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2018 Update for Internal Revenue Code Section 162(m) Changes

On Behalf of | Apr 24, 2018 |

The Tax Cuts and Jobs Act of 2017 made fundamental changes to Section 162(m) of the Internal Revenue Code. The general nature of those changes is noted below, along with thoughts about their impact on public companies – and next steps that compensation committees should consider. Forward-minded action is warranted in order to preserve corporate deductions, especially for severance and other post-employment compensation that were previously safe from 162(m).

Grandfathering Rules

  • 2017 Tax Law Change: An exemption from 162(m) remains broadly available for taxable income that is paid pursuant to a written binding contract that was in effect on 11/02/2017 and is not thereafter materially modified.* Compensation Committees – In order to preserve grandfathering, be careful to preserve grandfathering not only through caution before amending any compensatory plans or agreements in effect before 11/02/2017, but also by assuring that material modifications do not occur for performance-based awards (such as, arguably, by failing to maintain committee independence or to provide proper certifications of performance results, when needed).
  • Contract Renewals – These are deemed material modifications, so consider 162(m) implications before renewing employment agreements for senior executives.
  • “Negative discretion” – It is unclear, though reasonably arguable, that a material modification does not occur if a company exercises negative discretion after 11/02/17 provided that right existed beforehand. Companies should seek updated information from legal counsel before exercising such discretion.

No Future Exemption for Performance-based Compensation

  • 2017 Tax Law Change: gone is the 162(m) exemption for income from for stock options, SARs, or other performance-based compensation (unless attributable to a grandfathered contract).
  1. For new or amended equity award and incentive plans: consider eliminating 162(m) provisions, such as those that require –award timing in first 90 days of the year;
  2. decisions by “non-employee directors”;
  3. purely objective formulae and metrics (because subjective measures and increased discretion are allowable now that 162(m) does not foreclose);
  4. Certification of results by non-employee directors before payouts; and
  5. Shareholder approval of the plan or awards.
    • Be careful to examine shareholder-approval issues before amending a plan that previously received such approval.
  • To preserve corporate deductions, consider increased use of deferred compensation and restricted stock (with longer vesting schedules), and less use of stock options.
  • Likewise, draft new severance plans and employment agreements to provide for installment payouts, as well as to allow severance bonus payouts at target – 162(m) formerly did not allow.
    • Beware of Code 409A implications before changing the time of payment for the severance due under existing employment agreements.
  • Be aware of 8-K and proxy statement disclosure requirements for any actions taken.
  • See “New Year, New Stock Plan” for further alternatives to consider.

Expanded “Covered Employee” Definition

  • 2017 Law Changes: (1) CFOs join CEOs and the top three highest paid employees listed in proxy statements, and (2) once a covered employee after 2016, always a covered employee, in contrast to prior law which applied only to those employed at year-end.
  • Consider deferred compensation, installment payouts, and other changes that preserve the company’s ability to deduct compensation, and severance, paid after a covered employee’s termination of employment.
    • Be careful to make changes for corporate purposes, and in accordance with Code 409A.
    • Avoid material modifications to compensatory plans and awards that were in place on 11/02/2017 and that provide post-employment compensation (e.g. SERPs).

New Companies Brought within 162(m)’s Scope

  • 2017 Law Change: expands 162(m) to cover companies with publicly-traded debt, and foreign companies with publicly-traded ADRs.

Anticipated Reaction from Shareholder Advisory Groups

  • Take into account the likely reaction of investors and shareholder advisory groups before updating executive compensation plans and practices in response to the foregoing 162(m) changes. Reproduced in the Appendix below are comments that ISS published early in 2018, in order to provide its perspective.


  • It has long been generally accepted that, although 162(m)’s $1 million deduction limit is a factor to consider in executive compensation planning, it is more important to structure executive compensation in a manner that achieves corporate goals. Interestingly, the tax law changes that occurred in 2017 should make it easier to align these considerations, mainly because public companies are now freed from jumping through the 162(m) hoops that were required before 2018 in order to secure performance-based exemptions.


ISS Warnings (from David Kokell, head of ISS U.S. Compensation Research, posted 1/25/2018 on Harvard Governance Blog):

  • GENERAL ADVICE: “For companies, think carefully about significant departures from your existing compensation framework and, to the extent possible, test those changes with your shareholder base to get early feedback whether they view the changes as beneficial.”
  • FORMULA AWARDS: “As in previous years, changes that generally reduce the transparent and objective pay-and-performance alignment between shareholders and executives will be viewed negatively when we evaluate compensation pay-for-performance. Negative changes could include material shifts away from performance-based compensation, less transparent disclosure of performance metrics and goals, selecting metrics and setting performance goals later in the performance cycle, and issuing in-the-money stock options.”
  • SHIFT TO SALARY? “We’ve seen at least one high profile company, citing the new tax regime, replace variable bonus opportunities with large guaranteed base salaries. Such a decision effectively eliminates the at-risk nature of pay and severs the linkage between pay and performance. I have no doubt that any board that eliminates or reduces performance-conditioned incentives in favor of guaranteed or highly discretionary pay is going to face investor backlash. ISS will continue to closely scrutinize any decision that diminishes performance pay, and wholesale shifts to fixed pay components will likely result in adverse vote recommendations.”
  • PLAN CHANGES: “I would caution companies that may be considering removing these shareholder-friendly features (such as limits on discretion or award caps) from their incentive programs simply because they are no longer required under 162(m). ISS, and many investors, will view such actions as detrimental to shareholders’ interests.”
  • DISCRETION AND AWARD LIMITS: “The requirement that awards be contingent on the attainment of pre-established performance goals remains paramount. Investors also tend to prefer an objective payout formula with performance goals established early in the performance measurement period. I would also stress that setting individual award caps and limiting the ability for upwards discretion on payouts will also be viewed as important safeguards. That said, we’ve heard from some investors that they have comfort with some level of discretion embedded in programs, as long as that discretion is applied judiciously and is well-explained.”