The recently enacted Tax Cuts and Jobs Act substantially modifies the limitation on corporate deductibility of executive compensation under Section 162(m) of the Code. The stricter limitations on executive compensation deductibility are presumably intended as a partial offset to the reduction in the corporate tax rate from 35% to 21%.
Section 162(m) limits the deduction for compensation paid by a publicly held corporation to certain of its executive employees to $1 million per year. Before the Tax Act, the applicable executives (for a corporation other than a “smaller reporting company” under the SEC rules) were the corporation’s principal executive officer and the next three highest-paid executive officers, other than the principal financial officer, who was not included. For a smaller reporting company, the applicable executives were the corporation’s principal executive officer and the next two highest-paid executive officers, which could include the principal financial officer. The limitation applied only to those executives who were in such positions on the last day of the corporation’s tax year. Publicly held corporations generally were defined to include only those having securities required to be registered under Section 12 of the Securities Exchange Act of 1934. Additionally, commissions and performance-based compensation payable under stockholder-approved plans were not subject to the deduction limitation.
The Tax Act has made the following changes to these rules:
Covered Employees
The Tax Act has amended the definition of “covered employee” to correspond to the general SEC reporting requirements for named executive officers. These are the corporation’s principal executive officer, principal financial officer, and the next three highest-paid executive officers. There is no reduced requirement for smaller reporting companies.
Additionally, covered employee status is no longer limited to those executives holding the positions at the end of the applicable tax year. Once an executive has become a covered employee in any tax year beginning after December 31, 2016, such status continues in perpetuity. It no longer will be possible for corporations to deduct deferred compensation in excess of $1 million per year paid to former executives after they have ceased to be covered employees. In fact, amounts paid to a former executive’s beneficiaries after his or her death will continue to be subject to the deduction limitation.
Publicly Held Corporations
The Tax Act also has amended the definition of “publicly held corporation.” Corporations subject to the deduction limitation now also include corporations required to file reports under Section 15(d) of the Securities Exchange Act. The amended definition may include certain corporations that are not publicly traded, such as large private C corporations and possibly some S corporations.
Performance-Based Compensation
Most significantly, the Tax Act has eliminated the exemptions for commissions and performance-based compensation. These exemptions are utilized by many public companies to receive tax deductions for performance bonuses and equity incentive compensation well in excess of $1 million per year to top executives. Any such performance-based compensation will now be included in compensation subject to the $1 million limitation.
Effective Date
In general, the changes to Section 162(m) apply to the deduction of compensation in tax years beginning after December 31, 2017.
The Tax Act provides an exception for compensation paid pursuant to a written binding contract that was in effect on November 2, 2017, and is not modified after such date. As it relates to performance-based compensation, it is not sufficient that a plan under which the compensation is paid was in place on such date, but rather there must have been a written agreement with the executive, including the performance criteria and formula under which the compensation is to be paid, in place on such date.