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The new tax law strengthened a provision that prevents public companies from getting a tax deduction for compensation to top executives in excess of $1 million—a change that practitioners and taxpayers are still grappling with.
“I’m not surprised that Congress went in this direction,” Eric Winwood, a partner at Baker Botts LLP in Dallas, told Bloomberg Tax. The law eliminates commission- and performance-based compensation exceptions to a limitation under tax code Section 162(m), which says publicly held companies may not deduct payments to certain executives when the compensation exceeds $1 million. Tax legislation introduced in 2014 by former Ways and Means Committee Chairman Dave Camp (R-Mich.) suggested a similar change.
What’s surprising is the lack of transition relief, Winwood said. The new provision took effect in 2018, shortly after the legislation was signed into law. “It didn’t give companies a lot of opportunity to switch gears and assess how they were doing things,” he said.
As companies deal with this change, there are several issues they should consider.
One of the biggest concerns raised by tax professionals is the extent to which companies will be able to take advantage of the “grandfathering provision” under the 2017 tax act ( Pub. L. No. 115-97).
This provision says that the tighter limitation won’t apply to compensation paid under a written binding contract in effect on Nov. 2, 2017, provided that the contract hasn’t been materially modified. The conference report’s description of this provision seems to indicate that if a company has the right to terminate or materially amend a contract, it is not grandfathered, Ernst and Young LLP wrote in a late-December tax news update.
“Basically, unless a compensation amount is ‘set in stone’—it can’t go up, it can’t go down—it’s not going to meet the grandfathering rule,” Winwood said. This may preclude many employers from taking advantage of that transition relief because contracts often will include provisions that allow a company to reduce an individual’s pay if he or she isn’t meeting individual performance standards, he said.
This is referred to as “negative discretion,” and past Internal Revenue Service regulations under Section 162 allowed employers to exercise this discretion and still qualify for the performance-based compensation exception to the deduction limit, Winwood said. The ability to increase pay, however, has never been permitted.
Negative discretion is “a very common feature of annual bonus plans and other performance-based arrangements,” G. William Tysse, a partner at McGuireWoods LLP in Washington, told Bloomberg Tax. There isn’t a consensus among practitioners about how the new tax law treats negative discretion and there probably won’t be any resolution until the IRS issues guidance, he said.
The tax law also revises the definition of a “covered employee” subject to the executive compensation deduction limit.
The group of covered executives under the law includes the chief executive officer of the company, the chief financial officer, and the next three highest-paid executives. The provision includes anyone who holds these positions at any time during the year, and once a person is a covered employee, he or she remains a covered employee for all future years, including after the person leaves the company, retires, or dies.
For some publicly held companies, this change will mean that instead of having a handful of people to track for purposes of the Section 162(m) limitation, “you could have 20, 30, 40, 50 people,” said Bret Busacker, a partner at Holland & Hart LLP in Boise, Idaho.
This could be especially burdensome for corporations where the three top-paid executives behind the CEO and CFO change from year to year, Busacker said. For example, who holds those spots could depend on whether one division is more successful than another, or on bonus compensation, he said. Companies may now look for ways to “minimize and mitigate the number of people who fall into this category.”
Tysse agreed that employers likely will have greater administrative costs in dealing with the covered employee change but that most of his clients aren’t that concerned.
“They’re not planning any changes to their comp plans at this point that would try to mitigate the impact of having potentially a larger population of executive officers who are subject to the deduction cap,” he said. “Employers, by and large, aren’t extremely worried about losing the additional deduction because of the drop in the corporate tax rate,” which has decreased the tax benefit associated with the deduction, he said.
Both Busacker and Tysse said companies may tweak their performance goals in light of the new law.
Prior to the enactment of the 2017 law, companies were spending a lot of time designing compensation plans in a way that ensured compliance with Section 162(m) and the performance-based compensation exception, Busacker said. It’s tended to skew the performance goals that companies use and the vehicles they choose—for example, whether they decide on stock options or performance-based restricted stock, he said.
With the exception gone, companies have more flexibility to design performance metrics that better reflect their objectives, “instead of having all of these workarounds” stemming from Section 162(m), Busacker said.
In the past, annual bonus programs and long-term equity-based performance programs had to be very objective, formulaic, and mechanical to comply with the Section 162(m) exception, Tysse said. Now, companies may have slightly more subjective performance goals, he said.
However, “it’s not like the sky is the limit,” Busacker said. Public companies still have to consider what their shareholders want, he said.
Most “shareholders generally still want to see programs that are largely objective and formulaic,” Tysse said.
Employers also need to be careful how they alter their performance goals because they may inadvertently impact their nonqualified deferred compensation plans under Section 409A, which includes a definition for performance-based compensation similar to the former definition under Section 162(m), Busacker said. A nonqualified deferred compensation plan is an arrangement between an employer and an employee to pay the employee compensation in the future.
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