Compensating Executives Under the New 162(m)

One of the changes to the Internal Revenue Code (IRC) last fall seemed like a throw-in, targeting a small group of corporate executives that few would notice other than affected executives or individuals involved in determining how executives are compensated. The small group that does understand the change, however, knows it is a pretty big deal.

Let’s recap so that we can all be on the same page: Prior to the Tax Cut and Jobs Act (TCJA), and oversimplifying somewhat, under IRC section 162(m), public companies were entitled to deductions for executive compensation up to $1 million per year for a “covered employee” (generally, the CEO plus the four other highest compensated employees). Performance-based compensation was generally not counted against this limit.

These rules – especially the exception for performance-based compensation – left employers with a certain amount of flexibility with respect to executive compensation, without jeopardizing corporate tax deductions.

The TCJA made several key changes to these rules:

  • If you become a covered employee in 2017 or any later year, you remain a covered employee of the company, essentially forever;

  • The “CEO plus four other highest paid” rule has been changed to “CEO plus CFO plus three other highest paid;”

  • Companies no longer get an exemption for performance-based compensation; and

  • Some grandfathering exists for certain agreements that existed in writing on November 2, 2017.

These changes have taken away a lot of the “wiggle room” that existed under the prior rules. Especially for companies that have provided large amounts of performance-based compensation to their executive group, meaningful deductions may be gone.

For employers that find themselves with a problem under new IRC section 162(m), one alternative that may be worth considering is an increase in executive benefits under the employer’s tax qualified retirement plans.  Amounts that are deductible under IRC section 404 – which governs the deductibility of contributions to tax-qualified retirement plans – are unaffected by the TCJA changes.

There are, of course, a number of complicated (and in places rigid and hyper-technical) rules limiting the amount of benefit that may be provided to an executive (or other highly-compensated employee) under a tax-qualified retirement plan.  But for most companies that still maintain ongoing defined benefit pension plans, the ability to transfer some otherwise nondeductible executive compensation to it will in many cases still exist. It’s one of the tools in the tool box that companies should look into.