The Tax Bill's Ripple Effect on Annual Bonuses and Incentive Awards

The Tax Bill’s Ripple Effect on Annual Bonuses and Incentive Awards

December 21 2017

The moment the tax bill is signed by President Trump, companies will be making financial adjustments that could affect their current year net income, in many cases quite substantially.  If the “ripple effect” of the tax bill would move a company’s net income up or down, annual bonuses and long-term incentive awards that measure performance based on company net income could move up or down along with it.

For companies with a December 31 fiscal year, the gyrations in net income will happen with barely a week left in the year.

Here is a simplified explanation.  Companies operate on an accrual basis, so each year they figure out what part of their income will have to be paid in taxes and accrue that, although the taxes actually will be paid in a future year.  A future tax amount payable is a deferred tax liability; a future tax benefit flowing to the company is a deferred tax asset.

These deferred tax items are calculated based on the tax rates written into the law, as applied to the circumstances of the company.  Until the tax bill is signed, a profitable company could expect to be paying U.S. federal income taxes at a top marginal rate of 35%.  When the tax bill reduces this to a top rate of 21%, any projected future tax payment is immediately reduced.

So, if a company has deferred tax liabilities (taxes it expected to pay in the future), those liabilities are reduced by the tax bill, and very likely the amount of the reduction will flow back in a positive way as net income.  Conversely, if a company has deferred tax assets, the reduction in value of those assets likely will result in a negative hit to net income.  Ouch.

Many annual bonus programs use net income as a key metric for determining the size of an executive’s bonus, or the amount of funding to flow into a bonus pool for employees.  Or, the program may use a metric that incorporates net income into the bonus calculation, such as earnings per share, return on assets or return on equity.  Long-term performance shares and other long-term awards also use these kinds of performance measures, and these too could feel the ripple effects of adjustments to deferred tax items.

A company that sees its incentive award formulas affected by the adjustment to deferred tax assets or liabilities will have much to ponder – and soon, if it is a December 31 fiscal year company.  Key questions will include the following:

  • What impact do the adjustments have: Is it positive or negative for net income and related metrics, and how big?
  • What language was written into the plans or award terms regarding adjustments; does that language compel or permit an adjustment to an affected metric in determining the level of performance and the corresponding payout level for the incentive award?
  • Would an adjustment disrupt tax deductibility under Code Section 162(m) (the $1 million deductibility cap, which, by the way, the tax bill is also changing in a major way)? Under 162(m), adjustments in some cases can be made only if specified in language put in place at the beginning of the performance period.
  • If an adjustment is permitted but not required, is an adjustment appropriate? Generally, if a bonus payout was authorized based on business planning that did not anticipate the effects of the tax bill, the tax bill effects would not seem to be something for which management should be rewarded or punished.
  • Do plan and award terms give the Company leeway to make an adjustment by preserving discretion? In some cases, this may only be “negative” discretion, allowing a reduction in payouts if net income was boosted, but not allowing an upward adjustment to payouts if net income was reduced due to the ripple effects of the tax bill.