Tax Cuts and Jobs Act – Impact on Executive Compensation Arrangements

December 21, 2017

On December 19, 2017 and December 20, 2017, the House and the Senate, respectively, passed the Tax Cuts and Jobs Act (the “Act”), with President Trump expected to sign the Act into law before Christmas.

While the Act is extensive, this Advisory discusses only the changes made in the Act to executive compensation arrangements, and possible actions that employers might want to take before the end of 2017.  Although the initial drafts of the House and Senate Bills provided for the replacement of Code Section 409A with Code Section 409B, which effectively eliminated tax deferral for most nonqualified deferred compensation plans, the provision was removed from the final Act.

Code Section 162(m) Changes – Impact on Publicly Traded Companies.

Effective for tax years beginning on or after January 1, 2018, the Act modifies – and greatly expands – Code Section 162(m) and the $1 million limit on deductions for covered employees, in the following important ways:

  • Increased Number of “Covered Employees.”
    • Under the Act, the definition of “covered employee” under Code Section 162(m) is revised to include both the principal executive officer and the principal financial officer and the three most highly compensated officers for the taxable year.
    • In addition, any individual who is treated as a “covered employee” of an applicable public company under Code Section 162(m) for a taxable year beginning after December 31, 2016 will continue to be considered a “covered employee” with respect to that company so long as the company continues to provide remuneration to such individual (including years after the individual has died and compensation is paid to a beneficiary).
      • This means that covered employees for 2017 (and future years) will remain covered employees until they are terminated and no longer receiving compensation from the company.
  • Code Section 162(m) Performance-Based Exceptions Repealed.
    • The Act eliminates the performance-based compensation and commission exceptions under Code Section 162(m), causing the $1 million deduction limit to apply to all compensation paid to covered employees, including performance-based bonuses and compensation from stock options, stock appreciation rights, performance stock units and performance shares granted to covered employees.
      • This means that, unlike under current law, performance criteria could be modified during a performance period (for example, to reflect events that were not anticipated at the time of grant) and performance criteria could be subjective.  That said, companies will want to consider ISS and shareholders’ reactions to any modifications that move away from a performance-based compensation structure.
  • Companies Subject to Code Section 162(m).
    • The Act extends to all domestic publicly traded corporations and all foreign companies publicly traded through American depositary receipts (“ADRs”), and companies that have publicly traded debt, even if they do not have publicly traded stock.
  • 162(m) Transition Rule.
    • The only good news coming out of these changes is that the amendments to Code Section 162(m) described above will NOT apply to any written binding agreement in effect on November 2, 2017, provided that the agreement is not modified after that date in any material respect.
      • The Conference Committee Report notes that a plan may qualify for the transition rule even if an employee is not yet eligible for the plan or has not accrued any benefits, provided there is a “written binding agreement” and, as of November 2, 2017, the employee was employed by the company and had the right to participate in the plan. The transition rule may potentially cover awards issued and/or benefits earned in future years under plans that qualify for the transition rule.  We expect clarification on this matter to be issued by the IRS.

Consider Accelerating Compensation Payments to Take Advantage of Deductions in 2017.

Companies should consider taking action by December 31, 2017, to accelerate the accrual of deductions into 2017 for cash bonuses and certain equity grants otherwise payable in 2018 or later years (such as restricted shares, restricted stock units and other equity awards). Deductions in 2017 may be more valuable to the Company than the 162(m) transition rule, because acceleration results in a higher deduction in 2017, in lieu of a 21% deduction or (for executive compensation in excess of $1 million under Code Section 162(m)) a 0% deduction in a future year.

Companies should take the following steps if accelerating deductions into 2017:

    • Ensure that the Company takes all actions necessary to support a 2017 deduction. 
    • Ensure that the Company does not inadvertently cause Code Section 162(m) performance based compensation to fail to qualify as such under current Code Section 162(m) provisions, if preservation of those amounts as performance-based compensation is desired.
    • If accelerating compensation that is not performance-based, remember that the acceleration may cause compensation for Code Section 162(m) covered employees to exceed the $1 million threshold in 2017.
    • Ensure that acceleration is permitted under Code Section 409A.

    For outstanding performance-based awards that cannot be accelerated in 2017, determine whether the awards qualify for the Act’s transition rule, which would permit the awards to remain eligible for the Section 162(m) performance-pay exception.

    Review and revise plan documents and award agreements to preserve flexibility for awards not eligible for the transition rule.

    Tax on Excess Executive Compensation Paid by Tax-Exempt Entities.

    Effective for tax years beginning on or after January 1, 2018, the Act imposes a tax on “excess” compensation paid to certain employees of tax-exempt organizations, including not only 501(c)(3) organizations, but also 501(c)(4) and 501(c)(6) organizations, as well as governmental employers and political organizations:

    • Tax-exempt employers will owe 21% (the tax rate equal to the corporate tax rate) on the sum of:
      • Compensation (other than an excess parachute payment) in excess of $1 million paid to a “covered employee”; and
      • Any excess parachute payments paid to a “covered employee.”
    • Compensation for these purposes means wages as defined for income tax withholding purposes (but excluding designated Roth contributions) and shall be treated as paid when there is no substantial risk of forfeiture with respect to such compensation (i.e., when the compensation becomes vested).
    • A “covered employee” is an employee who is one of the 5 highest compensated employees of the employer for the tax year or who was a “covered employee” of the organization for any preceding taxable year beginning after December 31, 2016.
      • This is very similar to the new definition of covered employee under Code Section 162(m).
      • An exemption from the excise tax applies for compensation payable to a covered employee who is a licensed medical professional for the performance of medical or veterinary services. The exception does not apply to compensation paid to a licensed medical professional for services in any other capacity, such as for services as an officer.
    • A parachute payment means a payment that is contingent upon the covered employee’s separation from service with the employer and that exceeds three times the base amount, which is the five-year average of the covered employee’s compensation.
      • Payments under a qualified retirement plan, such as a 401(k) plan or 403(b) plan, or a 457(b) deferred compensation plan are excluded from parachute payments and parachute payments also exclude compensation paid to employees who are not highly compensated employees, as determined under Code Section 414(q).

    If you have any questions about this Advisory, please contact a member of our Employee Benefits Group or Executive Compensation Group.

    Sherman & Howard has prepared this advisory to provide general information on recent legal developments that may be of interest. This advisory does not provide legal advice for any specific situation and does not create an attorney-client relationship between any reader and the Firm.

    ©2017 Sherman & Howard L.L.C.                                                                                   December 21, 2017