Limit on Deductions for Executive Compensation at Public Companies

The Limits Applied to Public and Private Companies

The Tax Cuts and Jobs Act (TCJA) made important changes to Section 162(m) of the Internal Revenue Code. That section limits a publicly held corporation’s tax deduction for compensation paid to each covered employee to a maximum of $1,000,000 per year. A corporation is publicly held if it has issued securities required to be registered under Section 12 of the Securities Exchange Act of 1934. Under TCJA, Section 162(m) also applies to private companies that file reports under section 15(d) of the Exchange Act.

The Tax Cuts and Jobs Act (TCJA) made important changes to Section 162(m) of the Internal Revenue Code. That section limits a publicly held corporation’s tax deduction for compensation paid to each covered employee to a maximum of $1,000,000 per year.

A corporation is publicly held if it has issued securities required to be registered under Section 12 of the Securities Exchange Act of 1934. Under TCJA, Section 162(m) also applies to private companies that file reports under Section 15(d) of the Exchange Act.

TCJA expanded the term “covered employee” to include anyone who serves or acts as the Chief Executive Officer or the Chief Financial Officer at any time during the year even if not employed at year-end. The definition also includes the three other highest-compensated officers if the Securities and Exchange Commission requires that their compensation be reported to shareholders. Effective January 1, 2018, TCJA also provides that anyone who has been a covered employee in any year after 2016 will continue to be a covered employee for all subsequent years. Consequently, a former officer who provides services on a part-time basis could still be a covered employee. Therefore, the number of covered employees a company has could grow over time.

Prior to the TCJA, two broad types of compensation were not subject to the $1,000,000 limit:

1. Commissions paid “solely on account of income generated directly by” the individual’s performance.
2. Performance-based compensation paid “solely on account of the attainment of one or more performance goals.” 

The elimination of the exception for commissions does not impact many companies because few senior executives are paid commissions. However, elimination of the exception for performance-based pay is a dramatic change since many companies base their officers’ pay on performance and have relied heavily on that exception.

To meet the performance-based exception, specific goals must have been approved in advance by a compensation committee of the Board of Directors. The committee had to include at least two outside directors. Further, the goals had to be disclosed to shareholders and approved in advance by most of the shareholders. The compensation committee was required to certify that the performance goals were met before the compensation was paid. The goals had to be objective, such as increasing the company’s stock price, market share, sales or earnings-per-share to certain levels. Simply maintaining the current stock price was enough, but continued employment with the company alone was not enough. Regardless of these requirements, Congress felt that deductions for executive compensation needed further reduction.

The exceptions for commissions and performance-based pay are still available if paid under a contract that was binding on November 2, 2017, unless that contract was materially modified after that date.

Even after TCJA, certain types of compensation are still not subject to the $1,000,000 limit:

1. Contributions to qualified retirement plans.
2. Tax-excludable welfare benefits, such as health insurance.
3. Certain amounts earned under a pre-1993 written contract (Section 162(m)(4)(D)).

There is one rule that TCJA did not change. The $1,000,000 limit is still reduced by any amount disallowed as a deduction under Code Section 280G, which applies to golden parachute payments.

Despite the new rules, many Boards of Directors are continuing to pay performance-based compensation amounts to retain and motivate their executives, even though those amounts are not fully deductible.

The regulations under Section 162(m) are lengthy and have not yet been updated for changes in the TCJA. However, the Internal Revenue Service provides guidance and examples in Notice 2018-68.

---

Stephen D. Kirkland, CPA, CMC, CFF, is a compensation consultant for privately-owned companies and non-profit organizations. He serves as an expert witness in court cases involving potentially unreasonable compensation. He can be contacted and found through www.ReasonableComp.biz.

Mr. Kirkland can be contacted at (803) 724-1414 or by e-mail to Stephen.Kirkland@AECG.biz.