What do these IRC Section 162(m) Changes Mean for Executive Compensation?

IRC Section 162(m) Will Change with Proposed Tax Law Revisions, Impacting Aspects of Executive Compensation

Fulcrum Partners Executive Benefits News, Fulcrum Partners LLC White Paper

Fulcrum Partners shares insights on the proposed tax reform, specifically related to IRC Section 162(m), with our clients and colleagues.

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Internal Revenue Code Section 162(m) [IRC  §162(m)] addresses federal tax code regulations “relating to the deduction limitation for certain employee remuneration in excess of $1,000,000 under the Internal Revenue Code. These regulations affect publicly held corporations.”

After the U.S. House and Senate respectively approved separate tax reform bills, the conference committee went to work, reconciling, compromising, and in some cases discarding aspects of the proposed tax code revisions. As we have already witnessed, the projected tax changes have, thus far, taken a few twists and turns with regard to executive compensation. (See Your Retirement is Not Yet Safe from Tax Reform and Tax Reform is Still Putting Your Retirement at Risk).

The following update provides insights on select aspects of executive compensation as potentially impacted by the proposed tax changes.

Where IRC Section 162(m) Tax Code Reform Currently Stands

As of the writing of this article, the tax reform plan contains three significant changes that were contained in both the Senate and the House version of the tax bills:

  • Both versions remove the performance-based compensation exception to the $1 million pay cap under current Section 162(m). Likewise, they both expand the definition of a “covered employee.” Currently the rule applies only to the year-end CEO and the three highest paid executive officers for the year in addition to the CEO. The new laws would also cover the CFO and include anyone who holds the CEO or CFO position at any time during the tax year, not just the individuals holding those positions at year-end).
  • When an executive is a covered employee in any year (starting with 2017), the executive’s compensation will be subject to Section 162(m) in all future years, including after the executive’s employment is terminated
  • In the updated version of the tax code, Section 162(m) will apply to companies with only debt securities registered with the SEC

What do these IRC Section 162(m) Changes Mean for Executive Compensation?

The types of performance-based executive compensation that will be subject to the $1 million cap on deductibility (in the same way base salary is currently treated) include: stock options, stock appreciation rights (SARs), performance-based equity awards, and annual incentive awards.

With the proposed top tax bracket for C-corporations set to be lowered to 21 percent, many of the companies that lose Section 162(m) deductibility will have lower taxes on a net basis. Although the exact percentage remains a moving target, it presumably will be significantly lower than the current 35 percent. Moreover, companies then face a higher after-tax cost of executive compensation. One concern is that the lower tax rates are currently slated to commence in 2019 while the loss of deductions under §162(m) would begin in 2018.

Another issue related to the timing of the tax change implementation is that companies that start a new fiscal year after December 31, 2017, may have only days to make adjustments before the new tax laws take effect. In contrast, companies that have a June 30 fiscal year end will have a little more breathing room.

The Matter of Future Compensation

Future compensation based on older equity awards and deferred pay is a potential issue. The House and the Senate plans differed on this topic, with the Senate Bill grandfathering in compensation from written binding contracts that were in effect on, and not materially modified after, November 2, 2017.

Presuming that tax changes are implemented as they currently stand, deferring income of over $1M until the termination of employment, and then deducting it after termination, will no longer be an option. However, there will likely be opportunities to structure post-termination compensation in such a way that each year, it remains, largely within the $1M threshold.

When the Dust Finally Settles

As proposed tax changes are presently defined, and withstanding any further amendment, the current rules of IRS Code section 409A will continue to apply to nonqualified deferred compensation arrangements. IRC Section 162(m), however, is undoubtedly headed for modification.

If President Trump’s promised “Giant Tax Cut for Christmas” does, in fact, occur before lawmakers depart for the holidays, then speculations can finally come to an end. Even before the dust settles, you’ll find the team at Fulcrum Partners ready to help companies and executives achieve optimal solutions for effectively compensating top talent and realizing corporate objectives.

Fulcrum Partners advises you to always consult your own tax, legal, and accounting advisers.

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