Estate Planning

The Tax Cuts and Jobs Act (the “Tax Act”) has significant implications for public company executive compensation plans for tax years beginning after December 31, 2017 and will likely have a considerable impact on the future design and administration of public company executive compensation programs. Before the Tax Act, Section 162(m) of the Internal Revenue Code (“Section 162(m)”) prohibited a public company from deducting annual compensation paid to its chief executive officer and the company’s next three highest paid officers (other than its chief financial officer) in excess of $1 million, unless the compensation paid qualified for the “performance-based compensation” exception to Section 162(m). Generally speaking, the “performance-based compensation” exception applied if, among other things: (i) the compensation was paid solely on account of the attainment of pre-established, objective performance goals; (ii) the performance goals were established by a compensation committee comprised solely of two or more “outside directors;” (iii) the material terms of the performance goals were disclosed to, and approved by, stockholders before the compensation was paid; and (iv) the compensation committee certified, in writing, that the performance goals were satisfied before the compensation was paid.

For tax years beginning after December 31, 2017, the Tax Act repeals the “performance-based compensation” exception subject to the Tax Act’s transition relief applicable to binding written agreements in effect as of November 2, 2017 and not materially modified thereafter. As a result, unless the transition relief applies, public companies will not be able to deduct compensation paid to covered employees in excess of $1 million. The 162(m) transition relief and some of the more significant changes made to Section 162(m) by the Tax Act are summarized below:

• Expanded Definition of Covered Employees. In addition to a public company’s chief executive officer and the company’s next three highest paid officers, the definition of “covered employee” now specifically includes the company’s chief financial officer. In addition, any individual who was a covered employee at any time during 2017 or during any tax year thereafter will remain a covered employee for all future years, even following the individual’s termination of employment. This is a significant expansion to the old Section 162(m) rules, under which an individual ceased to be a covered employee if he or she was not a covered employee (i.e., employed) on the last day of the year.
• Expanded Definition of Publicly Held Employer. The type of companies to which the $1 million deduction limitation applies now includes all companies that are required to file reports under Section 15(d) of the Securities Exchange Act of 1934. As a result, companies with publicly traded debt and certain foreign issuers whose stock is traded through the American Depository Receipt System will be subject to the Section 162(m) deduction limit.
• Transition Relief. The repeal of the “performance-based compensation” exception does not apply to written binding contracts that were in effect on November 2, 2017 and are not materially modified thereafter. The scope of the transition relief is far from clear and we expect the Internal Revenue Service to provide additional guidance on the applicability of the transition relief. That said, deductions in 2018 and future years may still be allowed for certain equity awards and bonuses granted on or prior to November 2, 2017, and settled/paid after such date, if such arrangements are not modified and satisfied the requirements of the pre-Tax Act “performance-based compensation” exception. In addition, it is possible that the $1 million deduction limitation may not apply to amounts paid to a covered employee following his or her termination of employment (e.g., pursuant to an employment agreement or deferred compensation plan) if the arrangement was in place on or prior to November 2, 2017 and has not been modified.

While the full impact of the changes to Section 162(m) is not yet known, there are a number of related issues that public company employers may wish to consider, including, without limitation:

• Before making any changes to existing covered employee compensation arrangements, consider whether such changes are material modifications that will make the transition relief unavailable.
• Revise the standard tax discussion that appears in proxy statements and other securities filings to reference the changes to Section 162(m) and the impact of such changes on existing executive compensation programs and future compensation decisions.
• In new compensation plans, consider omitting language that was previously intended to comply with the old “performance-based compensation” exception. For example, public company cash and equity programs included a list of performance goals and individual award limits that company stockholders were asked to approve. In light of the changes to Section 162(m), stockholders no longer will be required to approve these features to obtain a tax deduction so the removal of such provisions from new plans may be desirable. Of course, before removing such provisions, companies should consider the impact of such removals on shareholder relations.
• The “performance-based compensation” exception was not available if compensation was accelerated on termination without cause, termination for good reason, or retirement. In new compensation arrangements, companies may wish to accelerate vesting on termination without cause, termination for good reason, or retirement.
• The “performance-based compensation” exception allowed compensation committees to decrease (but not increase) the amounts payable upon the earning of a performance-based compensation award. In new arrangements, the compensation committee can now exercise positive discretion to increase the amounts payable to covered employees. Similarly, adjustments to performance goals no longer need to be pre-established, which means that adjustments may be made after a performance period has already begun (making such adjustments may have adverse accounting or shareholder relations consequences so caution should still be exercised).
• To qualify for the “performance-based compensation” exception, amounts needed to be certified by a committee of two or more “outside directors.” Subject to the requirements of applicable securities laws and listing rules, companies may wish to revisit, update and revise their existing compensation committee membership and charters to reflect the repeal of the “performance-based compensation” exception. In doing so, companies should recognize that awards that are intended to qualify for the Tax Act’s transition relief may still need to be certified by a compensation committee that meets the old Section 162(m) standards for “outside directors.”

Although the changes to Section 162(m) should give compensation committees more flexibility and may result in the simplification of public company cash and equity plan documents, we do expect public companies to continue the general practice of aligning pay with performance and linking the vesting of cash and equity awards to objective performance goals. That said, because compliance with the rigorous old Section 162(m) rules will no longer result in a tax deduction, we do expect to see more variation in both compensation design and the way public companies administer their executive compensation programs.