Thought Leaders

New Tax Laws: Silver Linings to Loss of Compensatory Deductions Under Section 162(M)

Matthew B. Grunert and Carolyn A. Exnicios
Executive Compensation Practical Pointers

December 2017

The recently enacted Tax Cuts and Jobs Act of 2017 (the “TCJA”) amended the Internal Revenue Code of 1986 to eliminate the performance-based exception to the $1mm deduction limit under Section 162(m) of the Internal Revenue Code of 1986 (“Section 162(m)”). This article discusses some of the new opportunities for publicly-traded corporations resulting from the TCJA’s amendment of Section 162(m).

Business Point

Repeal of the performance-based exception to the $1mm deduction limit will have a financial impact on many publicly-traded corporations, but it will also simplify the administration of compensatory arrangements, and more importantly, will free the Compensation Committee to design compensatory programs that drive increases to shareholder value without the artificial restrictions of the performance-based exception. The result is that many publicly-traded corporations are likely to redesign their executive contracts, annual bonus programs and equity incentive plans to eliminate the restrictions that were otherwise required under the performance-based exception.

Technical Points

With the repeal of the performance-based exception to the $1mm deduction limitation on compensation payable to certain executives, the following are among the things that should be given consideration:

  • Equity incentive plans will no longer require shareholder approval for 162(m) purposes (though shareholder approval will still be required pursuant to NYSE and NASDAQ listing rules and for purposes of stock options qualifying for incentive stock option (“ISO”) treatment);
  • The elimination of Section 162(m) language within an equity incentive plan document should streamline and simplify both the document and its administration;
  • Equity plans will not need to contain individual employee limitations on annual grants (though such may be desired as a form of good governance and certain requirements regarding ISOs continue to apply);
  • Equity awards and other executive contracts can be drafted to accelerate payment of performance-based compensation upon events such as death, disability, changes of control and involuntary terminations of employment without regard to whether the performance conditions are actually satisfied (previously such acceleration was subject to stringent limitations if deductibility was to be preserved);
  • Grants of restricted stock and RSUs may become more appealing since under the TCJA stock options and SARs will no longer have preferential deduction treatment under Section 162(m);
  • Compensation Committees may now use discretion to increase the amount of a performance award (previously only negative discretion was permitted if the amount was to qualify for the performance-based exception);
  • Performance goals are no longer required to be objectively determined, which means subjective performance goals such as leadership are likely to be used more frequently and potentially with more weighting;
  • Performance goals can be adjusted throughout the performance period;
  • The members of the Compensation Committee will no longer be required to satisfy the definition of “outside directors” as defined in Section 162(m) (though the requirement for independence of Compensation Committee members will continue to apply under SEC Rule 16b-3 and NYSE and NASDAQ listing rules);
  • The Compensation Committee is no longer required to set performance goals within 90 days of the start of the performance period;
  • The Compensation Committee can now delegate authority to set performance goals (e.g., CEO can set performance goals for other executives);
  • The Compensation Committee is not restricted to selecting only those performance goals set forth in the plan document; and
  • The Compensation Committee is no longer required to certify achievement of performance goals.

Note that certain compensation/arrangements may be grandfathered and still eligible for deduction under the performance-based compensation deduction. Guidance from the IRS regarding grandfathering for this purpose is expected in the near future.

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