Section 162(m) FAQs - Tax Cuts and Jobs Act

Section 162(m) FAQs – Tax Cuts and Jobs Act

December 11 2017

**Updated December 11, 2017**

Below are some questions and answers regarding how the House and Senate tax bills (as of Nov. 27, 2017) would alter the landscape of Code Section 162(m), the $1 million annual cap on deductibility of executive compensation. We have added some updated information (December 11 – in bold italics or italics), discussing things that we have learned working through the issues.

1 – What big changes are in store for Section 162(m) in the current tax bills?

The current versions of both the Senate and House tax bills include these major changes to Section 162(m):

  • The performance-based compensation exception would be scrapped
  • The CFO would be returned to the group of covered employees, as was the case prior to 2008
  • Once an executive is a covered employee in any year (starting in the current year, 2017), compensation will be subject to Section 162(m) in all future years, including after termination
  • Section 162(m) will now apply to companies with only debt securities registered with the SEC
2 – How bad is this?

Medium bad. If the final bill succeeds in lowering the top tax bracket for C-corporations to 20%, the majority of companies that will lose deductibility under Section 162(m) will, on a net basis, have much lower taxes even with the added 162(m) pain.  Nevertheless, the changes will raise the after-tax cost of executive compensation, and that should be of concern to the compensation committees and board.

In particular, the change could have a harsh impact on future compensation resulting from older equity awards and deferred compensation (see Question 5 below).

Update:  In one scenario, the “trade-off” of lower tax rates for loss of deductions on executive compensation under 162(m) could have a harsh result.  The Senate bill would lower the corporate tax rate starting in 2019, but the loss of deductions under 162(m) would begin in 2018.

3 – What performance-based awards are affected?

Stock options, SARs, performance-based equity awards, and annual incentive awards are commonly covered by the performance-based awards exception under Section 162(m).  All will now be subject to the $1 million cap on deductibility in the same way base salary is currently treated.

4 – When would the 162(m) changes kick in?

For fiscal years that begin after December 31, 2017.  Calendar year fiscal year companies may have only a few weeks before coming under the new regime.  A company with a June 30 fiscal year will have more time to acclimate.

5 – How would the changes affect old awards and deferrals that result in compensation in future years?

This is a huge issue, but there is hope.  Under the House bill, any compensation to a covered employee that otherwise would be deductible in a fiscal year starting in 2018 or later would be non-deductible to the extent it exceeds $1 million, regardless of whether it was 162(m) compliant when granted.  For example, stock options granted in past fiscal years, performance shares or deferred compensation could result in huge future payouts that up until now was thought to be excluded from the $1 million deductibility cap.  This applies to any executive that is a covered employee in 2017 or any later year.

The Senate Bill has now been modified to “grandfather” compensation resulting from a written binding contract that was in effect on November 2, 2017, and not materially modified thereafter.  (In mid-November, the Senate language also required that the compensation was vested by December 31, 2016, but this has been dropped, so even compensation that vests in future years can be covered by this exception.)  This should solve the problem for most compensation granted before November 3, 2017 if it is under a written binding contract (awards subject to “negative discretion” probably would not be grandfathered, however).  The House ought to go along with this sensible refinement, but there are no guarantees.

6 – Should a company accelerate payouts of 2017 annual incentive, to pay before year end?

For many companies, annual incentives won’t need to be accelerated into the current fiscal year to gain a 162(m) advantage.  The main reason is that many companies take the necessary steps so that annual incentive payouts made within 2.5 months after the end of a fiscal year are deductible in the just ended fiscal year.

If a company does not normally take the necessary steps to qualify post-year-end payouts as deductible in the just-ended year, it should consider doing so if the payout qualifies under 162(m) (or is an award to the CFO) and would save taxes.

Update:  To qualify annual incentive awards for tax deduction by the company in the performance rather than the year of payout, the company has to meet the IRS’s “all events” test, meaning that all events necessary so that the company is legally committee to paying out the bonuses must have occurred by the end of the fiscal year.  Until the IRS shined a spotlight on this issue a few years ago, it was widely believed that the only necessary step was to pay out bonuses within 2.5 months after year end.  Alas, the tests are much trickier than that. 

We have added a new Q&A, Question 11 below, to explain further.

7 – What about equity compensation?

In the case of vested, in-the-money stock options, an executive could save the company substantial taxes by exercising in the current fiscal year if the grandfathering of previous awards is left out of the final bill (see Question 5).  However, there is no benefit to the executive for exercising vested, in-the-money stock options earlier than they originally intended.

In the case of other equity awards, it is possible that a given award could be accelerated and paid out in 2017, but there are several impediments.  As a 162(m) qualifying award, the performance goal may not be of a kind that could be deemed to be achieved early.  If the award also is “deferred compensation” under Code Section 409A, acceleration may not be possible.  We suspect that this technique will be useful only in a few specific cases.

The CFO might be a special case meriting acceleration of awards into the current fiscal year.  Also, if an equity award is yet to be made to the CFO, he or she could be granted restricted stock and file an 83(b) election in the current fiscal year as another way to get one last tax deduction under the old rules.

8 – What about the two other ways commonly used to avoid lost tax deductions under 162(m)? 
  • Payments to an executive who terminates before the last day of the fiscal year are not subject to 162(m)
  • Deferral of compensation until termination of employment has been a widely used technique to avoid the 162(m) deductibility cap

Both no longer will work.  Covered employees will include anybody who was the CEO or CFO in any fiscal year (at any time, not just at year-end) beginning on or after January 1, 2017, including interim holders of those titles, plus anybody who was one of the three other most highly compensated executive officers for any post-2016 fiscal year.  Once a covered employee, always a covered employee, even after termination.

One new technique we may see is for post-termination compensation to be structured in a way that keeps it largely within the $1 million threshold each year.  This would likely be done by spreading payments out over multiple years (creating 409A deferred compensation, which is its own can of worms).

9 – Wait, I thought the tax bills were going to kill non-qualified deferred compensation?

Yes, the original bills would have, but those provisions have been dropped.  Code Section 409A lives on.

10 – If a company has a lot of deferred compensation, could it rely on the little used 409A rule allowing termination of all deferred compensation plans so the compensation is payable in the current fiscal year?

No.  The 409A rule provides that payouts be delayed for 12 months when a company terminates all of its plans (for plan terminations not relating to a change in control).  It’s too late to try this.

December 11 Update:

11-  What steps should a company take to make sure annual incentive awards are deductible as 2017 compensation (even if paid in early 2018), so that the 162(m) performance-based exception will apply to that compensation?  

Assuming a company has a December 31 fiscal year, here is a high level overview of the steps to be taken to meet the IRS’s “all-events” test:

  1. Determine whether annual incentives paid in early 2017 were claimed as deductible in 2016.  If so, do the same things again, but check your work – the IRS already is giving close scrutiny to “all events” compliance, and your process for the 2017 tax year may come under the IRS microscope.
  2. Determine whether the plan or award terms make the award forfeitable if the executive quits or is terminated before payout, which means that there remains service-based vesting into 2018.  If so, either this vesting will have to be moved up to December 31 or the company will have to commit (through a board or committee resolution) to pay out out a certain level of bonuses to a defined group of employees including the executive.  Note – companies currently are looking at the broader question of locking in 2017 tax deductions for bonuses to broader groups of employees in order to get the advantage of higher 2017 marginal tax rates, expecting that the final tax bill will lower the 2018 corporate rates (as the House bill does, but the Senate bill defers until 2019). 
  3. Determine whether 162(m) and other performance goals to be met for the 162(m) payouts are purely objective.  If so, resolutions committing the company to pay out the award can be based on the mechanical determination of the payout (the year-end accrual), based on final year-end numbers and the payout grid previously authorized.  Those final year-end numbers probably will only be known weeks into the next year, but the compensation committee certification (required under 162(m)) at that point should be a purely “ministerial” act – this is OK under the all-events test.  (But, you still need to consider the steps below other than step (4).)
  4. If step (3) is not available to you, for example because there are some aspects of the award that are subjective, the compensation committee probably will have to determine and certify before year-end that some level of the performance goals have been met, specifying a dollar level of payout to which the company is committed (probably at a conservative level based on projected results, such as 80% of the currently projected payout).  Watch out – the plan and award terms may have language that precludes taking this action (for example, stating that this determination has to be based on audited numbers, or stating that it will be made after the end of the performance year, etc.)  Whether that language can be amended must be considered (don’t amend anything that affects “grandfathered” awards – see Question 5 above).  The compensation committee will require that management express a high degree of confidence as to full year results before it irretrievably commits to paying a high level of bonuses.
  5. If a bonus pool approach is taken (as in the case where service-based vesting remains in place until a payout date in 2018), the resolutions should specify that any forfeited bonus amounts can only be reallocated to other participants – the money cannot flow back to the company.  No reallocation to a 162(m) covered employee can result in a payout beyond the 162(m) maximums or beyond the level earned based on the 162(m) performance goals.
  6. The resolutions must waive any discretion that the committee (or board or company) could exercise in 2018 to reduce the funding pool.  Here again, the plan or award terms may be inconsistent, preserving such discretion (usually negative discretion in 162(m) plans) in language that arguably does not allow a waiver.  Think broadly – there may be other discretion that must be cut off by year end, such as the ability to make discretionary adjustments.  Consider whether amending inconsistent plan or award language can fix the problem (but don’t let the amendment disturb grandfathered awards – see Question 5 above).
  7. Be careful to identify the correct decision-maker(s) – the compensation committee or the board – to take the needed actions. Committee action is required for 162(m) matters.  If a funding pool is created for a wider group of employees, carefully consider and specify what plans are covered and what subsidiaries or business units are covered.  For far-flung plans, the compensation committee or board may not be the true authorized decision maker, so documentation by others in management may be needed.  
  8. We have learned that, in examinations, the IRS may consider whether the company’s year end commitments have been communicated to participants, as a sign that there really was a commitment.
  9. The above steps need to be taken by year end.  Resolutions adopted earlier could allow the committee or board to revisit the issues up to the end of the year.
  10. Any annual incentives or bonuses meant to meet the all-events test then have to be paid out by March 15.
12 – We are a public company with a subsidiary that is a “debt-only” public company.  Do the 162(m) changes pick up executives of our subsidiary who are not also executives of the parent company, such as the CFO?

Apparently yes.  Existing regulations treat a publicly held subsidiary as being separately subject to 162(m).  (This is already an issue if the subsidiary has publicly held common stock.)  If any subsidiary executives would first become subject to 162(m) in 2018, and their compensation levels could exceed $1 million, it may be advisable to pay out 2017 bonus in a way that qualifies it as deductible in 2017.