Final Regulations Issued on Deductions for Executives’ Compensation

This article was originally published on December 23, 2020 and was updated on October 6, 2021.

Executives of public companies looking to their personal and company compensation planning in the New Year face a host of challenges. They and their compensation committees do, however, have the benefit of long-awaited clarity when it comes to the corporate income tax deduction for executive compensation in excess of $1 million under changes made in 2017 under the Tax Cuts and Jobs Act. Final regulations, effective upon publication, were issued December 18, 2020. Corresponding regulations related to compensation of executives of tax-exempt non-profit organizations were finalized on January 19, 2021 (effective January 15, 2021), with modifications published on May 5, 2021.

The Act materially broadened the reach of the limitation on the deduction of executive compensation in excess of $1 million by expanding the class of covered employees, publicly held companies, and applicable employee remuneration affected by the deduction limits. Although there is grandfathering of compensation under written agreements dating back to November 2, 2017, a material change in an agreement causes a loss of protections.The Build Back Better Act, which is currently making its way through the legislative process, would accelerate the expanded Section 162(m) limitation on business deductions for highly paid executive compensation so that it would take effect in 2022 instead of 2026. We will continue to monitor the status of the Build Back Better Act and its applicable provisions.

The Regulation provides clarity, although not in all cases, of the kind taxpayers were looking for:

• Covered Employees. Included in “covered employees” of publicly held companies are (i) the principal executive officer or principal financial officer; (ii) the three highest compensated officers (in addition to the executive and financial officers); and (iii) those in the first two categories for tax years beginning after December 31, 2016. Directors and independent contractors are considered employees as well. And once a covered employee, always a covered employee under the Regulations.
• Publicly Held Corporation. Any company whose securities, as of the end of the company’s taxable year, are required to be registered under Section 12 of the Securities Exchange Act of 1934 or is required to file reports under section 15(d) of the Exchange Act is a public company for purposes of the Regulations. In addition, publicly traded partnerships, S-corporations, certain real estate investment trusts, and foreign private issuers required to file reports under the Exchange Act are included. And an affiliated group may include more than one publicly held corporation. Companies going public during the year will be subject to the Regulation based on their status on the end of taxable year date.
• Applicable Employee Remuneration. Executive compensation is complex – cash or equity, current or deferred, qualified or non-qualified, performance-based or not, paid during life or after-death to another. The Regulations take an expansive view of “applicable employee remuneration.” There is no longer an exclusion for shareholder-approved qualified performance-based compensation. The Regulations include numerous examples to provide guidance to the taxpayer. Special rules and effective dates apply to publicly held corporations holding partnerships.

Tax law changes in complex areas such as executives’ compensation warrant grandfathering to ease the transition, and there is a grandfather rule under the Act and the Regulations. But a few words of caution are in order here. The burden off-setting the benefit of the grandfather rule is that the “old Regulations” remain in effect, as applicable, and it is important to know and understand both the old and the new provisions. And, perhaps more important in this time when executive compensation is being revisited and renegotiated in light of pay-equity and corporate COVID-19 impacts, material modification to existing written agreements will often result in loss of grandfather rule protections. This is not to say that modifications are not advisable. It is to say that the impact of the loss of grandfathering is a factor to take into account prior to implementing a change.

Clarity, yes. Simplicity no. Opportunities for executives and companies to plan for optimal outcomes, yes.