Sec. 162(m) dramatically altered public corporation compensation practices by mandating a series of requirements to preserve the tax deduction for performance-based compensation. Aside from the exemption granted CFOs in 2007, Sec. 162(m) has remained essentially unaltered since taking effect in 1994.1 However, P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017 (TCJA), brought sweeping changes to Sec. 162(m), effective for tax years beginning after Dec. 31, 2017. These statutory changes alter the environment surrounding executive compensation and thus have broad, immediate implications for executive compensation arrangements. This article presents how the TCJA altered corporations' responsibilities and discusses the potential compensation implications.
As revised, Sec. 162(m) can be summarized as follows: For publicly traded corporations, the compensation tax deduction is limited to $1 million per covered executive. The TCJA changed the definition of "publicly traded" corporation and of "covered executive" and eliminated the tax deduction for all compensation in excess of $1 million, whether performance-based or not. The table, "Comparison of Sec. 162(m) Under Prior Law and New Law," below, presents a comparison of the principal changes.
Expanded definition of publicly traded corporation
Before 2018, Sec. 162(m) applied only to corporations that issued common equity securities required to be registered under Section 12 of the Exchange Act.2 The TCJA expanded this definition to include foreign corporations with equity traded through American depository receipts (ADRs) and domestic corporations with publicly traded debt.3
Planning implication: Consequently, the tax deduction limitations of Sec. 162(m) now apply to some privately held corporations, thereby reducing the incentive for these corporations to remain off the public exchanges. The incentive also exists for foreign corporations to buy back their existing ADRs and for domestic private corporations to redeem their publicly traded debt.
Expanded definition of covered executive
Before 2018, in each fiscal year, each publicly traded corporation had four executives subject to Sec. 162(m), composed of the individual serving as the CEO on the last day of the fiscal year plus the corporation's three highest-paid non-CEO, non-CFO named executive officers. The TCJA greatly expands the definitions of Sec. 162(m)-covered executives. Rather than applying to a single CEO, Sec. 162(m) now extends to all executives who serve as the CEO during any part of the fiscal year. This same broad definition also applies to CFOs, who are no longer exempt. Similar to CEOs, all individuals serving as the CFO anytime during the fiscal year are classified as a covered executive, based on their position with the corporation and not compensation. The next three highest-paid executives continue to be classified as covered executives.
As a consequence of this expanded definition of coveredexecutive, corporations can have more than five executives classified as covered by Sec. 162(m) beginning in 2018. Moreover, the TCJA provides that an executive, once covered, is always covered by Sec. 162(m). In other words, any executive who is classified as covered in one year remains classified as covered as long as he or she is employed with the corporation, after the employment relationship ends, and even following death. It is irrelevant how the executive became covered, e.g., temporarily serving as the CEO or CFO in a transition period or because a one-time bonus placed the executive among the top-three non-CEO/non-CFO executives in one fiscal year. Therefore, the number of coveredexecutives at each corporation may grow rapidly, which increases the amount of non-tax-deductible compensation.
Retroactive consequence: While the changes to Sec. 162(m) took effect Jan. 1, 2018, the once-covered, always-covered rule applies to executives classified as covered in any tax year beginning after Dec. 31, 2016. Therefore, all executives classified as covered by Sec. 162(m) in a firm's last year under the prior law will remain so classified. "It is not uncommon to see that a firm's three highest-paid executives will fluctuate from one year to the next," said Stephen Pakela of Pay Governance LLC.4 "Consequently, the once-covered, [always-]covered rule will have an immediate impact, and I expect to see firms commonly having six, seven, or even eight executives covered by Sec. 162(m) beginning in 2018."5
Planning implication: Sec. 162(m), as revised, provides a definitive line: All compensation over $1 million is non-tax-deductible, but only for covered executives. Therefore, to maximize the firm's compensation tax deduction, a corporation should actively monitor compensation arrangements to limit the number of covered executives. Allowing an executive to enter this category in one year limits the tax deduction in the current and all future years. For example, if a corporation needs to appoint an executive to serve as the interim CFO during an unexpected search, the corporation could appoint an executive already classified as covered to avoid expanding this new costly class of executives. Without some control, it is conceivable that the number of covered executives may become so large that the lost tax deduction becomes very costly, both to the bottom line and politically.
Ironically, controlling the number of covered executives may inadvertently serve to increase compensation levels.
Example: Corporation X's compensation committee awards executives A and B their respective incentives based on their individual compensation contracts. Based on these awards, A earns $10,000 more than B, so that A will be the third-highest paid executive for the fiscal year and classified as a covered executive immediately and forever. If B is already classified as covered, Corporation X can increase B's bonus by $10,001, and maintain A's tax-deductible status. Because A's compensation contract may prevent the corporation from lowering A's award, increasing B's compensation may be the only option to avoid increasing the number of covered executives and the amount of non-tax-deductible compensation.
Legal implication: Because corporations can and have paid compensation that is not qualified under Sec. 162(m), some shareholders have attempted to use the legal system to force corporations to preserve their compensation tax deduction. However, these shareholder derivative actions, which fundamentally assert that boards breach their fiduciary duty to corporations by sacrificing some tax deduction under Sec. 162(m), have failed. Courts have consistently ruled that corporations are under no obligation to minimize taxes.6 Therefore, these prior cases suggest that shareholders will be unable to use the court system to force corporations to monitor and limit the number of covered executives, even if shareholders can establish that their failure to do so translates into additional federal corporate income tax expense.
Repeal of the qualified performance-based compensation tax deduction
From 1994 through 2017, the $1 million compensation deduction allowance did not apply to qualified performance-based compensation. Therefore, corporations could deduct up to $1 million of nonqualified compensation, plus all qualified performance-based compensation for each covered executive.
Qualifying compensation for a tax deduction under Sec. 162(m) required more than satisfying performance-based goals. Corporations needed to follow a series of costly procedural requirements. First, the corporation had to establish a compensation committee, comprised solely of two or more independent directors. Second, the compensation committee had to determine the business criteria, e.g., operational metrics, that would be used to measure performance under the plan. Third, shareholders had to vote to approve these criteria prior to any payouts. If the board was provided any discretion under the plan in applying the criteria, a shareholder vote had to be held no less than every five years for the plan to remain qualified under Sec. 162(m). Fourth, the compensation committee had to establish the performance goals based on the criteria that had been approved by the shareholders no later than 90 days into the fiscal year. The goals had to be objective, with a "substantially uncertain" outcome.7 Finally, following the end of the fiscal year, the compensation committee had to certify that the performance goals were met before the payouts. Any misstep disqualified the plan and its compensation awards. Therefore, even if the executive satisfied all performance goals, some compensation may have failed to qualify as tax-deductible.
Beginning in 2018, there is no tax benefit for corporations to follow these procedures. While independent compensation committees and shareholder approval of equity compensation plans are both mandated by the major exchanges, it was Sec. 162(m) that incentivized corporations to establish nonequity, performance-based incentive plans with preestablished performance goals that had been approved by shareholders. Following 2017, corporations will no longer incur a tax penalty for awarding discretionary awards, not putting nonequity incentives to a shareholder vote, or modifying performance goals throughout the year as circumstances change.
Regardless of the procedures followed and goals obtained, any compensation over $1 million will not be tax-deductible if paid to a covered executive. Corporations are still accountable to shareholders through both their performance and detailed proxy statement compensation disclosures. However, the repeal of the tax deduction will likely lead some corporations to adjust their compensation procedures to both reduce their administrative expenses and increase board flexibility, which may influence their compensation arrangements. David Kokell, head of U.S. Compensation Research at Institutional Shareholder Services (ISS), expressed the concerns of some investors, stating that they fear that the TCJA "encourages companies to be less transparent, less objective, less performance-based, and less well-governed around executive compensation."8
Warning: The TCJA grandfathers some incentive plans (generally, previously granted performance-based awards), preserving the performance-based tax deduction. These plans must be in writing, binding, and in effect on Nov. 2, 2017. Payouts in excess of $1 million under grandfathered plans may still qualify as tax-deductible, including equity awards, awards to CFOs, and awards to executives with written binding contracts in effect on Nov. 2, 2017, to participate in grandfathered plans, even if the executives are not active participants until after Nov. 2, 2017. Corporations should be extremely careful to avoid disqualifying their plans from grandfathered status. Any plan that is "modified in any material respect" following Nov. 2, 2017, will lose its protected status, which will disqualify all payouts from the performance-based tax deduction allowance.
Planning implication: A renewal of a grandfathered contract does not extend the performance-based deduction allowance. Any grandfathered contract renewed after Nov. 2, 2017, is treated as a new contract on the date that the renewal takes effect.
Planning implication: Prior to 2018, executives could elect to defer compensation that would otherwise be non-tax-deductible under Sec. 162(m). The deferrals could remain unfunded, to avoid triggering tax recognition, and be paid out at some future date when the executives are no longer covered under Sec. 162(m). However, executives now remain covered, even in retirement.
What does this mean for corporations?
The impact on corporations may stem less from the additional tax expense, and more from the procedural relief discussed above. Pakela, of Pay Governance, expects that the changes will ultimately "simplify the process and provide boards more flexibility."9
Planning implication: Corporations are now immediately relieved of the responsibility to satisfy the procedural steps formerly mandated by Sec. 162(m), without the risk of reducing their compensation tax deduction. Firms commonly used a two-tier framework for performance-based plans. The top tier was the broad, more general "umbrella" metric used specifically to comply with Sec. 162(m) and fund awards to covered employees at the maximum level. The umbrella plan authorizes the second tier of metrics, which are used to determine the level of negative discretion needed to arrive at each executive's actual award. Because corporations have no need to submit performance criteria to shareholders for a vote, firms are now free to eliminate the umbrella plans. Further, the compensation committee does not need to establish objective performance goals for each of the second-tier plans within 90 days of the start of the fiscal year, offering more flexibility to consider appropriate performance goals.
Planning implication: Sec. 162(m) under prior law required objective, quantifiable measures, which may have limited corporations' ability to incorporate nontraditional goals. Under the revised statute, corporations now have more freedom to incorporate subjective performance measures into incentive compensation arrangements, including financial, operational, or individual strategic performance measures aimed at providing a "balanced scorecard" or more socially responsible measures.
Planning implication: Before 2018, modifying performance goals beyond Sec. 162(m)'s 90-day requirement disqualified the incentive awards from qualifying for the performance-based tax deduction allowance. Beginning in 2018, corporations may modify their compensation contracts more frequently during the year, in response to changing circumstances, because these changes bring no tax repercussions. However, corporations are still required to provide detailed disclosures in proxy statements and provide shareholders with the say-on-payvote required under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, P.L. 111-203. Further, the ISS's Kokell expects that investors, and the ISS in particular, will continue to expect compensation arrangements to emphasize performance-based incentives, and that ISS will continue to evaluate executive compensation within that framework. This should help to mitigate the temptation to adjust performance-based goals midyear or greatly expand the number of adjustments.
Legal implication: Shareholders first saw some success with a Sec. 162(m)-based legal action in 2003, when shareholders claimed that Datascope provided defective disclosures regarding executive incentive plans.10 Generally, the successful legal actions under Sec. 162(m) were based on a procedural failing, e.g., defective disclosures,11 or payments in excess of a plan allowance.12 Further, IRS procedures directed auditing agents to look for various Sec. 162(m) procedural errors or plan overpayments for which to deny compensation deductibility.13 The repeal of the performance-based deduction frees corporations from both Sec. 162(m)'s procedural requirements and inflexible compensation plan limits. Following 2017, boards are generally free to pay discretionary, non-plan-based awards without any tax ramifications.
Warning: Until Treasury provides further guidance, corporations with grandfathered plans must be cautious paying any non-plan-authorized discretionary awards. Firms must carefully review each plan's terms to confirm that discretionary awards outside of the plan cannot be deemed a material alteration to the plan, which would disqualify the plan and its payments for the performance-based deduction allowance.
Lost tax deductions
Even prior to the TCJA, corporations commonly chose to not qualify all of their executive compensation. The authors estimate that large U.S. corporations paid more than $126 billion in non-tax-deductible compensation from 1994 through 2016, sacrificing more than $22 billion in tax savings.14 However, most corporations attempted to qualify some incentive compensation under Sec. 162(m), either to preserve the tax deduction or for political reasons, i.e., to appease investors. Unless all executives agree to limit their total compensation to $1 million per year, which is unlikely, the majority of publicly traded corporations will now lose some tax deductions.
For example, a large technology company recently reported that its CEO's annual base salary was $3 million, and for each of the other five named executive officers (NEOs) was $1 million.15 The CEO also received $9.7 million in nonequity incentives and miscellaneous compensation, with an average of $3.1 million provided to each NEO. Further, the CEO's compensation also included approximately $89.2 million from the vesting of restricted stock grants, while each NEO averaged more than $17 million. Under the new Sec. 162(m), of the total $231 million of compensation paid the CEO plus the top-five NEOs, only $6 million qualifies as a tax deduction, assuming all six were classified as covered. At a 21% corporate tax rate, the $225 million of nondeductible compensation translates into more than $47 million in lost tax savings.
State tax consequences: While corporate income taxes vary by state, the majority build off of the federal tax system, with some states automatically adopting all federal changes, i.e., rolling conformity. Therefore, the lost tax deduction may also translate into higher state taxes.
What does this mean for executive compensation?
Sec. 162(m) was enacted based on the belief that executive compensation was excessively high and insufficiently linked to corporate performance.16 The performance-based tax deduction allowance was provided to increase this link. While there is considerable debate as to whether the performance-compensation link was strengthened by allowing the deduction, the charts under the heading "Salary and Total Compensation Levels of CEOs and Non-CEO Executives, 1994-2016", below, illustrate that mean total compensation levels increased greatly under Sec. 162(m). From 1994 through 2016, mean total compensation levels increased by 9% per annum for CEOs (10% for non-CEOs), exceeding both inflation and wage growth for the average American worker.17
Salary and total compensation levels of CEOs and non-CEO executives, 1994–2016
While total compensation levels increased rather rapidly under Sec. 162(m), there is variation in the growth of its components, variation that could be attributed to Sec. 162(m). The charts below illustrate that from 1994 through 2016, mean annual salary grew by an average rate of 3% for CEOs and 4% for non-CEOs, respectively, barely outpacing inflation. In 2016, only 2.5% of non-CEOs received salary over $1 million. While 27% of CEOs received salary over $1 million, in general the amounts were close to $1 million, i.e., more than 80% of these CEOs received salaries in the $1 million to $1.5 million range. This suggests that Sec. 162(m)'s $1 million threshold affected salary levels.
With limited salary growth, salary as a percentage of total compensation decreased under Sec. 162(m), while the use of incentives, particularly equity compensation awards, increased, as shown in the chart "Salary and Equity Compensation as a Percentage of Total Direct Compensation, 1994-2016," below. The form of equity compensation has evolved since 1994. Originally dominated by options, which provided an accounting benefit prior to FASB Statement No. 123(R), Share-Based Payment (equity compensation financial reporting), restricted stock grants have generally replaced option awards as the dominant form of equity compensation since 2006.18 However, both forms of equity awards help link the executive's wealth to that of the shareholders.
Beginning Jan. 1, 2018, Sec. 162(m) provides no incentive for corporations to maintain salary levels below $1 million per executive. Moving forward, both salary and performance-based compensation over $1 million are treated alike for tax purposes, i.e., will be non-tax-deductible to the corporation. In response to this change, economic theory predicts that corporations should evaluate the influence of the tax change and, if beneficial, adjust their compensation arrangements to maximize the creation of shareholder wealth.19 This may involve shifting compensation from performance-based to salary, like Netflix has done,20 or shifting from plan-based, nonequity incentive awards to discretionary bonuses. Nevertheless, Pakela considers the Netflix response unique. He believes that most boards plan on continuing to limit salary and to rely heavily on various cash and stock performance-based incentives to motivate executives to create value.21
However, Sec. 162(m) was enacted in 1994 in response to the belief that executive compensation bore little relation to corporate performance, suggesting that executives controlled their own compensation. Corporations therefore need to be careful that changes they make do not give that appearance. Increases in salary can be justified because they lower compensation risk and the incentive to take operational risks, but they need to be offset by decreases in other components of the compensation package.
Moving from nonequity incentive plan awards to discretionary bonuses can be justified because discretionary awards provide boards with the greatest flexibility to deal with unforeseen circumstances. But corporations should be cautious that it does not appear they are simply using discretionary bonuses to increase compensation. Further, both increases in salary and moving from nonequity incentive plan awards to discretionary bonuses may serve to weaken the link between compensation and performance, a link that is closely observed by both proxy statement advisers and institutional shareholders. Therefore, corporations should closely monitor this link to ensure that it does not weaken further due to the repeal of Sec. 162(m)'s performance-based tax deduction allowance.
1Congress expanded Sec. 162(m) with Sec. 162(m)(5), which applied to Troubled Asset Relief Program (TARP) recipients, and Sec. 162(m)(6), which applied to covered health insurance providers under the Patient Protection and Affordable Care Act, P.L. 111-148, expansions that did not directly influence the majority of publicly traded corporations.
2Regs. Sec. 1.162-27(c)(1)(i). The Exchange Act refers to the Securities Exchange Act of 1934, P.L. 73-291 (Regs. Sec. 1.162-27(c)(5)).
3The TCJA expanded the definition of a publicly traded corporation to include "any corporation which is an issuer (as defined in section 3 of the Securities Exchange Act of 1934 (15 U.S.C. 78c)) — (A) the securities of which are required to be registered under section 12 of such Act (15 U.S.C. 78l), or (B) that is required to file reports under section 15(d) of such Act (15 U.S.C. 78o(d))" (Sec. 162(m)(2), as amended by TCJA §13601(c)).
4Stephen J. Pakela is a managing partner of Pay Governance LLC, an executive compensation consulting firm. This quotation is from an interview with Amy Yurko on Jan. 29, 2018.
5Interview with Amy Yurko on Jan. 29, 2018.
6See, e.g., Freedman v. Adams, 58 A.3d 414 (Del. 2013); Seinfeld v. Slager, C.A. No. 6462-VCG (Del. Ch. 6/29/12).
7Regs. Sec. 1.162-27(e)(2)(i).
8Discussion available at www.issgovernance.com.
9Interview with Amy Yurko on Jan. 29, 2018.
10Shaev v. Saper, 320 F.3d 373 (3d Cir. 2003). The Third Circuit rejected the Datascope executives' motion to dismiss, which asserted that the tax deduction lost under Sec. 162(m) is immaterial, and ruled that improper Sec. 162(m) disclosures may violate Rule 14a-9.
11See, e.g., Resnik v. Woertz, 774 F. Supp. 2d 614 (D. Del. 2011); St. Louis Police Ret. Sys. v. Severson, No. 12-cv-5086 (N.D. Cal. 10/3/12).
12See, e.g., Shepherd v. Simon, No. 7902-CS (Del. Ch. 9/25/12) (petition filed); Mor v. Collis, No. 1:13-cv-00242 (D. Del. 2/15/13) (petition filed); Iclub Investment Partnership v. Collis, No. 2:13-cv-00688-PBT (E.D. Pa. 12/15/14) (voluntarily dismissed), in which shareholders successfully compelled the firms to modify their compensation awards.
13IRS, Section 162(m) Audit Techniques Guide (02-2005), available at www.irs.gov.
14The authors' estimate is for firms in Compustat's ExecuComp database, which covers more than 2,800 firms, including those in the S&P 1,500 plus firms formerly in the S&P 1,500. Subject to data limitations, the authors conservatively estimate nontax deductible compensation (NDC) as the sum of the following: salary, any miscellaneous compensation, non-performance-plan-based cash awards, and restricted stock grants, in excess of $1 million per covered executive. The total amount of each firm's NDC is the sum of NDC paid the CEO plus the four highest-paid non-CEO executives (three highest-paid non-CEO, non-CFO executives following 2006). The authors estimate the tax savings lost as NDC multiplied by each firm's simulated marginal tax rate provided by Compustat's MTR database or, if unavailable, John Graham of Duke University, available at faculty.fuqua.duke.edu.
15Information retrieved at sec.gov.
16U.S. Congress, House of Representatives, Fiscal Year Budget Reconciliation: Recommendations of the Committee on Ways and Means, p. 209 (U.S. Government Printing Office 1993).
17Davis and Mishel, Economic Policy Institute, CEO Pay Continues to Rise as Typical Workers Are Paid Less (June 12, 2014), available at www.epi.org.
18Murphy, "Executive Compensation: Where We Are and How We Got There," 2 Handbook of Economics of Finance 211 (Elsevier 2013).
19For a detailed discussion of the economic theory supporting this prediction and the costs and benefits associated with Sec. 162(m) in 1994, see Balsam and Ryan, "Response to Tax Law Changes Involving the Deductibility of Executive Compensation: A Model Explaining Corporate Behavior," 18 Journal of the American Taxation Association 1 (Supp. 1996).
20Williams, "Netflix Gives Some Top Executives Big Raise in Salary, Citing New Tax Law," MarketWatch.com (Dec. 29, 2017), available at www.marketwatch.com.
21Interview with Amy Yurko on Jan. 29, 2018.
|Steven Balsam, Ph.D., is a professor of accounting and Merves Senior Research Fellow at Temple University in Philadelphia. John Harry Evans III, Ph.D., is Katz Alumni Professor of Accounting and Area Director for Accounting at the University of Pittsburgh. Amy J.N. Yurko, J.D., Ph.D., is an assistant professor of accounting at Duquesne University in Pittsburgh. For more information about this article, please contact firstname.lastname@example.org.