New Tax Rules for Deducting Executive Compensation

The Section 162(m) $1 million deduction limit for executive compensation has been further restricted under the new tax law. The performance-based and commission-based pay exemptions have been eliminated, CFOs have been added to the list of covered employees, and all companies that report to the SEC are now subject to these rules.

There are a variety of ways that a company’s highest-level employees are paid – in addition to a regular salary, executive compensation packages include bonuses, stock options, long-term incentive plans, paid expenses, insurance, and/or other benefits. It is well known that an executive’s total compensation far exceeds the salaries of most of a company’s workers, and for the past 25 years the U.S. government has attempted to keep these high salaries in check.

A little background on IRC Section 162(m)

Until the latter part of the 20th century, the public knew very little about the earnings of corporate executives. Suspicions were aroused during the Great Depression, when people who had lost everything noticed big spending by the managers of several large companies. Numerous efforts to obtain information about their compensation followed, culminating in the Securities Exchange Act of 1934 and the enactment of federal securities laws that mandated the disclosure of compensation paid to high-ranking executives of public companies. In the decades that followed, it became clear that companies were employing a variety of alternative compensation methods for their top executives to circumvent whatever tax restrictions were in force at the time.

In an effort to curb continued increases in executive compensation plans, in 1993 Congress enacted 26 U.S. Code § 162(m). This section limited the amount that companies could deduct for executive compensation paid to their CEO and three highest-paid employees to $1 million each. Before enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), that limitation excluded qualified performance-based compensation and commission-based pay, and applied only to publicly held companies.

Elimination of the two exceptions to the $1 million limitation

Under Section 162(m)(4) of the TCJA, the aggregate compensation paid during the tax year (“applicable employee remuneration”) is more comprehensive than before. The new tax law in effect eliminated two exceptions to the Section 162(m) executive compensation deduction limitation:

  • The performance-based pay exception. Before the TCJA, compensation made pursuant to a written agreement that was approved by two or more board members and by the shareholders was exempt from the $1 million deduction limit. The new tax law eliminates this performance-based compensation exemption beginning January 1, 2018. Note that if a contract was signed before November 2, 2017 and not modified after that, the compensation still qualifies for the exemption – that is, unless (1) the board and/or shareholders can reduce the compensation, or (2) the agreement auto-renews at the end of the contract term, in which case compensation earned after the date of renewal is not exempt.
  • The commission-based pay exception. Before the new tax law came into effect, compensation earned solely on commission was also exempt from the $1 million limitation. This exemption has also been removed.

Expansion of employees covered by the limitation

The TCJA also expanded the type of employee that is covered by the $1 million limitation. In the past, the top officers subject to the limit were the CEO and the three highest-paid officers. Now the company’s CFO is specifically included on that list. See Section 162(m)(3).

Anyone classified as a “covered employee” from January 1, 2017 onwards remains a covered employee in all subsequent years. This also applies to payments made after employment is terminated.

Broadening the scope of applicable companies

The new tax law also broadened the scope of the types of companies subject to the Section 162(m) limitation. The limitation used to apply only to publicly-traded companies. Under Section 162(m)(2), it now applies to all companies that are required to register or file reports with the SEC.

San Francisco full service tax firm

New IRS Notice 2018-68 has clarified many of the new tax law’s provisions regarding executive compensation. To learn how we can help you maximize your executive compensation and help you take best advantage of the deductions available to your company, contact the San Francisco office of Moskowitz, LLP today. A thorough review of your business finances before the end of the year could significantly improve your tax situation and your bottom line.