How the 2017 tax overhaul changed Sec. 162(m): What this means for corporations and compensation practices.

• Author: Balsam, Steven

Sec. 162(m) dramatically altered public corporation compensation practices by mandating a series of requirements to preserve the tax deduction for performance-based compensation. Aside from the exemption granted CFOs in 2007, Sec. 162(m) has remained essentially unaltered since taking effect in 1994. (1) However, P.L. 115-97, known as the Tax Cuts and Jobs Act of 2017 (TCJA), brought sweeping changes to Sec. 162(m), effective for tax years beginning after Dec. 31, 2017. These statutory changes alter the environment surrounding executive compensation and thus have broad, immediate implications for executive compensation arrangements. This article presents how the TCJA altered corporations' responsibilities and discusses the potential compensation implications.

New Sec. 162(m)

As revised, Sec. 162(m) can be summarized as follows: For publicly traded corporations, the compensation tax deduction is limited to $1 million per covered executive. The TCJA changed the definition of "publicly traded" corporation and of "covered executive" and eliminated the tax deduction for all compensation in excess of $1 million, whether performance-based or not. The table, "Comparison of Sec. 162(m) Under Prior Law and New Law," below, presents a comparison of the principal changes.

Expanded definition of publicly traded corporation

Before 2018, Sec. 162(m) applied only to corporations that issued common equity securities required to be registered under Section 12 of the Exchange Act. (2) The TCJA expanded this definition to include foreign corporations with equity traded through American depository receipts (ADRs) and domestic corporations with publicly traded debt. (3)

Planning implication: Consequendy, the tax deduction limitations of Sec. 162(m) now apply to some privately held corporations, thereby reducing the incentive for these corporations to remain off the public exchanges. The incentive also exists for foreign corporations to buy back their existing ADRs and for domestic private corporations to redeem their publicly traded debt.

Comparison of Sec. 162(m) under prior law and new law Prior law 1994-2006 2007-2017 Covered executives CEO on last day CEO on last day of fiscal year + of fiscal year + 4 highest-paid 3 highest-paid executives executives (CFO excluded) Maximum covered executives 5 4 per year Determination of covered Each year stands alone, i.e., status as a executives covered executive in one year does not carry over to the next Maximum tax deduction per $1 million + qualified covered executive performance-based compensation Shareholder voting Preapprove performance goals, and requirements, to qualify generally reaffirm every five years compensation for performance-based exemption under Sec. 162(m) Performance-based goal Established no later than 90 days after requirements, to qualify the start of the fiscal year, such that compensation under the "outcome is substantially uncertain" Sec. 162(m) Publicly traded corporations, Corporations with publicly traded equity subject to Sec. 162(m) New law (2018-) Covered executives All CEOs during year + all CFOs during year + 3 highest-paid executives + all executives defined as covered for any year beginning after Dec. 31, 2016 Maximum covered executives No limit per year Determination of covered Once covered, always covered, even executives after leaving corporation and death Maximum tax deduction per $1 million covered executive Shareholder voting Not applicable requirements, to qualify compensation for performance-based exemption under Sec. 162(m) Performance-based goal Not applicable requirements, to qualify compensation under Sec. 162(m) Publicly traded corporations, Corporations with publicly traded subject to Sec. 162(m) equity or debt, and foreign corporations publicly traded through American depository receipts Expanded definition of covered executive

Before 2018, in each fiscal year, each publicly traded corporation had four executives subject to Sec. 162(m), composed of the individual serving as the CEO on the last day of the fiscal year plus the corporation's three highest-paid non-CEO, non-CFO named executive officers. The TCJA greatly expands the definitions of Sec. 162(m)-covered executives. Rather than applying to a single CEO, Sec. 162(m) now extends to all executives who serve as the CEO during any part of the fiscal year. This same broad definition also applies to CFOs, who are no longer exempt. Similar to CEOs, all individuals serving as the CFO anytime during the fiscal year are classified as a covered executive, based on their position with the corporation and not compensation. The next three highest-paid executives continue to be classified as covered executives.

As a consequence of this expanded definition of covered executive, corporations can have more than five executives classified as covered by Sec. 162(m) beginning in 2018. Moreover, the TCJA provides that an executive, once covered, is always covered by Sec. 162(m). In other words, any executive who is classified as covered in one year remains classified as covered as long as he or she is employed with the corporation, after the employment relationship ends, and even following death. It is irrelevant how the executive became covered, e.g., temporarily serving as the CEO or CFO in a transition period or because a one-time bonus placed the executive among the top-three non-CEO/non-CFO executives in one fiscal year. Therefore, the number of covered executives at each corporation may grow rapidly, which increases the amount of non-tax-deductible compensation.

Retroactive consequence: While the changes to Sec. 162(m) took effect Jan. 1, 2018, the once-covered, always-covered rule applies to executives classified as covered in any tax year beginning after Dec. 31, 2016. Therefore, all executives classified as covered by Sec. 162(m) in a firm's last year under the prior law will remain so classified. "It is not uncommon to see that a firm's three highest-paid executives will fluctuate from one year to the next," said Stephen Pakela of Pay Governance LLC. (4) "Consequently, the once-covered, [always-] covered rule will have an immediate impact, and I expect to see firms commonly having six, seven, or even eight executives covered by Sec. 162(m) beginning in 2018." (5)

Planning implication: Sec. 162(m), as revised, provides a definitive line: All compensation over $1 million is non-tax-deductible, but only for covered executives. Therefore, to...