The Tax Cuts and Jobs Act (TCJA) will make major changes to the $1 million limit on deductible compensation contained in Section 162(m) of the Internal Revenue Code.

Section 162(m) limits the tax deduction available to public companies for compensation paid to top executives to $1 million per year, per executive. However, the law contains significant exemptions, including exemptions for compensation that is performance-based or paid after termination. These exemptions have had a powerful influence on the design of public company executive compensation for more than 20 years and have encouraged the use of stock options, performance-based restricted stock units (RSUs), formulaic cash bonuses and deferred compensation. Some have argued that the exemptions have swallowed the general rule.

Changes to Section 162(m) have been proposed from time to time, usually with the intent of slowing the growth in executive pay. While restraining executive pay is not a traditional GOP priority, Section 162(m) changes have been included in the TCJA because they are expected to raise $9.2 billion in revenue over the next 10 years, which can then be used to offset the costs of other tax law changes sought by the GOP.

If the TCJA is enacted in its current form, Section 162(m) will change in the following ways:

• Removal of the exemption for “qualified performance-based compensation.” This is a seismic shift. For many companies, performance-based compensation (such as stock options, performance-based RSUs and formulaic cash bonuses) constitutes the majority of senior executive pay. With the elimination of the Section 162(m) exemption for performance-based compensation, a huge portion of senior executive pay will swiftly become nondeductible.

• Expansion of the officers covered. Currently, Section 162(m) covers CEOs and the next three most highly paid executive officers other than the CFO. The exclusion of CFOs is a technical glitch that arose in 2006 due to a disconnect between IRS and SEC rules. The TCJA corrects this glitch, so that CFOs will again be subject to Section 162(m).

• Expansion of the companies covered. Whereas Section 162(m) presently focuses on companies with publicly traded equity, the TCJA will expand Section 162(m) to also apply to companies with publicly traded debt, as well as to certain non-publicly traded companies with many stockholders.

• Expansion to compensation paid after termination. Currently, Section 162(m) limits the deductibility of compensation paid to executives only while they are employed in covered positions. This means, for example, that compensation paid after termination of employment (such as severance pay, nonqualified pension benefits or other compensation deferred beyond separation) is generally exempt from Section 162(m). The TCJA will alter this rule such that, once an employee is covered by Section 162(m), he or she will remain covered for all future years (even after death, with respect to compensation payable to his or her estate or beneficiaries).

• Crucial transition rule. Generally, the changes to Section 162(m) are effective for 2018 and later years. However, there is an important transition rule: The changes will not apply to compensation payable under a written binding contract in effect on November 2, 2017 (the date the TCJA was introduced in the House of Representatives), so long as the contract is not materially modified on or after that date. Many questions will arise regarding the proper application and scope of this transition rule, and we expect that future IRS guidance will attempt to address these points. In the meantime, employers should exercise caution before modifying existing plans and agreements.

The TCJA changes to Section 162(m) will result in a dramatic shift in how public company executive compensation is designed and administered. Among other things, these changes are likely to result in the decreased use of stock options (favored under existing law) and the increased use of discretionary bonuses (disfavored under existing law). The changes also will create a tension between the policies of proxy advisors like ISS and Glass Lewis, which advocate for objective linkages between corporate performance and executive compensation, and the tax deductibility rules of Section 162(m), which will become indifferent to the basis for compensation. It remains to be seen whether these changes slow the growth of executive compensation or if the widespread nondeductibility of executive compensation will cause corporate directors to conclude that deductibility is an issue that can be safely ignored.