Treasury Department and IRS Further Shrink Deductible Executive Compensation by Publicly Held Corporations
Significantly less executive compensation than previously thought may remain tax deductible by publicly held corporations, beginning with the 2018 tax year, under recent governmental guidance implementing a change in law made by the Tax Cuts and Jobs Act (TCJA). Covered companies will need to promptly identify additional employees covered by the new limitations, as well as outstanding compensation arrangements that may be exempt from the limits.
On Aug. 21, 2018, the U.S. Treasury Department and IRS issued Notice 2018-68 (“Notice”), which addresses several key questions relating to new limits on deductions for performance-based compensation that were enacted as part of the TCJA. The Treasury Department and IRS surprised some observers of the 2017 legislation by forecasting a more expansive view of the scope of employees who will be covered by the new deduction limits, and further by suggesting a narrow interpretation of a transition rule in the legislation intended to exempt certain compensation arrangements that were already in place when the TCJA became law.
As background, Section 162(m) of the federal tax code has long placed a limit of $1 million on the annual compensation paid to any executive employee that a publicly held corporation could deduct from its taxable income. Under the old law, “qualified performance-based compensation,” as well as commission pay, was excluded from executive compensation that was capped for corporate tax deductions. Significantly, the TCJA eliminated these distinctions, effective for tax years beginning after December 31, 2017.
More Executive Officers Covered
The first surprise announced in the Notice was the Treasury Department and IRS’s expansive view of which employees could now qualify as a “covered employee,” thus further limiting a publicly held corporation’s tax deductions for compensation paid to those employees. Under the old law, executives whose compensation was subject to the Section 162(m) deduction limit included a company’s chief executive officer (if employed by the company at the end of the tax year), and any employee whose total compensation had to be reported to shareholders under the Securities Exchange Act of 1934 (“Exchange Act”) by virtue of being one of the four highest compensated officers (other than the CEO) for that year. The new law expanded the categories of executives covered by the deduction limit to now include the following officers:
- A “principal executive officer” (such as the CEO, as previously included);
- A “principal financial officer” (such as the CFO);
- As previously included, any employee whose total compensation must be reported to shareholders under the Exchange Act by virtue of being among the three highest compensated officers (other than a principal executive officer or principal financial officer);
- Any employee who would otherwise qualify under (3) above if the required reporting applied to that employee (see “No SEC-Mandated Disclosure of Compensation Required” below); and
- Any individual who was a covered employee during any prior tax year that began or begins after Dec. 31, 2016.
No End-of-Year Employment Requirement to Become Covered
In the Notice, the Treasury Department and IRS addressed questions from the public about whether an officer whose compensation was reported to shareholders under the Exchange Act had to be employed by the company at the end of the tax year in order to be considered a “covered employee” subject to the new deduction limits. Despite similar SEC rules that do have such an end-of-year requirement for reporting executive compensation, the Treasury Department and IRS declined to limit covered employees to those officers employed at the end of the year. As a result, qualifying officers who otherwise might have been excluded because they did not finish the 2017 tax year employed at a covered company (the first year an employee can become covered) will now be covered by the rule in regard to their future compensation.
No SEC-Mandated Disclosure of Compensation Required to Become Covered
In the Notice, the Treasury Department and IRS also addressed questions from the public about whether an employee whose compensation is not required to be disclosed under SEC rules could nevertheless be a covered employee under revised Section 162(m). The Notice acknowledged ambiguity on this question but concluded that an employee’s compensation does not have to be subject to disclosure under the SEC’s rules in order to be a covered employee for Section 162(m)’s tax deduction limitation. For example, a covered employee will include an otherwise qualifying executive officer of a company that does not file a proxy statement because it delists its securities.
Transition Rule Limited
The new law provides transition relief, called the “grandfather rule,” that allows companies to deduct executive compensation under the old rules for any compensation paid under a “written binding contract” which was in effect on November 2, 2017, if the contract is not modified in any “material respect.” Since the new law’s passage, observers were unsure about whether an automatically renewed contract would be considered “modified.” In the Notice, the Treasury Department and IRS stated that the new deduction rules apply to a contract that is renewed after Nov. 2, 2017. In addition, a contract that can be terminated or canceled by a company without the employee’s consent after November 2, 2017, will be considered renewed (and therefore subject to the newly-expanded deduction limits), as of the date that the termination or cancellation, if made, would be effective.
To the interest of compensation committees, an example in the Notice also showed the Treasury Department and IRS’s view that the ability of a compensation committee to exercise discretion in reducing an executive’s performance-based bonus will, at least in some instances, subject the discretionary pay to the new deduction limits.
The Treasury Department and IRS also advised that they anticipate issuing proposed regulations incorporating Notice 2018-68 and providing further guidance on the new Section 162(m) for publicly held corporations.
