The Tax Cuts and Jobs Act (TCJA) of 2017 made a number of significant changes to the taxation of executive compensation
under IRC Section 162(m). Prior to the TCJA, publicly traded companies were limited to a $1 million compensation deduction for certain executives (defined as “covered employees”). There was an exception, however, for performance-based compensation (e.g., stock options or performance-based equity) that was allowed to be fully deductible. The TCJA removed the performance-based deduction exemption for company’s fiscal years beginning on or after Dec. 31, 2017, meaning all compensation above $1 million is fully taxable.
To study the impact of these new 162(m) regulations, Grant Thornton analyzed changes to compensation and annual incentive designs from two sectors of the Russell 2000 Index: Financial Services and Healthcare. We reviewed 40 companies in each sector between 2017 and 2018, and only considered companies that had their most recent fiscal year begin on or after Dec. 31, 2017, to ensure that such compensation was granted under the new 162(m) regulations. Grant Thornton selected the Financial Services and Healthcare sectors (as categorized by the Global Information Classification System, or GICS) to study due to their uniqueness in both pay levels and pay design, their prominence in representation in the Russell 2000, and the broader importance both sectors play in the macro-economy. Additionally, Financial Services (i.e., banking) and Healthcare have varying levels of pay leverage in the middle market, with Healthcare typically using a more leveraged compensation model (i.e., more long-term variable pay) and Financial Services adopting a much more balanced portfolio (e.g., comparable levels of fixed, annual and long-term pay).
Findings: Changes in compensation
The portion of our analysis on changes to compensation examined pay levels for CEOs and CFOs that were in their positions for their 2017 and 2018 fiscal years. We considered three measures of compensation:
- Base salaries
- Total cash (salary plus most recent annual bonus)
- Total direct compensation (total cash plus the grant-date fair value of long-term incentives)
To assess the impact Section 162(m) on executive pay levels, we measured the change in median for each pay element between 2017 and 2018:
Findings: Changes in annual incentive plan design
This portion of our analysis examined year-over-year changes in annual incentive plan design. In general, annual incentive plans that were quantitative in nature (i.e., specific metrics and/or weightings) qualified as performance-based compensation under prior 162(m) regulations. Annual incentive plans under the new 162(m) rules no longer receive such treatment, meaning companies have freedom to move from quantitatively-driven plans to designs that have (or use) discretion in modifying incentive payouts. Our goal was to determine whether companies (i) disclosed annual incentive changes explicitly as a result of 162(m), or (ii) whether any changes could be interpreted as being made as a result of 162(m) (e.g., introducing qualitative measures, moving to a fully discretionary plan, etc.).
Our study of 40 Russell 2000 companies in the Financial Services and Healthcare sectors revealed that only 2.5% and 5% of companies, respectively, made incentive plan changes related to Section 162(m):
Grant Thornton Insights
- Financial Services: One company of the 40 (2.5%) made a change related to 162(m). This particular company previously had an umbrella-funded plan for their named executive officers based on company-wide net income performance. Their new plan, however, is based on a scorecard of unweighted strategic goals that applies to the entire executive team.
- Healthcare: Two companies (5%) made changes related to 162(m). Both companies eliminated the metrics and weightings from their 2017 plans, and moved to fully discretionary plans in 2018.
- New 162(m) regulations have not had a major impact on CEO and CFO compensation.
In general, compensation levels for CEOs and CFOs in the Financial Services and Healthcare sectors did not dramatically change between 2017 and 2018. Rather, pay levels changed at rates comparable to movement pre-tax reform. This aligns with our initial expectations, given that many of our clients’ boards indicated a preference to avoid making pay decisions related to 162(m) until further study is done on potential strategies, taking into account the pros and cons of modifying pay design simply for the purpose of maximizing a tax deduction.
- The loss of the 162(m) performance-based deduction has had little influence on annual incentive plan design.
Our study of annual incentive plans between 2017 and 2018 revealed that companies have made little modifications to their plans as a result of 162(m) changes. Prior to the passage of the TCJA, many companies felt pressure from institutional investors and proxy advisors to design compensation plans that maximized their tax deduction. With annual incentive plans no longer being tax deductible, we have observed little changes in the way of plan design. While a number of companies in our study made changes to their incentive metrics or weightings, such changes appear unrelated to the loss of performance-based deductibility in the new 162(m) regulations.
Grant Thornton believes that the lack of incentive plan changes is attributable to organizations maintaining a “pay-for-performance” compensation philosophy that emphasizes clear and defined incentive goals tied to an organization’s short-term business strategies. The desire to appease proxy advisors and institutional investors, while still keeping a focus on a company’s key value drivers, has likely played a larger role in the continuation of existing programs instead of moving to more discretionary plans (in the absence of a qualifying tax deduction). In other words, pay strategy, the relationship between pay levels and performance, governance, and shareholder perspectives continue to be the primary driver of executive pay design, and not the reduction in potential tax deductions.
Based on the results of this study, the changes to IRC 162(m) have had a minor impact on CEO and CFO pay levels in the Russell 2000 Financial Services and Healthcare sectors. Top executive pay in these industries continues to trend moderately upward in an effort to attract, retain and motivate key talent.
Similarly, annual incentive programs have maintained their focus on performance-based metrics, likely as a result of continued pressure from proxy advisors and institutional shareholders. Though there are no longer tax deductions for qualifying performance-based compensation, companies have kept their annual incentive designs consistent with historical practices.
Although companies in our study have made little changes to compensation levels and incentive design, we do not believe that organizations should maintain their current compensation programs for the sake of “best practice.” Compensation committees in particular should view the new regulations as an opportunity to use discretion in modifying payout levels when the “quality” of financial results are not fully reflected in initial incentive payout calculations.
While we do not recommend that compensation committees use discretion more than 10% to 20% of the time, we do encourage companies to design their incentive programs with the ability to do so, especially in business sectors prone to market volatility. Companies should be sure to fully disclose and elaborate on when (and why) discretion was used in order to maintain clear communication with their major shareholders and proxy advisors. As always, companies should continue to consult with their outside compensation professionals to consider when (and if) the use of discretion is appropriate in the post-TCJA environment.
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