Bar News - February 15, 2017
Tax Law: Executive Compensation: Limits and Unintended Consequences
By: Michelle Radie-Coffin
Designing and structuring efficient compensation packages for executives reaches beyond the relevant pay, worth, and retention discussions typically had by a company’s board of directors and compensation committee.
Since 1993, executive compensation has been subject to varying tax treatment promulgated to accomplish several complex policy goals. The obligation to adhere to the tax code while at the same time incentivizing the executive, can make for a tedious tight rope act in draftsmanship.
Federal regulation of executive compensation is carried out by two agencies, the Internal Revenue Service (IRS) and the Securities and Exchange Commission (SEC). The IRS handles taxation and the SEC handles disclosure requirements. This article focuses on the taxation aspect, but the two agencies intersect in the area of executive compensation because of the requirement set forth by Congress and the SEC to disclose compensation-related information to investors.
The federal government regulates executive compensation by requiring differing tax treatment for executive pay. Through this differing treatment, the government is able to promote or discourage the use of certain types of compensation. Further, the regulations may have the impact of limiting the amount of money companies pay an executive by implementing a cap on certain types of compensation. For instance, if the company pays the executive more than the cap amount as base salary, the company will not be allowed to take the business expense deduction for the amount over the cap. The regulations were initially implemented not with the usual intent of raising tax revenue as the goal, but instead were intended to curb excessive, non-performance-based compensation.
Code Section 162(m) provides that no deduction is allowed any publicly held corporation for applicable employee remuneration for any covered employee in excess of $1 million for the tax year. Certain types of compensation, most notably performance-based compensation subject to shareholder approval, are excluded from this limitation. Section 162(m) defines a covered employee as any employee of the taxpayer if, as of the close of the tax year, such employee is the chief executive officer, or the total compensation of the employee is required to be reported to shareholders under the Securities Exchange Act by reason of being one of the three highest compensated officers for the taxable year, other than the chief executive officer.
The federal corporate income tax is intended to tax corporate profits to raise revenue for federal government operations. Prior to 1993 and the enactment of Code Section 162(m), compensation to executives and all other employees was considered a deductible business expense for a corporation.
Typically, corporations were taxed on the income that remained after all deductible and allowable expenses were subtracted from the corporation’s total revenue for a given year. After 1993, if a covered executive was paid more than $1 million in cash-based compensation, the corporation could no longer deduct that excess amount, thereby resulting in overstated income. Even more concerning, the government is receiving tax monies on the same income, twice. The executive, of course, must include it in his or her gross income, and the corporation, no longer able to deduct this compensation from the revenue as an expense, is paying tax on this overstated income.
The deduction limitation does not apply to qualified performance-based compensation. Generally, all compensation paid to a covered employee during the year is includable in determining the $1 million limit, unless the compensation falls under performance-based exception.
To qualify for this exception, the compensation must meet several requirements (discussed below), including approval by vote of the shareholders. Many large companies seek to limit their covered executives’ base salary to the deductible amount and then provide increased remuneration in the form of long-term incentives linked to achieving performance-based goals. Focusing attention on how to align pay with performance is one of the most critical aspects of designing a compensation plan that will achieve the dual goal of incentivizing the executive while maximizing deductible expenses for the company.
Certain types of compensation are excluded from the 162(m) limitations on deductibility. For instance, retirement income from a qualified plan, commission-based compensation, and qualified performance-based compensation are not subject to the deductibility restrictions of 162(m).
To qualify as performance-based compensation and therefore be fully deductible, the following requirements must be met: The compensation must be paid solely on account of the executive’s attainment of one or more performance goals determined by an objective formula; the performance goals must be established by a compensation committee of two or more independent directors; the terms must be disclosed to shareholders and approved by a majority vote; and the compensation committee must certify that the performance goals have been met before payment to the executive is made.
Compensation tied to performance can be in the form of both non-equity (e.g. bonuses and non-equity incentives under a written plan), and equity compensation awards (e.g. stock grants, stock options, and stock appreciation rights). Although bonuses are theoretically a reward for performance, they are generally not awarded or paid pursuant to a written plan approved by the shareholders, and therefore do not qualify as performance-based under Section 162(m). While non-equity plans are often similar to bonuses and tied to performance, they are typically pursuant to a written plan, which can be designed to meet the requirements of 162(m).
It is important to note that a written plan will not qualify as performance-based if the plan allows compensation to be paid in the event of termination, regardless of whether the performance conditions were met. So if the written plan allows the employee to achieve the performance-based compensation, even after the employer terminates without cause, the plan fails under 162(m) and no deduction will be allowed. Similarly, if the employee resigns for good reason, and the plan allows that employee to receive the performance reward, then no deduction for the employer.
Grants of stock options, stock appreciation rights (SARs) and restricted stock will qualify as performance-based compensation for purposes of Section 162(m) as long as the following requirements are met: The grant is made by the compensation committee; the plan provides for the maximum number of shares that may granted to an employee during a specified period; and in the case of stock options and SARs, the compensation received is based solely on an increase in the value of the stock after the grant date.
In the case of stock options and SARs, if the above requirements are met, neither the grant nor vesting of the award must be tied to attaining a qualifying performance goal. Conversely, stock grants must be designed with vesting occurring only upon achieving a performance-based goal, in order to meet the deductibility requirements of Section 162(m). Stock grants vesting based on the passage of time alone will not qualify.
There are two other areas worth mentioning when it comes to executive compensation, and while this article will not cover them in detail, a good compensation plan should explore both. One is profits interests; the other is pensions and deferred compensation.
Profits interests are yet another way to provide equity to executives. Recently, in May 2016, the IRS issued temporary regulations clarifying that an individual cannot be both a partner of a partnership and an employee of the partnership’s subsidiary, if that subsidiary is taxed as a disregarded entity. For example, if an individual employed by a disregarded entity is granted a profits interest in the entity’s parent, the individual must be considered a partner. The consequences of being a partner instead of an employee is significant (see regulations effective Aug.1, 2016).
Briefly, pensions and deferred compensation will be fully deductible if the plans meet the requirements of Section 409(A) of the Code. Generally, if the compensation is deferred until after retirement, it will be fully deductible. A good compensation plan must include a thorough review of the Section 409(A) requirements.
Code Section 162(m) was intended to put limits on executive compensation. However, seemingly tax-sophisticated corporations have figured out ways around this, mostly through performance-based pay. For those companies making cash payments over the $1 million mark, the disallowed deduction results in decreased profits and diminished returns for the shareholders. Finally, did Section 162(m), with all its good intentions, potentially establish $1 million as the base salary for CEOs? It will be interesting to see if a major reform to Section 162(m) will happen under this new administration and if all forms of compensation will once again be deductible expenses.
Michelle Radie-Coffin is an associate at Shaheen & Gordon. She is a member of its Business, Real Estate, Immigration, Employment and Estate Planning Group.