Executive compensation and changes to Sec. 162(m)

The size of executive salaries has long received considerable media attention and, in turn, has drawn the scrutiny of the SEC (which mandates extensive proxy statement disclosures) and Congress (which enacted Sec. 162(m)). Whether in response to the attention or to regulatory changes, public companies have increased their use of performance-based forms of compensation. With this evolution, equity awards have emerged as the dominant component in the public company executive compensation package.

Under the original version of Sec. 162(m), performance-based compensation, including equity awards, was generally tax deductible to the company.¹ The 2017 law known as the Tax Cuts and Jobs Act (TCJA)² removed this performance-based exception. Sec. 162(m) now strictly limits public companies’ tax deduction for compensation of covered executives to $1 million per individual. Further, Congress expanded the number of executives covered by Sec. 162(m), in 2017, with a subsequent expansion set to take effect in 2027.

Even without considering the influence of Sec. 162(m), accounting for equity compensation and the associated deferred tax asset is complex because of the inherent nature of equity compensation. The value of a public company equity award almost certainly changes from the date of the grant to the actual vesting (if a share grant) or exercise (if an option) by the executive. Generally, companies account for equity awards by recognizing over the vesting period both the compensation expense and the estimated tax savings based on the grant date value.

In contrast, the value at vesting or exercise generally applies for tax purposes. If the tax deduction (vesting or exercise date value) of the award exceeds the book expense (grant date value), the actual tax savings may exceed the original book estimate of those savings, i. e., the deferred tax asset. The difference between the estimated and actual tax savings is referred to as the “excess tax benefit.” Under FASB Accounting Standards Update (ASU) No. 2016-09, now codified as part of ASC Topic 718, Stock Compensation, this excess tax benefit should reduce the book-tax expense, thereby affecting book income.

Adding to the difficulty of accounting for equity compensation, Sec. 162(m) reduces or eliminates the tax deduction for some equity awards for some executives. Under ASC 718, a deferred tax asset is recorded only when the compensation is expected to provide a tax deduction in a future tax year. This determination requires two predictions: (1) will the executive be covered by Sec. 162(m) at the time of vesting, and (2) how much of the award will be nontax- deductible? These questions may be complex because equity awards are commonly long-term incentives spanning three or more years. In addition, recent changes to Sec. 162(m) (discussed below) have expanded its coverage and further increased the uncertainty in answering those questions. Because the expansion of Sec. 162(m) increases the amount of non-tax-deductible compensation, companies may find that they have overestimated the tax savings from equity awards. This overestimation of the tax savings may require the writedown of the deferred tax asset, thereby increasing the company’s tax expense.

This article discusses Sec. 162(m), its evolution over time, and implications for the future. It then discusses how Sec. 162(m) and its changes interact with ASC 718, illustrating their combined influence on book income tax expense and companies’ effective tax rates (ETRs).

The evolution of Sec. 162(m)

Sec. 162(m), which dates to 1993,³ limits the deductibility of executive compensation to $1 million per “covered” executive. As originally written, Sec. 162(m) included a performance-based exception, whereby compensation in excess of $1 million paid to a covered executive would be tax-deductible if it met certain performance and shareholder approval conditions. Equity compensation in the form of stock options readily qualified for this exception, and stock grants could be designed to qualify as well. Further, covered executives were originally defined as the CEO and the next four highest-paid employees. A quirk in the 2006 proxy statement revision caused the IRS to later change the coverage of Sec. 162(m) to define covered executives as the CEO and the next three highest paid executives, with the CFO expressly excluded.

The TCJA dramatically changed Sec. 162(m) in two respects. First, it eliminated the performance-based exemption, such that all compensation in excess of $1 million paid to a covered executive is non-tax-deductible. Second, the TCJA modified the number of covered executives. Consistent with SEC disclosure requirements, executives covered under Sec. 162(m) now include the CEO, the CFO, and the next three highest-paid employees. In addition, the TCJA added the “once covered, always covered” rule. Specifically, any individual who serves as the CEO or CFO (even if only on an interim basis) or who is classified as one of the next three highest-paid executive officers will forever remain designated as an employee covered by Sec. 162(m), even after death. This will, over time, almost certainly expand the number of executives with non-tax-deductible compensation beyond the original five.

More recently, the American Rescue Plan Act (ARPA)⁴ expanded the list of covered employees to include five more of the highest-paid executives for tax years beginning after Dec. 31, 2026. Once this provision is effective, covered executives would include the CEO, the CFO, the next eight highest-paid executives, and all executives included because of the once-covered-always-covered rule. An interesting twist is that it appears that those five additional executives added by ARPA are not subject to the once-covered-always-covered rule. Consequently, companies will be required to monitor covered executives, identifying those subject to the once-covered-always-covered rule and those who are not. In the context of equity awards, these rules have implications regarding the ability of companies to predict whether an award will provide a tax deduction when it vests or is exercised, perhaps three or more years in the future.

The calculation of the deferred tax asset post-TCJA

With the elimination of the performance-based exception and the expansion of the number of covered employees, more compensation will not be tax-deductible, including equity awards. This needs to be considered when setting up the deferred tax asset for equity compensation for those employees covered by Sec. 162(m), because only equity awards expected to reduce taxable income should create a deferred tax asset. Coupled with the increased complexity associated with the prediction of who will be covered by Sec. 162(m) at some future date, these changes increase recordkeeping requirements and create some interesting situations.

For example, an equity award may have been expected to generate a tax deduction at the time of the grant (because the executive was not covered by Sec. 162(m)), but then ultimately might not be tax-deductible because the executive is covered at the time of vesting or exercise. The reverse may also occur for executives who are classified as covered for a short time only under ARPA’s expanded definition of a covered employee but are later uncovered at vesting/exercise.

Consider the table “Example of Sec. 162(m)’s Influence on Tax Expense and ETR,” below, which includes four examples to illustrate the impact of Sec. 162(m) post both the TCJA and ARPA. 

The employee is awarded shares with a grant date value of $12 million and a three-year vesting period. The table uses a 21% tax rate. For simplicity, assume that the award is granted on the first day of the fiscal year and that vesting is probable for the entire grant. With straight-line amortization of the compensation cost, the company recognizes $4 million of pretax compensation expense each year (see “Journal Entry 1,” below).

In the first example in Column 1 of the table, the executive is a Sec. 162(m) covered executive at the time of the award. Falling under the once-covered-always- covered rule, the company anticipates that none of the equity award will be tax deductible.⁵ In other words, the entire $12 million award ($4 million per year) is a permanent book-tax difference. Consequently, there is no credit to income tax expense, and no deferred tax asset is established. While pretax book income is set to be $100 million, the company pays taxes on $104 million because of the $4 million compensation permanent book-tax difference. With total tax expense of $21.84 million, the company’s ETR is 21.8% (ignoring, of course, other items that affect the ETR).

Many, perhaps most, recipients of equity compensation are not covered by Sec. 162(m), which leads to the scenario presented in Column 2 of the table. If the company anticipates that the award will be fully tax-deductible at vesting (i.e., that the employee will not be covered by Sec. 162(m) at the time of vesting/exercise), the book expense of $4 million accrued each year will be treated as a temporary book-tax difference. Therefore, the firm should recognize the associated annual book-tax savings of $840,000 ($4 million × 21%), creating the corresponding deferred tax asset. The tax savings reduce the annual net after-tax book expense of the award to $3,160,000 ($4,000,000 – $840,000) (see “Journal Entry 2,” below).

In Year 3, when the shares vest at $21,000,000, the award provides total tax savings of $4,410,000 ($21 million × 21%). The difference between the book-tax expense savings ($2,520,000 = $840,000 × 3 years), and the tax return savings ($4,410,000) is $1,890,000, which is the excess tax benefit that reduces the firm’s ETR. With the vesting value of the compensation fully tax-deductible, the book-tax expense is $19,110,000, and, consequently, the ETR is reduced to 19.1%. In accordance with ASC 718-20-55-21, the company should write off the deferred tax assets and adjust the current tax expense to recognize the excess tax benefit (see “Journal Entry 3,” below).

Columns 1 and 2 in the table present very different scenarios, with nondeductibility in Column 1 leading to a higher ETR relative to companies with fully tax-deductible compensation in Column 2. Because of the lost tax deduction in Column 1, the firm’s ETR is increased 0.8% over the statutory tax rate. In contrast, in Column 2, because the excess tax benefit is realized entirely in the year of vesting, the company’s ETR is reduced by 1.9%. While these two scenarios present contrasting situations, they are similar in that the expectations at grant matched the eventual tax treatment.

In practice, expectations will not always match outcomes, particularly after ARPA. Because the TCJA eliminated the performance-based exception, tax deductibility depends on whether the executive is covered at the time of vesting and the extent to which the award exceeds that $1 million threshold. This requires companies to estimate probabilities. If it is “more likely than not” that the equity award will not be tax-deductible, the company should follow the scenario presented in Column 1, with the equity award neither reducing book-tax expense nor generating a deferred tax asset. If the company anticipates that the award will be tax-deductible, then the treatment in Column 2 is appropriate. However, predicting the future is not an exact science, and both predictions can be wrong. If so, the company will effectively have to reverse the prior years’ accounting treatment in Year 3, which will affect book-tax expense and the ETR. These possibilities are presented in Columns 3 and 4.

In Column 3, the company does not expect in Years 1 and 2 that the executive will be covered by Sec. 162(m). But the executive is covered in Year 3 (the vesting year), which determines the coverage of Sec. 162(m). Thus, the equity grant vesting that year is nontax- deductible. Under ASC 718, the previously recognized deferred tax asset ($1,680,000 = $840,000 × 2 years) needs to be reversed in Year 3, with a corresponding increase in income tax expense of that year. Thus, the company in Year 3 recognizes the book accrual of compensation expense, which is the same as in the two previous years (see “Journal Entry 4,” below).

To fundamentally correct the incorrect expectations of Years 1 and 2, the company reverses the previously recognized deferred tax asset in Year 3, as shown in “Journal Entry 5,” below.

Therefore, in the Column 3 scenario, Year 3 effectively reflects the full impact of the Sec. 162(m) deduction limitation on this equity award. Rather than increasing the Year 3 ETR by only 0.8% (as in Column 1), ETR is increased by 2. 5% (0.8% + 1.7%), bringing the ETR to 23.5%.

Finally, Column 4 of the table presents the scenario where the company expected the executive to be a covered executive in Year 3, in which case no deferred tax asset was set up in Years 1 and 2. However, the executive is not covered by Sec. 162(m) in Year 3. Again, it is only the Year 3 (vesting) status that matters for Sec. 162(m) coverage. Therefore, the company will deduct the full $21 million on its Year 3 tax return, unconstrained by the Sec. 162(m) deduction limitation. Because of its incorrect prediction regarding the application of Sec. 162(m), the company must recognize the entire book-tax savings/reduction in income tax expense associated with this equity award in Year 3. But that is not all. Because the vesting value of this award exceeds its grant date value, this equity award triggers the $1,890,000 excess tax benefit, presented in Column 2. As is the case for all other scenarios, the company will recognize the third-year accrual of the equity award, as shown in “Journal Entry 6,” below.

However, to again fundamentally correct the Years 1 and 2 expectations, the entire three-year tax savings ($4,410,000) associated with the $21 million tax deduction is recognized in Year 3 as shown in “Journal Entry 7,” below.

For financial reporting purposes, the tax benefits of the Column 4 award are reflected only in Year 3. In direct contrast to Column 3, this swings the effect in the opposite direction, leading to an ETR of only 17.4%, as shown in the table.

In summary, the existence of an excess tax benefit from equity compensation, which is a consequence of the tax deduction exceeding the book-tax expense, reduces the company’s ETR below the statutory 21% rate. However, if the tax deduction is limited by Sec. 162(m), the effect is to increase the ETR beyond the 21% rate. The full impact of the elimination of the performance-based exception may have been delayed, as some equity grants are still tax-deductible due to the grandfathering allowed by the TCJA. As the grandfathered plans sunset and as the number of Sec. 162(m) covered executives expands, the positive impact of the excess tax benefit on companies’ ETRs (i.e., reducing the ETR) may dissipate, such that the scenarios presented in Columns 1 and 3 may become more the norm.

Adjusting to uncertainty

The TCJA imposed more stringent deductibility limitations on executive compensation for covered executives, removing the previously allowed performance-based exemption, which allowed companies to deduct amounts in excess of $1 million per covered executive. Post-TCJA for Sec. 162(m) covered executives, the likelihood exists that the book expense for share-based awards will commonly exceed the tax deduction. This effectively eliminates the excess tax benefit and corresponding ETR reduction for C-suite equity awards, creating a reverse scenario where the tax deduction is lower than the accounting expense, leading to a higher ETR, as shown in Scenarios 1 and 3 of the table.

Further, companies’ recognition of equity compensation and the associated deferred tax asset is based on expectations of each executive’s Sec. 162(m) status at vesting, i.e., a future date. The ARPA expands the scope of Sec. 162(m) and increases the uncertainty regarding that future Sec. 162(m) status. Because of this increase in uncertainty, the adjustments shown in Scenarios 3 and 4 of the table may become more common, which may increase the variability of ETRs.

Footnotes

¹Incentive stock options (ISOs) are an exception to this general rule. ISOs, also known as qualified stock options, provide preferential tax treatment to the employee while eliminating the company’s tax deduction. Because there are strict requirements for an equity award to qualify as an ISO, including award value and ownership in the company, the use of ISOs is limited. For a more detailed discussion, see Edwards and Sharara, “Tax Clinic: Stock-Based Compensation: Back to Basics,” 50 The Tax Adviser 318 (May 2019).

²P.L. 115-97.

³Sec. 162(m) was enacted as a result of the Omnibus Budget Reconciliation Act of 1993, P.L. 103-66, signed into law on Aug. 10, 1993, and became effective for tax years beginning on or after Jan. 1, 1994.

⁴The American Rescue Plan Act of 2021, P.L. 117-2, §9708.

⁵This scenario assumes that the executive’s other compensation surpasses the $1 million tax-deductible allowance. If this executive’s other compensation totals less than $1 million in the year of vesting, a portion of this award may be tax-deductible.

Contributors

Steven Balsam, CPA, Ph.D., is a professor of accounting and Merves Senior Research Fellow at Temple University in Philadelphia. Amy J.N. Yurko, J.D., Ph.D., is an associate professor and KPMG Faculty Fellow in Accounting at Duquesne University in Pittsburgh. For more information about this article, contact thetaxadviser@aicpa.org.

AICPA & CIMA RESOURCES

Article

Murthy and McCumber, “Recent Executive Compensation and Fringe Benefit Changes,” 52 The Tax Adviser 760 (December 2021)

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