The Repeal Of The Section 162(M) Performance-Based Exception - The End Of Performance Pay?

by Orrick, Herrington & Sutcliffe LLP
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Orrick, Herrington & Sutcliffe LLP

The Tax Cuts and Jobs Act (the "Act") expanded the scope of the $1 million dollar deduction limitation under Section 162(m) of the Internal Revenue Code of 1986, as amended ("Section 162(m)") and, subject to a transition rule, eliminated the exception for performance-based compensation.  This Alert analyzes the impact of the changes on executive performance-based pay practices and concludes that, while issuers will have a little more flexibility in setting and determining the satisfaction of performance goals, annual bonuses and long-term equity incentives will remain performance-based to address shareholder concerns.

Summary of Changes to Section 162(m)

For calendar year companies, the following changes under Section 162(m) became effective for tax year 2018.  For non-calendar year companies, they will become effective for tax years commencing after December 31, 2017. 

  • The exception for performance-based compensation under Section 162(m) has been repealed and therefore, all compensation paid to a covered employee in excess of $1 million will be non-deductible, unless it is subject to the transition rule described below.
  • The "covered employee" definition has been expanded to include the CFO and to cover any individual who served as the CEO or CFO at any time during the tax year (even if not serving in such capacity at year end).  The rule continues to cover the three other most highly compensated officers (other than the CEO and CFO) for the tax year.
  • The "covered employee" definition has been further expanded to provide that once an employee becomes a covered employee for any tax year beginning after December 31, 2016, the employee will remain a covered employee for all future tax years, including after termination of employment (e.g., with respect to payments following termination or death, severance and deferred compensation. This is a major change to the prior rules. Under the prior rules, an individual's status as a covered employee was determined annually, and the individual ceased to be a covered employee upon termination of employment unless he or she was terminated on the last day of the fiscal year.
  • The scope of companies subject to Section 162(m) has been expanded to include privately held companies that have registered debt offerings subject to the reporting requirements of Section 15(d) of the Securities Exchange Act and certain foreign private issuers.

Transition Rule Under Section 162(m)

The changes to Section 162(m) will not apply to compensation payable under a written binding contract which was in effect on November 2, 2017, provided that the contract is not materially modified or renewed on or after that date.  Whether a written binding contract exists may depend on whether the Compensation Committee has discretion to reduce the compensation and/or whether the parties have discretion to terminate or materially modify the contract.

Plan-by-Plan Impact

The following plan provisions will need to be evaluated due to the new changes:

  • Compensation Committee composition;
  • Individual award limits;
  • Performance goals and exclusions and their pre-establishment;
  • Compensation Committee certification of satisfaction of performance goals; and
  • Prohibition on the use of positive discretion.

Individual Award Limits.  Because individual award limits under Section 162(m) are typically high compared to a company's compensation practices, companies may want to consider keeping existing individual plan limits in place in order to avoid the perception of a shareholder take-away.  

Preserving Grandfathered Arrangements and Performance Goals.  While many plans are drafted with a qualifier that the Section 162(m) requirements only apply to the extent an award is intended to qualify under Section 162(m), some plans are hard-wired or contain a mix of mandatory and discretionary provisions.  We expect that companies will preserve these provisions to the extent necessary to continue to exempt grandfathered arrangements (such as the Compensation Committee composition and certification provisions) but will amend out other provisions with respect to non-grandfathered arrangements that only serve a Section 162(m) purpose (such as the prohibition on the use of positive discretion).  Finally, provisions in bonus plans and equity plans (such as the laundry list of available performance measures) that are necessary to avoid Form 8-K disclosure when setting bonus targets and making equity grants should be preserved.  

No 8-K or shareholder approval required.  In most cases, we do not expect such amendments to require shareholder approval or a Form 8-K filing, although the Compensation Committee's approach to Section 162(m) and any impact of the loss of deductibility on its compensation philosophy should be discussed in the company's Compensation Discussion and Analysis (CD&A).

Grandfathered Bonuses and Performance Equity Awards.  Companies should be careful to not disqualify grandfather status and should continue to administer grandfathered awards in compliance with the performance-based compensation exception. Companies should consult counsel prior to the Compensation Committee exercising any negative discretion or making any amendments to existing plans or arrangements.

Future Bonuses. Although Compensation Committees will no longer need to pre-establish objective bonus performance conditions, exclusions and targets, if they establish those criteria at a time when the targets are substantially certain of being satisfied, the bonus will be reportable in the Summary Compensation Table as a discretionary bonus rather than as a non-equity incentive award.  In addition, the same result may occur to the extent that the Compensation Committee exercises positive discretion to pay a bonus above the amount dictated by the terms of the bonus, and any exercise of positive discretion will likely need to be discussed in the CD&A.  As many companies are aware, shareholders and their institutional advisors are very critical of discretionary bonuses, which are seen as contrary to pay for performance and we expect proxy advisors will adopt new voting guidelines which preserve some of the 162(m) requirements.  Accordingly, in order to avoid shareholder criticism, we believe companies will continue to set bonus awards when achievement of the targets is substantially uncertain, will use pre-established objective and subjective criteria, and will only exercise positive discretion when there are compelling reasons to do so.

Future Performance Equity Awards.  With respect to performance-based equity awards, the exercise of positive discretion may trigger similar shareholder and institutional advisor concerns and may result in additional summary compensation table disclosure if the exercise of positive discretion is a modification for accounting purposes.  Accordingly, we expect companies to continue to pre-establish adjustments to the financial performance results. Because shareholders will continue to expect rigorous performance goals attached to a substantial portion of an executive officer's equity, we expect to see little change in the mix of equity provided to executive officers on account of the changes to Section 162(m).

Status of the IPO Exception? The Act does not appear to eliminate the regulatory exception from Section 162(m) for newly public companies (e.g. IPO companies) that allows such companies to be exempt from the $1 million dollar deduction limitation for a limited period of time following the IPO.  We expect the IRS to issue additional guidance in the near future and they could take that opportunity to address this exception.  Companies that are planning an IPO or are in their post-IPO transition period will want to monitor these rules and consult with their counsel to confirm how Section 162(m) will apply to them.    

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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