Responding to the Tax Act's Executive Compensation Changes

New rules for paying top executives at publicly held and tax-exempt employers

By Alec Nealon and Melissa Ostrower © Jackson Lewis January 17, 2018
Responding to the Tax Acts Executive Compensation Changes

TheTax Cuts and Jobs Act signed by the president on Dec. 22, 2017, imade significant changes to the taxation of executive compensation arrangements for both publicly held corporations and tax-exempt organizations.

Publicly Held Companies:
Repeal of Performance-Based Compensation Exclusion

The tax act amended Section 162(m) of the Internal Revenue Code to require publicly held corporations and certain other companies not previously subject to Section 162(m), such as foreign private issuers, to revisit their executive compensation arrangements and make appropriate adjustments.

An employer generally may deduct reasonable compensation for personal services as an ordinary and necessary business expense. Section 162(m), however, limits the deductibility of compensation paid to a covered employee of a publicly held corporation to no more than $1 million per year.

Prior to the tax act, there was an exception to this rule permitting the deduction of compensation in excess of $1 million where the compensation was performance-based within the meaning of Section 162(m). The act has eliminated this exception.

In addition, the act has expanded the definition of "covered employee" to include an employer's chief financial officer and any individual who was previously a covered employee (so that the deductibility limit continues to apply to payments made to former covered employees or to their estates after their death).

The act contains a transition rule that exempts from these changes remuneration provided under a written binding contract that was in effect on Nov. 2, 2017 and that was not modified in any material respect after that date.

Employer Action Items

Although the performance-based exception has been eliminated, this change presents publicly traded employers with new flexibility to be more creative in structuring their performance-based executive compensation arrangements. For example, such employers will no longer be constrained by strict requirements under the eliminated performance-based compensation exception in setting and approving performance goals and can make adjustments to performance goals at the conclusion of a performance period that increase compensation payable where appropriate.

Publicly traded employers will need to:

  • Consider replacing with other forms of incentive compensation any stock options and stock appreciation rights that were previously granted to comply with the performance-based compensation exception.
  • Reevaluate their performance metrics to take into account the impact of the reduction of the corporate tax rate to 21 percent. In some cases, performance metrics affected by this reduction may be permitted or required to be adjusted.
  • Take advantage of greater flexibility to provide for acceleration of the payment of performance-based compensation regardless of whether performance conditions have been satisfied, such as in the case of certain involuntary terminations.
  • Conduct an inventory of their executive compensation arrangements and compensation committee charters in 2018 and thoughtfully consider, with assistance from their tax and legal counsel, what revisions may be required or appropriate given the changes made by the act.

In addition, certain companies that have publicly traded debt and some foreign private issuers, which were not previously subject to Section 162(m), will need to determine whether the amended Section 162(m) applies to them.

Finally, employers will need to take precautions to ensure that any pre-Nov. 2, 2017 grandfathered arrangements intended to comply with the performance-based compensation exception under Section 162(m) are not materially modified in a way that will cause them to lose their grandfathered status.

[SHRM members-only toolkit: Designing Executive Compensation Plans]

Tax-Exempt Employers:
New Excise Tax on 'Excess' Executive Compensation

Under the tax act, starting in 2018, tax-exempt employers, such as not-for-profit organizations, are subject to a new 21 percent excise tax on:

  • Remuneration exceeding $1 million paid to a "covered employee" in a tax year.
  • Any "excess parachute payment" paid to a covered employee.

"Covered employee" includes any active or former employee who is one of the 5 highest compensated employees of the organization for the current tax year, or was a covered employee in any prior year beginning in 2017 (so that the "covered employee" status persists into subsequent years, meaning that a tax-exempt employer may eventually accumulate more than 5 covered employees).

"Excess parachute payments" generally refers to compensatory "parachute payments" that are contingent on a covered employee's separation from employment and exceed the employee's 5-year average annual compensation (the "Base Amount"), provided that the aggregate parachute payments exceed 3 times the Base Amount. This definition is subject to some exceptions, including exceptions for payments made to individuals who are not "highly compensated employees" under Code Section 414(q) and payments for services performed by a licensed medical professional.

Remuneration is considered to be paid when the covered employee's right to such remuneration is not subject to a substantial risk of forfeiture, so deferred compensation may fall within the scope of these rules before it is actually paid to the covered employee.

This excise tax, if applicable, is payable by the tax-exempt employer and not by the covered employee. The act does not provide for any grandfathering of existing compensation arrangements, or any transition period.

Employer Action Items

Tax-exempt employers should:

  • Identify their "covered employees" for 2018 and 2017 because, as noted above, the covered employee status persists into subsequent years.
  • Review their existing executive compensation and severance arrangements, including any deferred compensation plans, to determine whether payments to any covered employee in 2018 or future years could result in the imposition of the 21 percent excise tax.
  • If so, consider potential modifications to such arrangements or other strategies to avoid or mitigate the impact of the excise tax.

Tax-exempt employers and their counsel will also need to consider the new rules when structuring new compensation arrangements for executives. For example, an employer may consider including protective language in any new executive compensation arrangements that would allow it to unilaterally modify or reduce compensation to the extent needed to avoid the excise tax.

Similar clauses are already used by some taxable corporations for excise taxes under Code Section 280G, but as this new excise tax is imposed on the employer rather than the executive, it may be more difficult to negotiate a cutback where the excise tax applies.

Although the new rules are already in effect, they raise a number of compliance questions that will need to be resolved by the IRS in future guidance. Until guidance is issued, employers and their counsel will need to put forth their best efforts to interpret the act. 

Alec Nealon is of counsel and Melissa Ostrower is a principal in the New York City office of law firm Jackson Lewis P.C., where they advises clients on executive compensation and employee benefits matters. © 2017 Jackson Lewis. All rights reserved. Reposted with permission.


Related Resource:

Executive Compensation Performance Metrics Will Change Under Tax Reform, Financial Executives International, January 2018

Related SHRM Articles:

IRS Releases New Withholding Tables for 2018, SHRM Online Compensation, January 2018

Tax Act Alters Executive Pay, Affects Bonus Deductions and Withholding, SHRM Online Compensation, December 2017

President Signs Tax Bill Altering Employee Benefits, SHRM Online Benefits, December 2017


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