Getting Ready for Proxy Season: Changes to Section 162(m)

February 16th, 2018

proxy-2-17-18.pngThe tax law signed by the president on December 22, 2017, makes a significant change to the ability of public companies to deduct compensation paid to top executives.

Section 162(m) of the Internal Revenue Code limits a public company’s ability to deduct compensation of “covered employees” in excess of $1 million each year, but the old tax law provided a broad exception for certain types of performance-based compensation. A “covered employee” had been defined as any employee who, as of the last day of the taxable year, was the chief executive officer (or individual acting in that capacity) or an employee whose compensation is required to be reported to shareholders in the proxy statement because he or she is one of the four highest compensated officers, other than the CEO. As board members and compensation committee members of public companies are aware, the nuances and exceptions to section 162(m) limits were an important consideration in setting annual and long-term compensation for executives.

Below, we briefly explain the new limitations on the deductibility of executive compensation under Section 162(m), and offer some next steps for boards and compensation committees to consider in the first quarter of 2018. Public boards and compensation committees will need to take action on this before proxy season.

Performance-Based Compensation Exception Repealed
Historically, performance-based compensation, such as stock-option income and compensation paid only on the attainment of performance goals, was excepted from the $1 million deduction limitation. The new law repeals this exception, and may change the approach of compensation committees regarding the mix of salary, bonus, performance awards and equity grants in compensation. Also, some plans that required shareholder approval due to the performance-based compensation exception will no longer require shareholder approval for deductibility.

CFOs Again Subject to Section 162(m)
The new law amends Section 162(m) to specifically include a publicly-held corporation’s principal financial officer as a “covered employee” that is subject to Section 162(m). This corrects an unintended gap that had left CFOs excluded from Section 162(m), due to changes in 2007 to the Securities and Exchange Commission’s executive compensation disclosure rules. For companies that had already included their CFO as a “covered employee,” this will not result in a change. However, for companies which had not included the CFO as a “covered employee,” this change limits the deduction for that executive.

Once Covered, Always Covered
If an executive is a “covered employee” subject to Section 162(m) in 2017 or any later year, the new law provides that he or she remains a “covered employee” for all future periods, including after termination of employment for any reason, including death. This eliminates the ability to deduct, for example, severance payments made after termination of an executive’s employment, to the extent that the severance results in compensation in excess of the limit.

Expansion of Covered Companies
Previously, Section 162(m) applied to a company issuing any class of common equity securities required to be registered under the Securities Exchange Act of 1934. The definition of a publicly held corporation subject to Section 162(m) is expanded by the new law to include any corporation “that is required to file reports under Section 15(d) of [the Securities Exchange Act of 1934]”. This change would subject private corporations with public debt that triggers Section 15(d) reporting to the $1 million deduction limitation.

Limited Grandfathering Rule
The new law grandfathers in compensation provided pursuant to a written binding contract in effect on November 2, 2017, so long as it was not modified in any material respect on or after November 2, 2017.

Next Steps
These rules are complicated and, with the grandfather rules, will require close attention by companies in advance of preparing their 2018 proxy statement. We recommend that boards and, as appropriate, compensation committees, do the following.

  • Educate the compensation committee on changes to the tax code.
  • Review all employment agreements, change in control agreements, severance plans, equity plans and cash bonus plans to determine if they qualify for grandfathering.
  • Evaluate the impact on bonus payment decisions for 2017.
  • Evaluate the non-equity bonus plan design for 2018.
  • Begin to redraft the Compensation Discussion and Analysis (CD&A) and other relevant sections of the proxy statement.
  • Determine which plans will be subject to shareholder approval going forward.

In addition to the changes that will need to be made to proxy statements to reflect the updates to Section 162(m), the SEC’s pay ratio disclosure requirements were not modified by the new tax legislation and are in effect for the upcoming proxy season as well.

razarow

Rob Azarow is a partner at Arnold & Porter, based in the New York office. He leads the firm’s financial institutions M&A practice and concentrates his practice in securities, corporate and banking law.

kwechter

Kathleen Wechter is a counsel for Arnold & Porter. She has more than 20 years' experience in employee benefits and executive compensation, drafting and advising clients on tax-qualified retirement and incentive plans as well as on employee stock ownership plans (ESOPs) and medical and welfare plans

dpelley

Douglas Pelley is counsel for Arnold & Porter. He guides clients through the complex and evolving regulatory landscape applicable to executive compensation arrangements, including employment agreements, deferred compensation, severance and golden parachute agreements, and incentive and equity compensation arrangements.