Time to Revisit Executive Compensation Arrangements in Light of Recent Tax Reform
The Tax Cuts and Jobs Act of 2017 (the “Act”) signed into law on December 22, 2017, will significantly impact many public company executive compensation plans and arrangements. Companies should take this opportunity to revisit their overall compensation design and consider whether changes are appropriate to enhance flexibility and/or better align compensation design with the company’s business objectives. This alert highlights changes in the law affecting public company executive compensation arrangements and key considerations in revising compensation plans and arrangements and overall compensation program design.
The Act made major amendments to Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”) (which caps deductible executive compensation at $1,000,000). However, unlike earlier drafts of the legislation, the final bill did not include any changes to deferred compensation arrangements under Code Section 409A, so the current complex rules continue to apply for deferred compensation subject to Code Section 409A. The changes brought about by the Act go into effect for taxable years beginning January 1, 2018. Amendments related to Code Section 162(m) include:
Performance-based Compensation Now Subject to $1M Deduction Cap. Previously, performance-based compensation meeting certain requirements was not subject to Code Section 162(m)’s $1,000,000 deduction limit. That performance-based compensation exception has been removed.
Covered Employee Definition Expanded. The list of covered employees has been expanded to include a company’s CFO, in addition to its CEO and three other most highly compensated executive officers. Further, once an executive becomes a covered employee under Code Section 162(m) (effective for years beginning January 1, 2017), he or she will now be subject to the Code Section 162(m) $1,000,000 deduction limitation in all future years – including after termination. Finally, anyone who was a CEO or CFO during any part of a company’s fiscal year (vs. being in service at year-end only) is now subject to Code Section 162(m). This change will have special impact for interim executives.
Certain Compensation Grandfathered. The Act provides a narrow transition rule that grandfathers the deductibility of certain performance-based compensation. To be eligible for this relief (i) a binding written contract must have been in effect on November 2, 2017 that gave the executive a right to participate under a plan and (ii) a company cannot materially amend or terminate the plan (except on a prospective basis before any services are performed with respect to the applicable period for which such compensation is to be paid). The fact that a plan was in existence on November 2, 2017 is not by itself sufficient to qualify the plan under the transition rule. Contracts that are unconditionally terminable at will (by either or both parties) without consent are considered new contracts on the effective date of such termination. It remains unclear whether a company’s retention of negative discretion in regards to final plan payouts precludes grandfather treatment (i.e., on the basis the executive had no legally binding right to the compensation as of November 2, 2017). It is also unclear whether awards made pursuant to a written shareholder-approved annual cash incentive plan qualify for transition relief, given there is no written contract between the executive and company. Companies should watch for IRS clarification on these points.Definition of Publicly Held Corporation Expanded. The companies covered by Code Section 162(m) have been expanded to include all companies required to file SEC reports under Section 15(d) of the Securities Exchange of 1934, as amended (i.e., picking up companies required to report solely because of public debt).
Compensation Programs Ripe for Revisit and Revision
In light of the above-discussed amendments, companies should review their current compensation structures and assess whether modifications are in the best interest of the company. In particular, companies should consider:
Compensation Mix. While it is not advisable to completely forego performance-based awards in light of current industry best practices and proxy advisor focus on performance-based compensation, some companies may determine that changing their compensation mix is appropriate. For instance, stock options and SARs will no longer receive preferential Code Section 162(m) treatment as performance-based awards, so other award types may become more attractive. Some companies may also choose to increase salaries or discretionary bonuses as there is now no difference in deductibility of salary or any discretionary bonus versus performance-based compensation.
Stock and Cash Incentive Plans and Award Agreements. Companies should consider whether it is appropriate to cleanse their incentive plans and other compensation arrangements of former Code Section 162(m)-related restrictions. Absent amendment of these provisions, a company may unnecessarily subject itself to limitations. In particular, companies may want to amend incentive plans and award agreements (as applicable) to:
remove or revise individual award limits (other than the total number of incentive stock option shares that may be issued, as that requirement stems from Code Section 422);
permit positive discretion in determining final awards for covered employees (versus negative discretion only, as formerly mandated by Code Section162(m));
remove the requirement that shareholders approve performance metrics and eligibility criteria;
expand the list of performance metrics to include subjective performance criteria;
permit adjustment of performance goals during or after a performance period; and
remove any requirement that performance goals must be set within the first 90 days/25% of a performance period.
Companies should keep in mind that any new or materially amended plans will need to be reported to the SEC on a Form 8-K and filed with that report or their next periodic report. Likewise, companies should file any new or amended award agreements with their next periodic report.
Stock Incentive Plan Prospectuses. Prospectuses should be checked for any Code Section 162(m) tax disclosures and updated as appropriate.
Employment Agreements; Severance Plans/Agreements; and Change in Control Plans/ Agreements. These documents may have terms related to the deduction of performance-based compensation under Code Section 162(m) and should be reviewed. For instance, bonuses can now be paid out at “target” or a guaranteed level in the year of an executive’s termination without a different tax consequence (i.e., consideration of actual performance is no longer relevant for Code Section 162(m) purposes).
Compensation Committee Charters. Charters should generally be reviewed and updated. For instance, committee charters frequently require Compensation Committees to be comprised of “outside directors” as defined under Code Section 162(m), such that the Compensation Committee is eligible to set and certify performance for Code Section 162(m) purposes. With the removal of the Code Section 162(m) performance-based exception, this requirement is rendered moot (except to the extent that a company has compensation that is eligible for transition relief as discussed above, in which case the Compensation Committee must continue to consist of “outside directors” under Code Section 162(m) for so long as such compensation is grandfathered). Therefore, the “outside director” reference may be removed from Compensation Committee charters and companies may disband any subcommittees of the Compensation Committee formed for 162(m) certification purposes.
Proxy Statement Disclosures. At a minimum, companies will need to indicate that they are subject to the $1,000,000 Code Section 162(m) deductibility cap and that the performance-based exception to this rule is no longer available going forward. The appropriate scope of the disclosure will depend on the materiality and impact of the Act’s tax changes on a company. Companies should also consider their past disclosures regarding any intent to comply with Code Section 162(m) so as to avoid opening the door to shareholder suits. Finally, any company that pays compensation when performance goals are not met will be required to disclose such payments in their proxy statement and should be prepared to provide disclosure regarding why such payments were made.
Payroll Considerations. The Act’s reduction in the tax rates for individuals impacts the tax rates used for federal tax withholding on equity awards. Companies should confirm that their payroll providers are prepared to implement any necessary changes in withholding rates so as to avoid adverse accounting consequences. Companies are also advised to check their relevant documents (e.g., stock plans, award agreements and implementing resolutions) to confirm that a change in the tax rate will not require any amendment.
Good Governance Considerations
While certain restrictions imposed under Code Section 162(m) may no longer apply, some of these limitations are matters of good governance that may be appropriate to continue. For instance, having the Compensation Committee certify compensation before it is paid and maintaining per person plan award limits may, in certain circumstances, serve as appropriate governance checks on increased company discretion. In addition, as noted above, proxy advisory firms such as Institutional Investor Services (“ISS”) presumably will continue to expect rigorous performance objectives and tight controls on plan discretion.
Anticipated Guidance Likely to Limit Drastic Change to Compensation Plans/Programs
While many companies will want to revise their compensation programs in light of the changes brought about by the Act, companies may consider waiting to amend their incentive plans/compensation arrangements until the Internal Revenue Service (“IRS”), ISS and stock exchanges have provided relevant guidance. As discussed above, open questions remain regarding the availability of the transition rule in particular on which the IRS is expected to issue guidance. As material changes to compensation agreements (and the underlying plans) may terminate the availability of grandfather relief, companies should generally avoid making any changes to existing compensation-related agreements or plan documents until the IRS has issued guidance. Further, plan amendments and other changes to compensation arrangements may be viewed unfavorably by proxy advisors like ISS. ISS considers the use of performance-based awards a best practice. It also considers it a problematic pay practice to change, cancel or replace performance metrics during a performance period without adequate explanation. Further, broad discretion regarding the vesting of awards that can result in “pay for failure” can negatively impact a plan’s ISS EPSC score, which determines whether ISS will recommend a vote in favor of or against a plan. Without further guidance from ISS, companies amending their plan documents may unknowingly implement disfavored compensation structures and be penalized. ISS issued its 2018 proxy guidance in early December 2017, before the passage of the Act, and has not supplemented its guidance to address the Act at this time. It is unknown when relevant guidance will be issued; however, one can assume ISS will provide greater clarity on its performance-based compensation expectations given its past focus in this area. Finally, stock exchanges may issue guidance regarding shareholder approval requirements in connection with amending a plan to address the changes to Code Section 162(m). For these reasons, most companies should proceed cautiously before amending plans and other compensation arrangements.
Although the loss of the performance-based deduction exception is a setback for public companies from a tax perspective (albeit the Act provides for corporate taxes at a lower rate), the tax changes implemented by the Act provide companies with an opportunity to enhance the design of their compensation plans and programs. In light of the changes to Code Section 162(m), compensation programs may become more flexible, simpler and easier to administer. However, before making any changes to compensation plans and other arrangements, companies should watch for guidance from the IRS, ISS and stock exchanges in addition to thoughtfully considering governance best practices that best serve the interests of the particular company and its shareholders.