United States: No Deduction For Good Performance?

Tax Reform, Performance-Based Compensation and Executive Compensation

I. Overview

The reconciliation of the House and Senate versions of the Tax Cut and Jobs Act,1 the sweeping tax reform bill overhauling the US federal income tax code (the "Tax Reform Bill"), has been finalized and is expected to be signed by the President imminently. The Tax Reform Bill, consistent with the Senate and House versions prior to reconciliation, as highlighted in our previous Stroock Special Bulletins dedicated to tax reform,2 makes significant changes that will impact executive compensation programs. The Tax Reform Bill (i) significantly expands the application of the Internal Revenue Code of 1986, as amended (the "Code") Section 162(m) $1 million deduction limit, including by eliminating the exception for performance-based compensation and (ii) introduces a new 21 percent tax on certain compensation paid to executives of tax-exempt organizations.

II. Expansion of 162(m) and Elimination of Performance-Based Exception

The current version of Code Section 162(m) caps a public company's corporate income tax deduction at $ 1 million per year for amounts paid to the CEO and three other highest paid executive officers (other than the principal financial officer) (collectively, "Section 162(m) Covered Persons"). The most significant exception to the Code Section 162(m) deduction limit, often utilized by public companies when designing compensation programs for executives, is the exception for qualifying performance-based compensation.

The Tax Reform Bill eliminates the performance-based compensation exception to Code Section 162(m) for compensation paid after December 31, 2017. The Tax Reform Bill includes an important transition rule for compensation paid pursuant to written binding contracts in place on November 2, 2017, provided the terms of the contract are not modified in any material way after that date.

This means that compensation payable to any Section 162(m) Covered Person in excess of $1 million in any given year will no longer be deductible — regardless of the individual's, or the enterprise's performance.

The Tax Reform Bill also expands the definition of Code Section 162(m) Covered Persons to include any employee who (A) was the principal executive officer or principal financial officer any time during the taxable year, (B) who is required to have his or her income disclosed pursuant to the Securities and Exchange Act of 1934 ("the '34 Act") by virtue of being one of the three most highly compensated officers of the company (other than the principal executive), or (C) Section 162(m) Covered Person of the taxpayer of any previous year starting with tax years beginning after December 31, 2016. This means that once a Section 162(m) Covered Person, apparently always a Section 162(m) Covered Person — at least at the same employer, even if the individual no longer would otherwise be considered a Section 162(m) Covered Person or the amounts are paid by the company to the individual's beneficiary.

The definition of a public company has also been expanded to include not just corporations with publicly traded equity, but also any corporations that are required to file reports under Section 15(d) of the '34 Act. As a result of expanding the definition of "public companies," companies with registered debt securities, or that are not listed on an exchange but that have a large number of equity holders, or certain foreign companies would now also be subject to the loss of deduction for compensation over $1 million.

III. Comments and Observations.

For some context on Code Section 162(m) and the performance-based exception, it is worth reflecting upon the twenty plus years since it was enacted. One commentator noted at the time of its passage, that "[t]he Clinton Administration's new tax package would give shareholders the ultimate power in deciding whether companies would be allowed to take tax deductions on executive compensation of more than $1 million. Shareholders would have to approve an executive's performance goals to allow the deductions."3

Executive compensation reforms have often brought with them unforeseen developments. For example, many did not necessarily foresee that Code Section 162(m) would result in an increase in the prevalence of stock options, as certain options could qualify for the performance-based compensation exception.

With the elimination of the performance-based exception to Code Section 162(m), some public companies may now feel more liberated to pursue compensatory arrangements that are discretionary or less dependent on stock options. However, even with the elimination of this exception to the Code Section 162(m) limit, companies may have other reasons for retaining performance-based compensation programs, including the influence of proxy advisory firms, institutional and activist shareholders, which have, in varying degrees, emphasized the benefits of pay for performance. Compensation practices continue to face a host of other internal, external and regulatory challenges and constraints that may at least in the short term, act as an inhibitor to significant changes in pay practices. Thus, while the Tax Reform Act vitiates the deduction exception for performance-based compensation, it does not change the importance of performance-based compensation generally.

IV. Excise Tax on Compensation Paid to Tax- Exempt Organization Executives

In what appears to be an attempt to align compensation paid to executives of tax-exempt organizations with the compensation limits imposed on public company executives, the Tax Reform Bill imposes a new tax equal to the corporate tax rate, (21 percent in the Tax Reform Bill), on any remuneration paid to "covered employees" by the tax-exempt organization (or any related organization) in excess of $1 million effective for tax years beginning after December 31, 2017. This tax also applies to any "excess parachute payments" paid to such covered individuals. The tax is a liability of the employer. A "covered employee" is one of the five highest compensated employees of the organization for the taxable year and any individuals who were covered employees for any preceding tax year starting with tax years beginning after December 31, 2016. As with the newly expanded Code Section 162(m), once a covered employee for purposes of this new tax — always a covered employee.

For purposes of the tax, remuneration is treated as paid when there is no substantial risk of forfeiture (within the meaning of Code Section 457(f)). The definition of excess parachute payment borrows from the Code Section 280G regime (referring to Code Section 280G for rules for applying base amounts, calculation of present value, etc.), however, rather than focusing on payments contingent on a change in control, parachute payment is defined in reference to payments contingent on the employee's separation from employment from the employer.


1 The Tax Cuts and Jobs Act, H.R. 1, as amended.

2 For the previous coverage on this topic see Stroock Special Bulletins of February 21, 2017, available at https://www.stroock.com/siteFiles/Publications/PresidentTrumpTaxPlan.pdf; November 6, 2017, available at https://www.stroock.com/siteFiles/Publications/TaxCutJobsAct.pdf; and November 10, 2017, available at https://www.stroock.com/siteFiles/Publications/OverviewSenateTaxLegislation.pdf.

3 Wall Street Journal, April 9, 1993.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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