changes will impact executive compensation disclosure in the annual proxy statement or Form 10-K.
Review Equity Incentive and Performance-Based Cash Bonus Plans. There is no longer a need to seek stockholder approval of cash bonus plans or performance criteria initially and on a periodic basis, which was previously required in order to grant qualified performance-based compensation. Accordingly, companies will no longer need to include a list of performance criteria in stockholder-approved equity incentive plans and certain individual limits in equity incentive plans may be removed. Companies will need to consider whether stockholder approval of such changes is necessary under the relevant stock exchange rules or the language of the plan itself. In addition, proxy advisory firms have not yet given any guidance on how they are likely to view such amendments.
Review Severance and Equity Acceleration Provisions. Under prior law, qualified performance-based compensation could only be payable upon achievement of the specified performance goal. As a result, compensation that was payable upon a termination of employment, regardless of whether the performance criteria were met, failed to qualify as performance-based compensation under Code Section 162(m). The elimination of the exception for qualified performance-based compensation may result in more companies paying bonuses at target levels (or prorated target levels) upon a termination of employment under certain circumstances and/or providing for acceleration of performance-based equity awards at target levels upon a change in control rather than based upon actual performance. However, as noted above, although companies will no longer be hamstrung by Code Section 162(m) requirements, they will still want to take into account the views of investors and proxy advisory firms in structuring severance and equity acceleration. Acceleration of performance-based equity awards at target upon a change in control in particular is disfavored by proxy advisory firms. In addition, because the $1 million deduction limit will now apply to compensation paid at any time to a covered employee, including after termination of employment, companies may consider structuring severance and other payments to be paid out over multiple years rather than in a lump sum in order to reduce or eliminate any nondeductible compensation paid to a covered employee in any one year (but will need to be mindful of Code Section 409A when making any changes to existing arrangements or implementing new arrangements).
Review Potentially Grandfathered Arrangements. The amendments to Code Section 162(m) do not apply to compensation payable pursuant to a written binding contract in effect on November 2, 2017, provided such contract is not subsequently modified in any material respect after November 2, 2017 (including any renewal of such contract). Guidance from the Treasury Department on this transition rule is still forthcoming and there are a number of questions regarding how the transition rule will apply, including whether a plan or agreement that includes negative discretion constitutes a binding contract. Until further guidance is issued, companies should use caution when considering changes to potentially grandfathered arrangements. We encourage companies subject to Section 162(m) to (1) consult with legal counsel before making modifications to existing performance-based compensation arrangements and (2) continue to maintain a compensation committee comprised of two or more “outside directors” for purposes of certifying attainment of performance criteria under existing arrangements.
Review Proxy Statement Disclosure. Item 402(b) of Regulation S-K lists “the impact of the accounting and tax treatments of the particular form of compensation” as a potentially material factor to be discussed in the Compensation Discussion and Analysis in a company’s proxy statement. Companies should understand whether the changes to Code Section 162(m) will have a material impact on their financial statements as a result of the lost deduction and review and revise any proxy statement disclosure regarding the impact of Section 162(m) accordingly. There has been some commentary encouraging companies to include a table in their proxy statements quantifying the nondeductible portion of each element of compensation identified in the Summary Compensation Table but we would caution companies to carefully consider such a step and to consult with legal counsel and their outside accountants before doing so.
Consider the Accounting Impact. Companies subject to Section 162(m) should work with their outside accountants to determine how the Act, including (1) the reduced corporate tax rate, (2) the expanded definition of covered employees and (3) the elimination of the exemption for commission-based and qualified performance-based compensation, will impact the cost of compensation for covered employees going forward.
Additional Deduction Limitation for Payments Related to Sexual Misconduct. The Act also includes a provision under Section 162(q) disallowing a deduction for “any settlement or payment related to sexual harassment or sexual abuse” (emphasis added) as well as any related attorney’s fees if the settlement or payment is subject to a nondisclosure agreement. It applies to payments made after January 1, 2018, even if the agreement with respect to such payments was entered into prior to such date. The vague and broad language of the provision raises a number of questions, including whether it applies to any settlement or payment that is subject to a nondisclosure agreement where there is a broad release of claims (including, but not limited to, sexual misconduct-based claims).
The Goodwin team continues to monitor the situation for additional guidance on Section 162(m), particularly with respect to the grandfathering provisions, and we look forward to assisting our clients in assessing the impact of the changes discussed in this alert on their compensation programs.