Like other publicly held companies, many financial services companies long have tailored their executive compensation packages to achieve full deductibility – but that opportunity has been curtailed.
H.R. 1, commonly known as the Tax Cuts and Jobs Act (TCJA), amends Section 162(m) of the IRC in ways that will prevent the deductibility of certain executive compensation that previously was deductible. While the new tax law does include a transition rule that maintains the deduction in its pre-TCJA form in some cases, the rule has created some additional questions that remain unanswered.
Repeal of Performance-Based Compensation Exception
Section 162(m) generally limits publicly traded companies’ deductions for compensation to $1 million per year per covered employee, but it previously included a valuable exception for performance-based compensation. As a result, a financial services organization that, for example, paid a covered employee $1 million in salary and $9 million in performance-based compensation in a tax year could deduct the entire $10 million that year.
The TCJA eliminates the exception, so performance-based compensation now is included in compensation that is subject to the $1 million deduction limit. It obviously comes with a cost, but the elimination of the exception should prove easier on companies administratively, as they no longer will need to jump through hoops to meet the performance-based compensation exception’s strict requirements when structuring their compensation programs.
Although the performance-based exception has been eliminated, financial services companies should consider continuing to comply with the former requirements for corporate governance purposes. For example, the exception required independent compensation committees to establish performance targets and certify whether such targets had been reached. Governance expectations might support continuing this practice, although perhaps with more discretion retained by the compensation committee to adjust the targets as warranted. Also, note that the exception’s requirements must continue to be satisfied for any compensation qualifying under the transition rule that is intended to be deductible as performance-based compensation.
Expanded Definition of Covered Employees
Before the TCJA, Section 162(m) and other applicable guidance generally defined covered employees as anyone who was, as of the last day of the taxable year, the CEO or one of the three highest paid officers other than the CEO or CFO. Thus, before the TCJA, the CFO generally was not a covered employee. The TCJA revises the definition to include any individual who served as CEO or CFO at any time during the tax year, as well as the three most highly compensated officers for the tax year (other than the CEO or CFO), who: 1) must be reported in the summary compensation table on the company’s proxy statement for the tax year, or 2) would be reported if such reporting requirements applied. The latter condition would seem to apply to companies subject to reduced reporting requirements under Securities and Exchange Commission rules.
Previously, the covered employee determination focused on the employee’s status at the end of the year. Thus, an employee who was a covered employee in prior years could retire or leave the company any time before the last day of the year and receive significant payments (such as large deferred compensation payments) that would not be subject to the $1 million deduction limit. Under the new rules, the limit will apply regardless of whether the individual has retired or otherwise left the company before the end of the year.
Moreover, under the new rules, once an employee meets the definition of a covered employee for any tax year beginning after Dec. 31, 2016, the deduction limit will apply to that person as a covered employee for as long as the company or its successors compensates that person, including after death or termination. As a result of this “once a covered employee, always a covered employee” rule, companies will have a growing number of covered employees in future years.
Expanded Definition of “Publicly Held Corporation”
The TCJA expands the definition of companies subject to Section 162(m). Under prior law, companies that held only publicly traded debt were not subject to the provision – it applied only to those that held publicly traded equity.
The tax law revises the definition of publicly held corporations to mean any corporation that is “an issuer,” regardless of whether it is an issuer of equity or of debt, that must register its securities under Section 12 of the Securities Exchange Act of 1934 or file reports under Section 15(d) of the act. The new definition also includes foreign companies publicly traded through American depository receipts and, in certain rare circumstances, large, privately held S and C corporations.
The TCJA provides a transition rule that exempts from the new rules compensation payable pursuant to a written binding contract that was in effect on Nov. 2, 2017, and has not been materially modified or renewed on or after that date. Any modification or renewal of a contract that was in effect on Nov. 2, 2017, will result in such contract being subject to the new rules as of the date of such modification or renewal.
For example, if a covered employee was granted a stock option in June 2017 pursuant to a written binding contract that was not subsequently amended, any compensation realized upon exercise of the option probably would not count toward the $1 million deduction limit, regardless of when it is exercised (assuming it qualifies as performance-based compensation under the old Section 162(m) rules). However, if the option is repriced after Nov. 2, 2017, it probably would count toward the deduction limit upon exercise.
The congressional conference agreement for the law1, however, includes some confusing and seemingly contradictory language. The conference agreement incorporates an example in which an employee who joins a company in October 2017 has an employment contract that indicates the employee is eligible to participate in a deferred compensation plan pursuant to the terms of such plan. The terms of the plan indicate that the employee is eligible to participate after six months of employment. The plan document also states that amounts payable under the plan are not subject to discretion and the company can materially amend or terminate the plan only on a prospective basis. The conference agreement indicates that, all other applicable conditions being met (for example, the plan is in writing), payments under the plan are grandfathered under the old rules.
The conference agreement goes on to state that “A contract that is terminable or cancelable unconditionally at will by either party to the contract without the consent of the other, or by both parties to the contract, is treated as a new contract entered into on the date any such termination or cancellation, if made, would be effective.”
Although such language could have different interpretations, absent guidance to the contrary, perhaps the most logical interpretation is that if a contract allows for either or both parties to terminate the contract without the consent of the other party, such contract will lose grandfathered status as soon as such contract could be so terminated, even if it isn’t terminated. This meaning would appear to jeopardize any contracts that contain negative discretion (that is, contracts that allow the employer to reduce or eliminate a benefit without the consent of the employee), such as existing Section 162(m) umbrella plans.
However, this deduced meaning might contradict the deferred compensation plan example provided in the conference agreement because that example indicates the employer can unilaterally terminate the plan on a prospective basis. If the preceding interpretation is correct and the employer can terminate the plan prospectively, the plan should lose its grandfathered status as soon as such a termination could be effective (presumably as early as Nov. 2, 2017), but the example makes no mention of this. If the proper application of the transition rule to the deferred compensation example instead is that the plan would qualify under the transition rule until the actual effective date of any future plan termination, what is the purpose of the “if made” language in the conference agreement? The “if made” language implies that grandfathered status is lost as soon as the plan could be unilaterally terminated, even if it isn’t terminated. Otherwise, it would have been much clearer for the conference agreement to simply indicate that a contract is treated as a new contract “on the effective date of any such termination or cancellation.”
As illustrated in the preceding discussion, the language in the conference agreement is open to multiple interpretations. In addition, other ambiguities surround the definitions of “written binding contract” and “material modification” that are not discussed here. Guidance from the IRS is expected in the future, and the sooner it arrives, the better.
While they await further guidance, financial services companies should not sit idle. They should review their performance-based compensation arrangements (and nonperformance-based arrangements for the CFO) to determine whether they might qualify for the transition rule, compute the potential value of lost deductions in light of the reduced federal corporate tax rate under the TCJA, and institute procedures to track which employees are covered employees under the new rules. They also should think twice before modifying any existing contracts that could potentially qualify under the transition rule. Taking these steps now will help chart the best course forward. Of course, once guidance is issued, some of these items will need to be revisited.
1 Joint Explanatory Statement of the Committee of Conference, p. 345, https://docs.house.gov/billsthisweek/20171218/Joint Explanatory Statement.pdf