How much do you know about the new Section 162(m) standards? Does Internal Revenue Code Section 162(m) apply to your business? Section 162(m) addresses executive compensation. Recent changes to the regulations make them apply to more businesses than before. Learn more about what Section 162(m) says and how it may apply to you.
Section 162(m) Of The Internal Revenue Code
Section 162(m) is a section of the Internal Revenue Code. It limits how much executive compensation a publicly-traded corporation can deduct from its income tax. The limit is $1 million per covered executive. Congress wanted executive compensation tied to how well the corporation was doing. Section 162(m) came into effect in 1994.
The $1 million cap originally had exceptions for performance-based pay and commission-based pay. The Tax Cuts and Jobs Act (TCJA) of 2017 substantially revised Section 162(m). These changes took effect for tax years starting after December 31, 2017. They are among several significant changes to corporate taxation and accounting regulations and standards that have recently taken effect.
The TCJA amends Section 162(m) in several important ways. These changes include:
- Increasing the number of public companies that the compensation deduction limit covers
- Covering more executives
- Eliminating the performance-based and commission-based compensation exceptions
- Eliminating IPO relief
The TCJA provides a "grandfather rule." This applies to compensation paid according to a written, binding contract. The contract must have been in effect on November 2, 2017. It must not have been significantly modified after this date. The old Section 162(m) rules apply to compensation that falls under the grandfather rule.
How Does Section 162(m) Define A Publicly Held Corporation?
After the reforms in the Tax Cuts and Jobs Act, a publicly held corporation either:
- Issues securities that must be registered under Section 12 of the Securities Exchange Act, or
- Must file reports under Section 15(d) of the Exchange Act
The corporation must fall into one of these categories as of the last day of its tax year. This expanded definition includes many types of corporations. Some foreign corporations are now subject to the regulations. Domestic corporations with publicly traded debt are also included. Publicly held subsidiary corporations are another example.
IRC Section 162(m) doesn't cover companies that voluntarily register securities. It doesn't apply to companies that voluntarily file public disclosure either.
New Definition Of Covered Executives
Publicly-traded corporations used to have four executives with a deduction limit. First was the CEO on the last day of the fiscal year. The next three executives with the highest compensation had a $1 million cap. The original version of Internal Revenue Code Section 162(m) didn't apply to the CFO.
More executives fall under the deduction limit as a result of the Tax Cuts and Jobs Act. Every person who served as CEO at any point during the fiscal year is subject to Section 162(m). CFOs aren't exempt from the regulations anymore. Anyone who filled the role of CFO at any time during the fiscal year is a covered executive.
The next three highest-paid executives remain classified as covered executives. Once an executive is classified as covered now, they keep this classification. Executives continue to be covered after their employment relationship with the corporation ends. The corporation must consider them covered even after their death.
This "once-covered, always-covered" rule applies to tax years beginning after December 31, 2016. It means that a corporation could quickly have a high number of covered executives.
Changes To Executive Compensation Limits
The Tax Cuts and Jobs Act eliminated the exclusion for performance-based and commission-based compensation under Section 162(m). The $1 million deduction limit applies to all executive compensation for covered executives. All compensation a covered executive received during the tax year falls under Section 162(m).
This includes compensation for activities like serving on a board or as a consultant. The deduction limit applies even if the executive provided those services in a different taxable year. Compensation goes beyond salary and includes things like stock options and housing allowances. In fact, 75% of CEO compensation in the last few decades has been in stock awards and stock options.
Elimination of IPO Transition Relief
Section 162(m) originally had a provision to help corporations that became public. It didn't cover compensation arrangements the corporation made before its initial public offering (IPO). The company must have disclosed these arrangements to prospective shareholders. The exemption applied for a certain period after the IPO.
The Tax Cuts and Jobs Act removed this exemption. Corporations that become publicly traded after December 20, 2019, won't get the post-IPO transition. Companies that become public after that date must follow Section 162(m) right away. Section 162(m) applies to the taxable year ending on or after the date of the IPO.
Implications For Businesses Under Internal Revenue Code Section 162(m)
The changes to IRC Section 162(m) have many consequences for public corporations. These consequences aren't all negative, however.
Loss of Tax Deductions
Businesses will lose some tax deductions. Many corporations didn't choose to qualify all of their executive compensation under Section 162(m). They gave up the potential tax savings. Most corporations tried to qualify at least some of their compensation, though. Executives are unlikely to agree to limit their total compensation to $1 million per year. Corporations will lose some tax deductions as a result.
However, the Tax Cuts and Jobs Act lowered the top federal corporate tax rate. This will help offset some of the lost deductions. State corporate income tax laws vary, but most are based on the federal Internal Revenue Code. The changes to Section 162(m) may result in higher state taxes for businesses.
Limiting the Total Number of Covered Executives
The once-covered, always-covered rule means that corporations need to limit their covered executives. This will help maximize any potential tax deductions. For example, if a corporation needs to appoint an interim CFO, the board should appoint an executive who is already classified as covered. This avoids adding another person to the covered category.
Businesses may change their recruiting and hiring practices to help limit the number of covered executives.
Streamlining Compensation Procedures
The new Section 162(m) standards have some positive results for corporations. Losing the performance-based compensation tax deduction simplifies the procedures for establishing compensation plans. The original standard had lengthy and expensive procedural requirements in order to qualify performance-based compensation under Section 162(m).
Even if an executive met the performance goals, some compensation might not have qualified as tax-deductible for technical reasons. Eliminating the performance-based tax deduction lets corporations change their compensation procedures. They can lower administrative expenses and increase flexibility.
Adjusting to the New Internal Revenue Code Section 162(m) Standards
The Tax Cuts and Jobs Act made changes to Section 162(m) that publicly traded corporations need to follow. Section 162(m) covers some corporations for the first time. Other businesses need to change their compliance mechanisms. Smaller reporting companies and emerging growth companies face the same requirements as larger companies.
Expert tax advice is essential to avoid problems. Watch out for our blog section to stay up to date on complex tax-related topics.