Executive Compensation

Many of us in the executive compensation field have been busy these past few months preparing proxy statements and corresponding executive compensation disclosures.  Now that the crush of proxy season is largely behind us, and companies have either made it through their first pay ratio disclosures or are about to file proxies with pay ratio disclosures, you might be tempted to take a pause and catch your breath. But wait! An unnerving and growing trend has emerged in which state and local governments have either passed or are considering new taxes and other rules that are tied to a company’s pay ratio.

Most of these new or proposed bills would add surtaxes based on a company’s pay ratio.  For example, Portland, Oregon adopted a new tax in which it will levy:

  • A 10% surtax on companies with a pay ratio of at least 100:1 but less than 250:1; and
  • A 25% surtax on companies with a pay ratio of 250:1 or greater.

Other states either have followed or are considering following suit (in their own unique fashions), including:

  • California (which, inconveniently, is considering adopting its own pay ratio formula)
  • Connecticut
  • New Hampshire
  • Rhode Island
  • San Francisco

We flagged this issue prior to the pay ratio rules becoming effective (see our comment letter here) as one of the many problems associated with the pay ratio rules.  Unfortunately, the trend of states and localities seeking to levy punitive taxes based on pay ratio disclosures, that even the SEC admits, are simply estimates, is troubling and may ultimately grow in prevalence.  We are continuing to monitor all pay ratio taxes and will provide updates as warranted.

Playing off our earlier post regarding how tax reform proposals never really die, they just resurface in new ways, we thought you might enjoy the following trip down memory lane:

Once a Covered Employee, Always a Covered Employee – Round 1

Attached is the Conference Report relating a portion of the version of the Small Business and Work Opportunity Act of 2007 put forth by the Senate Finance Committee.  Though these provisions never made it into the final law, this version of the bill took aim at Code Section 162(m) over a decade ago and proposed modifying the rule to cover compensation received by covered employees, even if they weren’t employed at the end of the year.  In addition, this version of the bill covered anyone who served as a CEO at any point during the year and addressed death benefits paid to beneficiaries.

Once a Covered Employee, Always a Covered Employee – Round 2

Many of the same themes reemerged in the 2017 Tax Act’s Code Section 162(m) reforms.  Starting in 2018, the following rules apply:

  • Removal for performance-based compensation exception to $1 million deduction cap for covered employees (subject to limited grandfathering);
  • Once a covered employee, always a covered employee; and
  • Addition of CFO to covered employee group.

Nonqualified Deferred Compensation Next?

It will be interesting to see if there’ll be a second act to Code Section 409B.  Here again, the Senate Finance Committee’s version of the Small Business and Work Opportunity Act of 2007 may be instructive (see the attachment following the 162(m) summary).  Here, the Senate Finance Committee proposed limiting the amount an individual could defer under a nonqualified deferred compensation plan to the lesser of:

  • $1 million; or
  • The individual’s five-year average aggregate taxable compensation.

Stay tuned…

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.

Now that the House and Senate are on the precipice of passing tax reform, we thought it might be helpful to provide a one-stop-shop resource for the historical bills that led to the final product. Also, as an executive compensation lawyer, I had to chronicle the rise, fall, rise and fall again of the proposed Code Section 409B.

As may know, both the House and Senate flirted with the idea of substantially remodeling the rules governing nonqualified deferred compensation. While the rule never made it into the final bills, if passed it would have provided that deferred compensation would be includable in income once there was no longer a “substantial risk of forfeiture” (i.e., once it was vested). If folks are interested, we have detailed analysis regarding the potential impact of Code Section 409B. While this rule didn’t make the final cut, proposed tax rules have a funny way of resurfacing in
new or similar forms in the future…

House Committee Bill – The emergence of Code Section 409B!

Final House Bill – Code Section 409B removed.

Senate Finance Committee Bill – Code Section 409B returns!

Final Senate Bill – The death knell to Code Section 409B.

Conference Agreement for H.R. 1 –