162(m): It’s Too Late. Now What?
Sorry, but it’s time to get serious to start the new year. 162(m) is better known $1Million tax deductibility rule. It was established during the Clinton Administration in an attempt to slow the escalation of executive pay. (Pro tip: it didn’t work.) For many compensation professionals, 162(m) has been essentially unchanged for their entire career.
Until Jan. 1, 2018, 162(m) applied to “covered employees” (the CEO and three other most highly paid officers). It allowed for an exception for “qualified performance-based” compensation. Most stock options and performance-unit awards as well as several other types of incentive plans, qualified for this exception. Companies who paid taxes received a corresponding tax deduction when an executive exercised stock options and made millions, or vested in a performance-unit award and received stock worth millions. It was a key component of design.
If you are an executive pay professional, this is all old news, if you aren’t this may sound pretty simple, but the actual rule is fairly complex (thanks, Cornell Legal Information Institute.) Enough with the background, what happened?
The Tax Cuts and Jobs Act, or “Tax Reform,” that was recently passed and signed into law, fundamentally changes 162(m). It removes any tax deductibility for pay above $1Million. It does leave in place some of the exceptions related to pay that was contractually finalized by November 20, 2017 and some of the exceptions for pay determined prior-to IPO. But, going forward, public companies will no longer be able to deduct taxes related to paying big bonuses, monster stock option exercises, and performance-based equity achievement.
Most publicly traded companies have designed their executive pay programs around the old rules, and the changes are material and immediate. They apply to tax years beginning Jan. 1, 2018 (yes, that date has already passed.) Anything you do now must be focused on maximizing the new rule, not avoiding it.
So now what?
Companies need to look at their executive compensation plans this month. Are there design elements of your plans that exist solely to maximize your tax deduction? Would you have designed things differently if the maximum in tax-deductible pay was only $1Million?
Should you add the ability to increase the award payout based on the discretion of the Board? This would have made the plan non-compliant with the old rules, but perhaps this was a goal that had been wished for in the past.
Should you consider more frequent payouts on your long-term incentives? If your current plan design has three-year cliff performance goals that may result in multi-million dollar payouts, you may want to consider having annual performance goals that result in smaller, but more frequent payouts. If the old plan expected a $12Million payout at the end of three years, perhaps you should consider annual payments of $4Million each. Only $1Million of the old plan will be tax deductible in the third year, but $3Million will be deductible if you use annual installments.
Perhaps you used a three-year cliff, because of expected tax deductibility, but a five-year annual schedule makes more sense given the new rules.
Are you fully aware of how the accounting related to your plans may change if you change key design elements?
Now may also be the time to educate or remind your shareholders that one of the key driving elements of your past plan design was adherence to the old version of 162(m). Getting them on board early may allow for a much easier approval process during proxy season.
For those companies who tightly manage their pay to maximize tax deductions, this change creates major headaches and potential opportunities for improvements. For companies who have built pay programs that provide outsized equity award values for executives, this may be an opportunity to reevaluate whether the cost of those payments still justifies avoiding cash LTI plans. Without the tax deduction, many companies may find themselves in a better position using simple time-vested cash or RSU plans, with lower values and lower risks. Of course, shareholders will also need to get on board, while they are still getting used to the increased use of performance-based equity programs.
Note: The new rule explicitly adds the CFO to the list of “Covered Employees,” regardless of pay. It also changes the definition of “publicly-traded company” to include companies that are required to file with the SEC due to public debt.
I’d love to hear how this may impact your company or clients. Are your pay changes already in the works, or are you waiting until the last possible minute to make your decisions?