As you likely know by now, the final tax reform bill substantially modified Code Section 162(m). Prior to tax reform, Code Section 162(m) limits publicly-traded companies to deducting as compensation expense, amounts in excess of $1 million paid to a company’s CEO and three highest compensated executive officers, excluding the CFO. Importantly; however, the pre-tax reform version of Code Section 162(m) allows companies to deduct an unlimited amount of “performance-based compensation”.
The new version of Code Section 162(m) makes the following changes:
- Eliminates ability to deduct “performance-based compensation” in excess of $1 million;
- Applies the $1 million deduction cap to a publicly-traded company’s CEO, CFO and three highest paid executives (i.e., closing the CFO gap, which was originally created with the SEC reformed its proxy reporting rules);
- Provides that once an employee is covered by Code Section 162(m), they are always covered by Code Section 162(m) – this means that the $1 million deduction limit will apply to individuals who once were proxy Named Executive Officers and to post-employment compensation paid to covered employees (i.e., SERP / nonqualified deferred compensation payments).
We’ll talk more about the nuances of the new Code Section 162(m) rules; however, the interesting conversations we’ve had with our clients surround the potential impact these changes may have on incentive pay practices. Many companies have expended tremendous amounts of time and energy developing pay programs that utilized the “performance-based compensation” deductibility rules. Once this deduction is no longer available, will there be a shift away from incentive-compensation to fixed pay (base salary) or time-based retention awards (non-performance based)?
Based on preliminary conversations we’ve had with our clients and compensation consultants, we see the following trains of thought emerging:
- Due to market norms and institutional shareholder pressure, companies will likely continue to want to demonstrate “pay for performance” – that is linking variable pay to company results.
- Companies are considering taking a fresh look at their incentive programs and thinking about refreshing them now that the prior Code Section 162(m) “performance-based compensation” rules are irrelevant. This includes, examining performance measures, use of discretionary bonuses and other operational features that were once prohibited by Code Section 162(m).
- We have not heard clamoring for a big shift from incentive pay to fixed pay; however, we expect that there may be an eroding of the $1 million base salary ceiling that you will see in many public company SEC filings.