Executive Compensation and the Role of the Compensation Committee

Tax Regulations

IRC Section 162(m)

Prior to 2018, Section 162(m) did not allow publicly held corporations to take tax deductions for annual compensation exceeding $1 million paid to covered employees specified as any of the top 3 highest paid executives and the CEO. The CFO was not included as one of the covered employees. Compensation exempt from the deduction limit included:

• individual commissions
• performance-based compensation
• payments to qualified pension plans or other benefit plans such as medical plans

As a result of the performance exemption, many corporations increased performance-based compensation in executive compensation packages.

The 2017 Tax Cuts and Jobs Act that went into effect the beginning of 2018 changed Section 162(m) to make all individuals holding the position of CEO or CFO at any time during the taxable year and, in addition, the top three highest paid officers, covered employees and subject to the deduction limitation for compensation in excess of $1 million. Also, an individual who becomes a covered employee for any taxable year beginning after December 31, 2016, remains a covered employee for all future years, including after termination of employment or even death. Under the old rules, a covered employee for any taxable year was determined by their status and compensation at the end of that year and there was no automatic carry over to subsequent years.

Another important change in the Tax Cuts and Jobs Act is the elimination of the individual commissions and performance-based compensation exceptions. Both forms of compensation are now subject to the $1 million deduction limit.

The 2021 American Rescue Plan Act adds an additional modification to Section 162(m). It specifies that beginning after December 31, 2026, for any taxable year, in addition to the five employees already covered, the next five highest paid employees will be covered by the $1 million deduction limit. These employees are not covered by the deduction limit indefinitely as are the CEO, CFO, and three highest paid individuals. They are only covered if, in the year their income is reported, they meet the next five highest paid criterion.

IRC Section 409A

The American Jobs Creation Act under Section 885 of IRC Section 409A was enacted in October 2004 and regulates deferred compensation plans that vest after 12/31/2004. When a plan is deemed non-compliant with 409A, the amounts deferred become taxable immediately with the addition of a 20% penalty paid by the employee. The type of deferred plans under the purview of Section 409A include:

• supplemental executive retirement plans
• voluntary deferral plans
• wraparound 401(k) plans
• excess benefit plans and equity arrangements
• bonus plans
• severance pay plans