Section 162(m) FAQs Under the House and Senate Tax Bills

Here are some questions and answers regarding how the House and Senate tax bills (as of Nov. 17, 2017) would alter the landscape of Code Section 162(m), the $1 million annual cap on deductibility of executive compensation:

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 before 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 deducibility 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).

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 deducibility in the same way base salary is currently treated.

4 – When would the 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, and was vested (i.e., the employee was no longer subject to a substantial risk of forfeiture) by December 31, 2016. This should solve the problem for most compensation granted and vested before the end of last year. Whether the House goes along with this sensible refinement is an open question.

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

For most 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 most 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.

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.