Executive Compensation: Understanding the Tax Law’s Full Impact

compensation-3-12-18.pngOn December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act, which amended certain provisions of the Internal Revenue Code of 1986. Bank boards and management teams should take time to familiarize themselves with these changes, as several amendments to the Code relate to the payment of executive compensation.

For corporate executives and compensation committees, the change to the Code that has garnered the most attention concerns an amendment to Code Section 162(m). Prior to the Act, Section 162(m) imposed a $1 million cap per executive on the tax deduction a public company could take on compensation paid to its chief executive officer and three other highest paid executive officers, excepting the chief financial officer—generally, the “named executive officers” included in the company’s annual proxy. Historically, most companies relied on an exemption for performance-based compensation to avoid this limit, which was fully deductible even if it exceeded $1 million. The new tax law has eliminated the performance-based compensation exemption.

In addition, the tax law has expanded coverage of Section 162(m) to apply to all Securities and Exchange Commission (SEC) reporting companies (i.e., companies required to file reports under Section 15(d) of the Securities and Exchange Act of 1934, which includes many companies required to file due to public debt), rather than solely those whose common stock is registered with the SEC. It also expanded the group of executives subject to the deduction limit to include not only the named executive officers during the current taxable year—now including the CFO as a “named executive”—but also any person who was a covered executive for any prior taxable year beginning after December 31, 2016. Companies subject to Section 162(m) should review their incentive plan documents, incentive award agreements, severance agreements and employment agreements in light of the removal of the exemption for qualified performance-based compensation because these documents may have been drafted to account for the Section 162(m) performance-based compensation exemption that no longer applies.

In addition, the Act amended Code Section 83 by adding a new subsection (i) regarding deferred taxation of equity compensation. Section 83 generally governs the amount and timing of income inclusion for property, including employer stock, transferred to an employee in connection with the performance of services. Under Code Section 83(a), most individuals must recognize income for the tax year in which the employee’s right to the stock is transferable or no longer subject to a substantial risk of forfeiture. This changes for some employees with the new Section 83(i), which allows non-executive and non-highly compensated employees of privately-held corporations to elect up to a five-year deferral in the taxation of illiquid shares issued to them upon the exercise of nonqualified options or the settlement of restricted stock units (RSUs), if certain conditions are satisfied. The options or RSUs must be granted under an equity compensation plan in which at least 80 percent of a company’s full-time U.S. employees are granted awards with the same rights and privileges. The amounts of the awards may vary by employee as long as each employee receives more than a “de minimis” grant—i.e., all participating employees must be eligible to receive a legitimate economic benefit. This deferred tax election is not available to the CEO or the CFO—or to certain persons related to them—or to any person who within the past 10 years was one of the four highest paid officers of the corporation or an employee that holds 1 percent of the company’s stock. Under this new regime, eligible employees of private companies receiving stock through equity compensation arrangements may consider making an election under Section 83(i) to defer taxation on such compensation.

The IRS is expected to issue guidance on these changes, particularly the amendments to Section 162(m). Stay tuned.

When Your CEO Becomes a Million Dollar Baby

5-20-15-Pearl.pngCEO compensation at community banks is often approaching $1 million or greater as bank profits and stock prices improve, and as merger and acquisition activity increases. Compensation committees are finding they must now address the cumbersome and confusing $1 million pay cap limitation under Internal Revenue Code (IRC) Section 162(m) in order to preserve the bank’s tax deduction for certain compensation payments. Understanding the regulation and how it applies to the bank’s compensation programs is the first step in developing an effective process for maintaining compliance. 

What is IRC Section 162(m)?

Public companies are prohibited from receiving a corporate tax deduction for compensation over $1 million paid to a covered employee (i.e., proxy-reported executive).  Under the code, compensation is based on the executive’s realized taxable wages in any given year, including actual incentives paid and the value of any vested shares and exercised stock options.  

However, Section 162(m) provides an exception for “qualified performance-based compensation” and this exception is widely used to exempt annual incentive plan payments and equity compensation from the $1 million limit. The requirements to qualify compensation as performance-based are summarized below.

Understanding How IRC Section 162(m) Applies

In general, the following types of compensation can qualify for the performance-based exception if Section 162(m) requirements are met:

  • Short-term incentive compensation with specific performance goals.  Discretionary components can be managed by creating a process that funds the plan at a maximum level using specific goals and exercising negative discretion to reduce the payouts.
  • Performance-based stock or stock units.  Goals need to be specified at the beginning of the performance period and generally should not include discretionary elements.
  • Stock option and stock appreciation rights.
  • Certain deferred compensation as long as the contribution is funded using specified performance goals.

What makes Section 162(m) confusing to many directors is that compensation must be qualified as performance-based at the time of award, even though realization of the compensation and its deductibility may be several years in the future.  In thinking through whether 162(m) may apply, directors need to foresee the level of compensation likely to be provided in the future. The future may include growing to an asset size where market-based compensation above $1 million is a reality for the CEO and other proxy-named executives.

Creating an Effective 162(m) Process

The first step in the process is to determine whether the bank is likely to be affected by 162(m). Target compensation provided to CEOs at banks with assets exceeding $1 billion generally begins to approach the $1 million level. Therefore, it is usually wise for public banks growing to that size during the time period in which a compensation program is paying out to proactively plan for compliance. The following suggestions can aid compensation committees in ensuring an effective process:

  • Incorporate all 162(m) language into an omnibus incentive plan. Having one plan in which annual incentives and equity compensation may be awarded keeps shareholder approval simple and eliminates the need to track multiple plans.
  • Add the process to qualify compensation as performance-based per 162(m) to the compensation committee’s calendar, keeping in mind the timing requirements for approval.
  • Develop a reminder system to ensure performance measures are approved by shareholders every five years as required by 162(m).
  • Obtain expert guidance whenever the committee is contemplating modifications to goals, accelerations and vestings. Individual modifications can disqualify awards from the performance-based exception for all covered employees.

Compensation committees have a responsibility to ensure that the bank preserves the tax deductibility of performance-based compensation. In doing so, compensation committees need to consider the bank’s future growth and how it relates to the compensation of their executive officers. Proper planning and development of a well-defined 162(m) process now can ensure the future deductibility of compensation expenses.

The key performance-based compensation requirements under the law:

  • The compensation terms (or plan) and performance measures are approved by shareholders within five years of the award date
  • Plan includes the maximum amount payable to any one covered employee
  • Performance goals are substantially uncertain at the time the goal is established
  • Compensation is awarded by a committee of at least two independent directors
  • Performance goals are established by the compensation committee within the lesser of 90 days or 25 percent of the performance period
  • Performance achievement is certified in writing by the compensation committee.