With both the House and Senate tax reform bills proposing to repeal the performance-based compensation exception to the IRC §162(m) deductibiity limitation and the seemingly increasingly likelihood that this will become the new reality, I thought that this commentary from Compensia was worth sharing as many companies look to updating their directors at their early December board and committee meetings: Elimination of “Performance-Based Compensation” Exclusion from Section 162(m)
Currently, Section 162(m) of the Internal Revenue Code disallows public companies a federal income tax deduction for remuneration in excess of $1 million paid to its so-called “covered employees” (that is, the chief executive officer and three other most highly-compensated executives, other than the chief financial officer) in any taxable year, unless such remuneration qualifies as “performance-based compensation.” Both the House and Senate versions of the bill would eliminate the exception to the deduction limit for performance-based compensation, including nonqualified stock options. Consequently, in operation no amounts paid to any covered employee over the $1 million limit would be deductible, including specifically gain resulting from the exercise of stock options, receipt of performance-based equity awards, or the payment of a performance-based cash bonus.
In addition, once an executive became subject to the deduction limit, he or she would continue to be subject to the limit on all compensation payments from the company in future years even if he or she is no longer a covered employee (and, in the case of severance payments, even, presumably, if he or she is no longer employed by the company). Finally, the provision would provide that the CFO of a public company is to be considered a covered employee.
Observations: While the elimination of the exception for performance-based compensation would simplify both plan design and administration, its reception by Boards of Directors and shareholders would be, at best, problematic. The amendment may cause companies that seek to ensure the deductibility of their executive compensation to rethink the use of performance-based equity awards as part of their long-term incentive compensation programs. On the other hand, a significant reduction in the corporate tax rate may cause some companies to reevaluate the importance of deductibility when compared to the plan design restrictions imposed by Section 162(m). Overall, Boards of Directors that rely on performance-based awards to align pay with performance and to drive shareholder value creation may ultimately decide that the loss of the tax deduction is an acceptable tradeoff.
Finally, we note that the Senate version of the bill indicates that the chamber is considering whether to extend the coverage of Section 162(m) to include certain additional corporations that are not publicly-traded, such as very large privately-held companies. The application of the deduction limitation to such companies may present unique issues based on their relative income tax positions.
See this article from The Hill: "Senate panel approves GOP tax plan," and numerous additional resources on the proposed reforms here.