January 31, 2023

Volume XIII, Number 31


January 30, 2023

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Executive Compensation in the Firing Line Under Tax Bills: Section 162(m) $1 Million Deduction Limit

The Tax Cuts and Jobs Act H.R. 1 passed by the US House of Representatives on November 16 and the Senate Finance Committee’s “Modified Mark” released November 14 would make sweeping changes to the tax treatment of executive compensation, fringe benefits, and tax-qualified plans (among many other areas) in order to pay for centerpiece reductions in both corporate and individual tax rates.

Both the bill passed by the House  and the Senate bill have taken out controversial initial provisions that would have repealed the ability to defer compensation and would have accelerated deferred compensation income under a new Section 409B. However, significant changes that affect executive compensation remain in the bills, particularly through expansion of the $1 million deduction limit under Section 162(m) of the Internal Revenue Code. The proposed changes to Section 162(m) are described below.

Both the House bill and the Senate bill expand the reach of the $1 million deduction limit under Section 162(m) to compensation for top officers of public companies.

  • Both bills eliminate the current exception for performance-based compensation, which would cause the $1 million deduction limit to apply to stock options, stock appreciation rights, performance stock units, and performance shares granted to top officers of public companies.

  • Under current law, Section 162(m), as interpreted by the IRS, excludes a company’s chief financial officer from the list of officers subject to the deduction limit. Both the House bill and the Senate bill include the chief financial officer in the top officer list, applying the $1 million deduction limit to the compensation of any individual who, at any time during the year, is the company’s chief financial officer or chief executive officer, or is among the company’s three top-paid officers (other than the chief financial officer or chief executive officer).

  • Both bills adopt a “once covered, always covered” rule. If an officer is subject to the $1 million deduction limit at any time, that individual’s compensation with respect to that corporation would remain subject to the deduction limit in perpetuity. For example, the $1 million deduction limit would apply to the officer’s compensation even if paid after the officer resigns from the company, dies, or is otherwise no longer a covered officer, and even if paid to a beneficiary after the officer’s death or to a former spouse pursuant to a domestic relations order.

  • The House bill extends Section 162(m) to corporations that have publicly traded debt, even if they have no publicly traded stock. While not entirely clear, the Senate bill appears to adopt the same approach.

In addition to the Section 162(m) changes, both the House bill and the Senate bill impose an excise tax on certain tax-exempt organizations with respect to compensation in excess of $1 million that is paid to a covered employee. For further details, see our Lawflash Tax Reform and Nonprofits: The Devil’s in the Details.

The House bill makes these changes effective for taxable years beginning after December 31, 2017, whereas the Senate bill includes a much-needed transition provision. The transition provision would exempt from the 162(m) deduction limit compensation under a written binding agreement that was in effect on November 2, 2017 and was not subsequently amended in any material respect, to the extent that the compensation was vested (not subject to a substantial risk of forfeiture) on or before December 31, 2016. Although the intended scope is not entirely clear, this transition rule would provide a grandfather provision for certain compensation that vested before 2017.

What to Do Next?

Companies can plan ahead by taking the following actions:

  • In anticipation of a reduction in the corporate tax rates, examine opportunities to accelerate deduction accruals to fiscal year end 2017 for bonuses and certain equity grants (such as restricted stock units and performance stock units).

  • Stay abreast of the tax proposals that most impact your business, since many are intended to be effective for tax years beginning after 2017.

  • Prepare for key management to be available to modify documents at the end of December.

The House bill already has been amended in multiple ways, and several amendments have been proposed in the Senate. We can expect more changes in the weeks ahead as Congress develops a final proposal that satisfies the key limitations imposed by the budget reconciliation process: In order to pass through a simple majority vote in the Senate, the legislation cannot increase the budget deficit by more than $1.5 trillion over a 10-year period, and cannot increase the budget deficit by any amount following that 10-year period. Both proposals currently exceed the $1.5 trillion figure, and significant “sunset” provisions may be required to satisfy the latter requirement. Since most of the proposed executive compensation–related changes raise revenue, they may be difficult to remove given these constraints. We will keep you apprised of significant amendments to proposals affecting executive compensation.

Copyright © 2023 by Morgan, Lewis & Bockius LLP. All Rights Reserved.National Law Review, Volume VII, Number 324

About this Author

Mims Zabriskie, Employment lawyer, Morgan Lewis

Mims Maynard Zabriskie advises on complex executive compensation and employee benefit plan matters, including the design, negotiation, and implementation of executive compensation, equity compensation, and tax–qualified retirement plans and shareholder approval of equity plans. She counsels large publicly and privately owned businesses, including Fortune 500 enterprises, technology companies, and universities on a range of legal issues related to executive compensation governance, and employee benefit plans. She also advises on benefits and executive compensation issues...

Rosina Barker, Morgan Lewis, Tax Attorney

Rosina B. Barker counsels clients on the Employee Retirement Income Security Act (ERISA), tax, and securities law aspects of their employee benefits and executive compensation plans. Her practice ranges from sophisticated defined benefit pension plan matters to complex executive compensation issues.

Rosina is a nationally known author on Internal Revenue Code Section 409A compliance, and numerous companies engage her specifically to provide counsel in this area. She has drafted and amended multiple equity, deferred compensation, and incentive pay plans for...

Mary Hevener, tax lawyer, Morgan Lewis

Mary B. “Handy” Hevener helps US and multinational enterprises minimize corporate payroll taxes and maximize benefits–related tax deductions. She focuses her practice on the tax treatment of employee and independent contractor benefits outside qualified retirement plans, including stock options and other stock-based compensation; executive income deferrals; golden parachutes; and fringe benefits that range from health and life insurance, to employee loans, cars, planes, and prizes.

Anna M. Pomykala, New York, Morgan Lewis, employee benefits lawyer

Anna M. Pomykala works with a team of employee benefits lawyers to assist clients in finding creative solutions to their employee benefit–related business challenges. Our clients include small, middle-market, and Fortune 500 companies in the technology, consumer goods, retail, pharmaceutical, healthcare, hospitality, and energy industries. We also represent many financial institutions, startups and tax-exempt organizations, educational institutions, and state and local governments. Prior to joining Morgan Lewis, Anna earned her LL.M. in taxation from New York University...