United States: Code Section 162(M) Changes – What You Should Be Thinking About Now

The "Bottom Line"

  • Learn the new rules for who is a "covered employee" and keep track of these individuals because "once a covered employee, always a covered employee"!
  • Evaluate compensation arrangements and contracts that were in effect on November 2, 2017, to see if you may be able to take advantage of the "grandfathering rules."
  • Assess current equity, incentive, deferred and other termination-related compensation plans and programs to see whether changes should be made going forward to maximize your company's tax deduction for compensation subject to Code Section 162(m).


The recently enacted Tax Cuts and Jobs Acts (the "Tax Reform Act") made dramatic and immediate changes to Internal Revenue Code Section 162(m). If you are involved in executive compensation for your publicly-traded employer, these changes will impact your company's approach to executive compensation.

Code Section 162(m) Before the Tax Reform Act

Code Section 162(m) imposed a $1 million limit on publicly-traded company tax deductions for most compensation payments made by the company to its "covered employees" in a particular fiscal year. The most important exception to this rule was that all performance-based compensation that qualified under the 162(m) rules was fully deductible, no matter the amount.

A publicly-traded company subject to these rules was a corporation that issued a class of common equity securities required to be registered under section 12 of the Securities Exchange Act.

A "covered employee" was an employee who, on the last day of the company's fiscal year, was either the Chief Executive Officer (or equivalent) or one of the highest three paid officers whose compensation was required to be reported in the summary compensation table of the company's proxy. Due to a fluke in the law, the Chief Financial Officer (or equivalent) was not a covered employee.

Publicly-traded employers spent a lot of time ensuring that a significant portion of the compensation paid to their covered employees qualified as Code Section 162(m) performance-based compensation, which maximized the company's compensation-related tax deductions. For example, compensation paid or recognized upon the exercise of stock options, annual cash bonuses, and performance shares or performance share units are all typical types of compensation that often qualified as performance-based under Code Section 162(m).

Changes Under the Tax Reform Act

The following changes to the 162(m) rules apply starting with a publicly-traded company's fiscal year that begins January 1, 2018 or later:

Who is a Covered Employee?

A "covered employee" will now be anyone who has ever been the CEO, CFO or one of the three most highest compensated officers in any fiscal year beginning after December 31, 2016. Thus, the new rule is essentially "once a covered employee, always a covered employee."

In addition to simply expanding the group of covered employees for which compensation is now subject to the $1 million deduction limit, there is another important effect of this change. Under the prior 162(m) rules, once an individual terminated employment he or she was no longer a "covered employee". Thus, all compensation paid after termination of employment was always fully deductible. Now, an individual never loses his or her status as a covered employee, meaning that all compensation paid to that individual – including all payments made after termination (including payments to the individual's beneficiaries following the individual's death) – will be subject to the $1 million deduction limit (unless grandfathered as described below). Thus, severance pay, deferred compensation payments, supplemental retirement payments, and similar types of post-termination employment payments to a covered employee are now subject to the annual $1 million deduction limit.

Practical Considerations: Employers will want to be careful about inadvertently bumping an executive into their top three highest compensated officers for a particular fiscal year, due to one-off payments (such as signing bonuses or other special one-time payments). While having to report such an individual in the employer's proxy for a single year was an annoyance in the past, it will now have the effect of making this individual a "covered employee" meaning that payments to such individual will forever be subject to the $1 million annual deduction limit. Thus, if possible, employers should structure those one-off payments in a manner that would not cause an individual who would not typically be one of the three highest compensated officers to become one for a particular year. In addition, employers need to start keeping an ongoing list of all "covered employees" going forward and the compensation arrangements that apply to such individuals.

Exception for Performance-Based Compensation

Unless grandfathered as described below, performance-based compensation is no longer exempt from the $1 million deduction limit. Thus, all performance-based compensation paid to a covered employee, including performance share units, stock options and annual bonuses, will now be subject to the $1 million annual deduction limitation.

Practical Considerations: One silver lining to the elimination of the performance-based compensation exemption is that some of the Code Section 162(m) restrictions, such as a prohibition on the Compensation Committee's exercise of discretion to increase a performance-based award, are no longer relevant. Thus, starting with 2018 awards (if not grandfathered, as described below), awards to covered employees no longer need to be subject to the 162(m) requirements. This may not necessarily mean that an employer should stop granting performance-based compensation altogether, as performance-based compensation will still be an important tool in driving performance, and is a favored compensation element by ISS and other proxy advisory entities. However, employers should assess current equity and incentive plans, award agreements and compensation practices to determine whether changes to those documents or compensation policies may now be appropriate in light of these new rules.

Expansion of Employers Subject to Code Section 162(m)

The companies which are subject to the new Code Section 162(m) rules are expanded to include entities required to file reports under Section 15(d) of the Securities Exchange Act of 1934.

Grandfathered Arrangements

The changes described above do not apply to compensation paid to a covered employee that is provided pursuant to a written binding contract that was in effect on November 2, 2017, and which is not modified in any material respect on or after such date. Thus, payments to a covered employee that would have been previously deductible under Code Section 162(m), such as payments made under performance-based compensation arrangements that comply with Code Section 162(m) or payments of severance made under an employment agreement, will remain deductible if they are paid under a written binding contract in effect on November 2, 2017. Currently, we have little guidance about what constitutes a written binding contract or what is considered a material modification to such contract. Based on similar grandfathering rules that applied when Code Section 162(m) was first passed, an arrangement will not be grandfathered as of the date that it could be unilaterally amended or terminated by the employer, or as of the date of renewal if either the employer or employee can elect not to renew. Under those same historic rules, an arrangement is considered materially modified if it is amended to increase compensation, or if it is amended to accelerate or delay payments (subject to certain exceptions). While we can make educated guesses about what arrangements will be treated as grandfathered under the new rules, and what will be considered a material modification, we will need to await Internal Revenue Service guidance before final determinations can be made.

Practical Considerations: Employers should inventory their written binding contracts that were in effect as of November 2, 2017, to understand what compensation may remain deductible in 2018 and beyond. This may also include determining deferred compensation account balances and SERP accruals as of that date. In addition, employers should think twice before modifying any written contract that was in place on November 2, 2017, without advice from legal counsel. A modification could cause the arrangement to lose its grandfathered status, subjecting the compensation payable under that arrangement to the $1 million annual deduction limit.

We invite you to our upcoming webinar in which we will provide more detail on these rules and the strategies you can implement now to position your company to manage the changes. Please join us on January 16 (Register Here).

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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