Tax reform’s impact on executive compensation

Tax reform’s impact on executive compensation The Tax Cuts and Jobs Act (TCJA), the most significant reform to tax legislation in over two decades, instituted a number of modifications to the taxation of executive compensation through changes to IRC Section 162(m). This article will review the key changes to Section 162(m) and highlight the executive compensation items that management teams and their compensation committees should be considering as they prepare for the 2019 proxy season.

162(m) changes In general, business can deduct the compensation and wages they pay their employees as an ordinary and necessary business expense. Prior to the TCJA, publicly traded companies were limited by Section 162(m) to a $1 million deduction for compensation paid to “covered employees,” which was defined as a company’s CEO (or principal executive officer) and the next three highest-paid executives, excluding the CFO. The IRS provided an exemption to the $1 million limit, however, if compensation qualified as “performance-based.” Common examples of performance-based compensation include annual incentive plan payouts, stock options, appreciation rights and performance-based equity awards. Note that restricted stock (or restricted stock units) that were only subject to time-based vesting did not qualify as performance-based compensation.

Following the TCJA, performance-based compensation is no longer exempt from the $1 million limit, meaning all compensation above $1 million is now taxable. Section 162(m) also expanded the definition of “covered employees” to include:

  • The CFO (or principal financial officer).
  • Anyone who served as the CEO or CFO at any point during the taxable year (the prior rule only considered who executives who served in such roles at the end of the year).

Additionally, anyone who was a covered employee for a taxable year beginning after Dec. 31, 2016 will remain a covered employee for all future years (i.e., once a covered employee, always a covered employee). The prior rule only applied to executives that were a covered employee based on that years’ compensation, and did not apply to future years.

Lastly, the TCJA also broadened the scope of companies subject to Section 162(m) to now include private companies with publicly traded debt and foreign private issuers.

To help companies adapt to the new Section 162(m) regulations, the IRS provided transition relief by grandfathering the deductibility of certain performance-based compensation granted prior to the TCJA. To qualify for transition relief, compensation must be payable under a “written and binding agreement” as of Nov. 2, 2017, and has not since been “materially modified.” The IRS has issued additional guidance that any compensation amounts subject to discretion (both positive and negative) would not receive transition relief, given that such amounts were not legally obligated to be paid (i.e., not subject to a binding agreement).

Go-forward considerations Following the TCJA, many companies (and their compensation committees) have taken a step back to critically evaluate the design and fit of their compensation programs. Now that performance-based compensation is no longer fully tax deductible, companies have the full freedom to align their compensation programs with their business strategies. The sections below highlight the key issues that public companies should be considering in their review:

Use of discretion Prior to the TCJA, companies were required to make their annual and long-term incentive plans based on quantitative performance goals/metrics to receive a deduction for compensation over $1 million. Many companies are using the removal of the performance-based deduction to evaluate whether they should give their compensation committees the discretion and flexibility to assess the quality of their financial performance, and not have their hands tied to a quantitative payout result. Giving committees the ability to modify payouts in situations where their business circumstances are not fully reflected in initial payout levels ensures financial results are not accepted “as is,” and holds management accountable to a higher standard beyond the final top- or bottom-line results.

Examples of when such uses of discretion may be appropriate include macroeconomic changes outside of a business’s control (e.g., major interest rate adjustments, changes in the tax law, etc.) or significant M&A activity.

Companies should also consider introducing qualitative incentive goals aligned with their short- and/or long-term business strategy when appropriate. Qualitative goals, especially during times of operational change or in a turnaround, can provide a stronger link to business strategy than a standard financial or operational metric. This is not to say that companies should abandon their current incentive plans that are quantitatively driven. Rather, companies should consider the business stage they are in, and whether qualitative or milestone-based goals may provide a stronger link with their strategic focus.

Mix of incentive and fixed compensation A number of Grant Thornton’s clients have used the change in Section 162(m) to evaluate their mix of incentive and fixed compensation. With performance-based compensation no longer entirely deductible, companies are reviewing whether it makes sense to shift a higher proportion of pay to base salaries and away from annual and long-term incentives. Situations where a shift to higher base salaries may be appropriate include:

  • Companies struggling with high burn-rate and overhang levels
  • Shifts in business strategy where it may be difficult to select quantitative metrics or qualitative goals
  • Companies with low salary positioning relative to market levels

For most companies, making such a shift to higher fixed pay would not align with their short- or long-term strategy. A higher emphasis on annual incentives often makes sense for more mature, operational-focused companies or companies in a turnaround situation. Start-ups and/or growth organizations prefer to grant a majority of their pay in long-term incentives due to their lack of cash and the better alignment with long-term outcomes, even for time periods that are not limited to the traditional three-year performance period (potentially longer than three years, or simply milestone-based such that awards do not vest or are not paid out until achieved).

It is important that companies consider the appropriateness of reducing their incentive-based compensation, especially in the age of “pay-for-performance.” Proxy advisors and institutional investors will undoubtedly be skeptical of a move towards higher salaries, so companies should be sure to disclose their rationale and justification of any major shifts in their compensation philosophy.

Monitoring covered employees The change in the definition of “covered employees” has caused companies to take an additional look at the compensation ranking/positioning of their executives for each fiscal year. Prior to the TCJA, companies would only need to monitor their CEO and the next three highest paid executives, excluding the CFO, for a given taxable year. In other words, a covered employee in one year would not necessarily be one the next year if that person fell out of the ranking of the four highest-paid.

Post-TCJA, however, an executive that becomes a covered employee remains a covered employee forever, even in retirement or death (i.e., compensation paid upon retirement or death to a covered employee would remain subject to 162(m) regulations). As such, we recommend that companies keep a close eye on the ranking of their highest-paid executives, particularly the highest-paid non-CEOs and non-CFOs. Companies should closely monitor annual pay adjustments that may position a non-covered employee above a current covered employee, and they should consider using deferred compensation arrangements to maintain their current covered employee list.

Grandfather status of prior awards To assist companies in their transition to post-TCJA regulations, the IRS has grandfathered the Section 162(m) performance-based exemption for certain types of compensation granted prior to Nov. 2, 2017. To receive grandfathering status, compensation (generally) must have been awarded through a written and binding contract, must not have been materially modified, and must not be subject to positive or negative discretion. Note that discretion does not have to be exercised to cancel the grandfathering of an award. Rather, having language in plan or award agreements allowing the use of discretion is enough to violate an award’s performance-based exemption.

Many companies are currently in the process of reviewing their historical equity awards to determine their grandfathering status. A number of companies have determined that their performance-based equity incentive plans do indeed have discretion for their compensation committees to modify payouts, thus excluding such awards from transition relief.

Companies should review their incentive awards on a grant-by-grant basis to ensure they have taken an appropriate position and consult their tax and/or compensation professionals with any additional questions.

Conclusion The major changes to executive compensation taxation have given companies, and their compensation committees, a fresh slate to reconsider their compensation levels and incentive programs. Although performance-based compensation is no longer fully tax-deductible, companies have a newfound freedom to utilize discretion and qualitative goals to better align compensation with their short- and long-term strategic goals.

Major changes, as always, must be considered with an eye towards institutional shareholder and proxy advisor preferences, and done in a way that still emphasizes a pay-for-performance ethos. Arguably, pay-for-performance alignment may be even more important now, considering that shareholders will want to ensure appropriate alignment given the loss of valuable tax deductions. Companies should continue to lean on their outside tax and compensation professionals to be kept aware of best practices and to ensure they have properly adapted their pay programs for a post-TCJA world.

Eric Gonzaga
Principal, Compensation Consulting
Minneapolis Office
T +1 612 677 5336

Rob Storrick
Senior Associate, Compensation Consulting
Minneapolis Office
T +1 612 677 5105

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