3521 / What was the pre-2018 exception for performance-based compensation to the rules for deduction executive compensation?

Prior to 2018, specifically excluded from the definition of applicable employee remuneration were commission payments, which generally were defined as any remuneration paid on a commission basis solely due to income generated directly by the employee’s performance.¹ The 2017 tax reform legislation repealed the exception that allows a corporation to deduct compensation in excess of $1 million to the top executive employees of a public company if that compensation is performance based. As a result, public companies are now only entitled to deduct $1 million in compensation.²

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Planning Point: Companies that offer a deferred compensation program should be advised that the Section 409A performance-based compensation definition has not changed.

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Planning Point: State law implications should also be examined by companies in light of the now firm $1 million cap on the deductibility of compensation. Most states calculate state taxable income based upon the company’s federal taxable income at some point (either before or after NOL and other special federal-level deductions). The impact will vary based on how closely a state conforms its tax rules to the IRC. Some states may conform to the IRC on a rolling basis (i.e., the new changes will immediately flow through to the state level), while others may conform at a fixed date. If the state uses the IRC as in effect at a fixed date (before the passage of tax reform), corporations in these states may have to separately track their starting point (for measurement of the amount of compensation paid during the one-year period) for state tax purposes.

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Certain other performance-based compensation (e.g., stock options and stock appreciation rights) payable solely on the attainment of at least one performance goal also was excluded, but only if (1) the goals were set by a compensation committee of the corporation’s board of directors, made up solely of at least two outside directors, (2) the terms under which the compensation would be paid were disclosed to the corporation’s shareholders and approved by a majority vote prior to the time of payment, and (3) the compensation committee certified that the performance goals had been attained before payment was made.³

A plan would not be considered performance-based compensation, however, if payment would be made when the employee was terminated or retired regardless of whether or not the goal was met.⁴

Amounts paid under a binding contract in effect on February 17, 1993, and not modified before the remuneration is paid, also are excluded.⁵ If a contract entered into on or before February 17, 1993 is renewed after this date, it becomes subject to the deduction limitation.⁶

The IRS has concluded that a proposed supplemental executive retirement plan (“SERP”) ( Q 3540) affecting employees subject to pre-1993 employment contracts did not provide for increased compensation or the payment of additional compensation under substantially the same elements and conditions covered under the employment agreements and thus was not considered a material modification of those agreements pursuant to Treasury Regulation Section 1.162-27(h)(1)(iii)(C).⁷

The IRS has released guidance clarifying that the CFO of a smaller reporting company will be treated as a covered employee for purposes of Section 162(m) if the CFO is one of the business’ two most highly compensated employees. In a notice released in 2007, the IRS had stated that a covered employee does not include an employee for whom disclosure is required because the employee is the company’s CFO. A 2015 CCA, however, clarified this rule in the case of smaller reporting companies. The new guidance provides that, in the case of a smaller reporting company, the principal financial officer is a covered employee if he or she is also one of the two most highly compensated employees (other than the CEO) at the end of the tax year. Disclosure is not required only because of the individual’s status as CFO, however.⁸ Under the 2017 tax reform legislation, however, the CFO of a company is now generally treated as a covered employee.

Revenue Ruling 2008-13

In Revenue Ruling 2008-13, the IRS took the new position that agreements providing for vesting acceleration on performance-based equity or cash awards following an executive’s termination without cause, without good reason, or due to retirement, or if the plan or agreement does not pay remuneration solely on account of the attainment of one or more performance goals and regardless of actual performance, will cause the plan to fail the requirements of Section 162(m), even if the accelerated vesting and payout is never triggered under the plan.

In effect, the IRS said that provisions in a plan for vesting and payment accelerations upon terminations without cause, for good reason, or due to involuntary retirement are not permissible payment events under Section 162(m) regulations. The provisions alone thereby cause loss of the compensation deduction, even if the acceleration of vesting and payment never occurs. Under the ruling, the IRS gave employers until January 1, 2009, to modify performance-based plans and agreements with “covered employees” to comply for years after 2009.