Tax reform legislation expanded the one-million-dollar annual deduction limitation applied to certain compensation paid to top executives of publicly held companies. The result? More disallowed compensation deductions for more companies and on more employees, a higher financial statement cost of compensation, and more work to account properly for the new tax effects in financial statements issued under generally accepted accounting principles.
How did tax reform affect the deductibility of, and income tax accounting for, compensation paid to top executives of public companies?
Answer: Previously, Section 162(m) of the Internal Revenue Code imposed a one-million-dollar annual limit on deductible compensation paid to each of up to four top executives employed at year-end by publicly held companies. Commissions and incentive pay meeting certain performance-based criteria could escape limitation. HR 1, commonly known as the Tax Cuts and Jobs Act (TCJA), expanded the application of the one-million-dollar limit to more companies, to more employees, for longer time periods, and to more types of compensation. For financial reporting purposes, to record the correct tax effect on accrued compensation expense, more analysis is needed to determine if that expense will ever be deductible in tax returns. What once were temporary differences that created deferred tax assets now may be permanently nondeductible book-to-tax differences.
Major Changes to Section 162(m)
These changes generally are effective for compensation deductible in tax years beginning after December 31, 2017:
- Companies. Section 162(m) previously applied to corporations issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act). Changes made by the TCJA now encompass issuers of any type of publicly traded security, including debt, as well as certain broker dealers and all foreign companies publicly traded through American depository receipts that file U.S. federal tax returns.
- Employees. Immediately prior to the TCJA, Section 162(m) covered only four employees—the principal executive officer (PEO) at the close of the taxable year and the three most highly compensated officers for the taxable year other than the PEO or the principal financial officer (PFO), all as defined in reference to the Exchange Act. Now, covered employees are those who were the PEO or PFO at any time during the year as well as those whose compensation must be reported in the company’s proxy statement (or would be required if the company had to file a proxy statement) because they were the three most highly compensated officers other than the PEO or PFO.
- Time period. Prior to the TCJA, compensation was subject to limitation only if it was deductible in a year in which an individual was a covered employee as of the last day of the tax year. The TCJA takes a “once a covered employee, always a covered employee” approach, extending the limitation to compensation paid to the employee, even after death, if he or she had been a covered employee of the taxpayer (or any predecessor) for any tax year beginning after December 31, 2016. Thus, the opportunity is lost to avoid the limitation by deferring payment of compensation until after an executive retires, and the number of covered executives will grow over time.
- Types of compensation. The TCJA removed the exception for commission payments and compensation meeting certain performance-based criteria. Now, all compensation will be subject to the one-million-dollar deduction limitation except qualified retirement plan payments and amounts excludable from the recipient’s gross income (such as employer-provided health benefits and miscellaneous fringe benefits). Amounts paid pursuant to a written binding contract in effect on November 2, 2017, and not materially modified on or after that date are not subject to limitation if they would not have been limited prior to the TCJA. Until further guidance is provided, considerable uncertainty exists about exactly what contracts would be grandfathered under this transition clause.
What Tax Accounting Analysis Is Required Under GAAP?
Prior to the TCJA, to record the proper tax effect, companies that paid different types of Section 162(m)-limited compensation to their covered executives had to determine an order of priority in applying the annual one-million-dollar limit to that compensation, particularly if some compensation was expensed for financial statement purposes in years before it potentially would be deductible in tax returns. This commonly occurred when a company granted restricted stock that did not meet the performance-based criteria in addition to paying cash salary. For example, assume a calendar-year company that on December 31, 2015, granted to its PEO a restricted stock award that would vest on December 31, 2017. The grant-date fair value was $1.6 million. The company would expense $800,000 of this amount in 2016 and in 2017. In addition, the company expected to pay and expense $1.2 million of cash salary to the PEO in each of 2016 and 2017. Absent Section 162(m), the company would expect to deduct $1.2 million in 2016 and $2.8 million in 2017 but could deduct only one million dollars each year due to Section 162(m). In practice, companies in this situation would adopt (or have adopted) and apply consistently from year to year one of three accounting policies for determining which items were not deductible:
- Cash first. This policy applies the one-million-dollar limit first to cash compensation deductible in each year. Thus $200,000 of the $1.2 million salary expense would be permanently nondeductible in each year. The entire stock award would be permanently nondeductible, since there is no limit left for it to use in 2017. The $800,000 of book expense each year would be treated as permanently nondeductible, instead of as a temporary difference creating a deferred tax asset.
- Stock first. This policy applies the limit first to any stock compensation expected to be deductible in the year. Since no stock compensation vests in 2016, that year’s entire limit is applied to the 2016 cash salary, leaving $200,000 of it as permanently nondeductible. The 2017 stock award vest would use the entire 2017 limit before any 2017 cash salary. Thus, the $800,000 expensed in 2016 ultimately would be deductible, and in 2016 it would be treated as a temporary difference creating a deferred tax asset. In 2017, $200,000 of the stock award’s additional $800,000 expense would be deductible, and thus it would be treated as a temporary difference until the vest date, with the remaining $600,000 treated as permanently nondeductible. Alternatively, the company could have taken the approach that 62.5 percent ($1 million of $1.6 million), or $500,000 of each year’s $800,000 stock award expense, was deductible. Either way, the entire 2017 cash salary would be permanently nondeductible.
- Pro rata. This policy allocates the one-million-dollar limit between both types of compensation expected to be deductible in a given year. As with the other two approaches, the entire 2016 limit is allocated to the 2016 cash salary, as no stock compensation is scheduled to vest then. The 2017 limit divided by the entire $2.8 million potentially deductible in 2017 ($1.2 million cash salary plus $1.6 million restricted stock vesting) equals 35.7 percent. Thus, 35.7 percent of the 2017 cash salary, and 35.7 percent of the $800,000 stock compensation expense in each of 2016 and 2017, would be treated as deductible.
A company should update its analysis at the end of each period for any changes in expected compensation expense. For example, if the number of restricted shares to vest depended upon meeting certain performance targets (albeit still not qualifying as performance-based for tax purposes), the company would update the amount of total compensation expense for changed expectations regarding target achievement. However, the analysis should always use the per-share grant-date fair value, ignoring any changes in market value that might affect the ultimate deduction amount. Changes to the potential tax deduction caused by market value changes would be dealt with discretely only in the quarter of actual settlement of a stock-based award.
After the TCJA, these same principles should guide accounting for the tax effects of executive compensation, and companies should continue to apply consistently any policies already adopted. However, changes initiated by the TCJA will add considerable complexity to scheduling the expected ultimate resolution of all compensation.
Prior to the TCJA, stock options typically met the performance-based criteria and thus were not a factor in the analysis described here. Now, unless grandfathered into prior treatment, deductibility of the expense of nonqualified stock options (NSOs) must be analyzed for limitation. For example, assume that on January 1, 2018, the PEO was granted non-grandfathered NSOs that had a grant-date fair value of $500,000, vested in two years, and expired on the earlier of January 1, 2030, or thirty days after the PEO terminated employment. The company would expense $250,000 in each of 2018 and 2019 and must determine whether to treat this expense as a temporary deductible difference or as permanently nondeductible, following any of the above policies already adopted. The most challenging aspect may be estimating when the NSOs might be exercised, thus creating the potential deduction event. Companies should consider using the same exercise assumptions employed when computing the fair value of the options at grant date.
Prior to the TCJA, supplemental employee retirement plans (SERPs) and compensation deferred under other nonqualified plans escaped the Section 162(m) limitation, because payouts typically occurred (and were deductible) after the executive was no longer a covered employee. Now, unless grandfathered, these payments will be subject to the limitation. Expected payout schedules will have to be created and analyzed to determine if amounts currently expensed for these plan obligations are temporary deductible differences or permanently nondeductible.
Annual cash bonuses often escaped limitation prior to the TCJA, either because they met the performance-based criteria or the executive deferred the payment to post-employment via a nonqualified plan. Again, unless grandfathered, these payments now will be subject to limitation. If a company’s bonus plan does not meet the criteria for deduction in the year of accrual (but does in the following year when paid), companies should follow a consistent policy for ordering the use of the one-million-dollar limit between current-year cash salary and prior-year bonus paid and deductible in the current year.
How Might the New Rules Change Executive Compensation Plans and Behaviors?
Lost tax deductions are unlikely to drive companies to pay their top executives less, given the competition to attract and retain top talent and the lower value of any tax deduction at the new twenty-one-percent corporate tax rate. However, the new rules might spur other behavioral changes. For example:
- Companies will have more flexibility in setting the criteria to use for performance-based compensation, because staying within the parameters for deductibility is no longer relevant. One item in particular, a company’s discretion to increase an award, precluded qualification for the pre-TCJA Section 162(m) performance-based exception. This feature now might appear more often.
- The mix of base versus incentive pay might change, because performance criteria no longer drive deductibility.
- Executives who previously agreed to defer portions of their compensation to nonqualified plans so the company could retain a deduction might see future deferrals as no longer necessary. Alternatively, pressure might increase to defer but elect payout over time versus taking a lump sum payment upon termination, thereby increasing the number of one-million-dollar annual limitations to support deductibility.
- Companies might be reluctant to modify older plans so as to save grandfathered deductions of future compensation payments.
If and how companies will revise compensation packages remains to be seen. It likely will take time for tax professionals to refine the new tax accounting analysis necessitated by the TCJA’s changes to Section 162(m), especially in light of the uncertainty noted earlier about applying the grandfathering provision to existing compensation arrangements. One thing is certain, however: there is increased cost, in terms of time and tax dollars, for paying executives the big bucks.
Sheryl VanderBaan, CPA, is a tax partner at Crowe LLP, one of the largest public accounting, consulting, and technology firms in the United States. Julie Collins, CPA, is a senior manager in the Crowe assurance professional practice