Among the many aspects of corporate finance affected by the Tax Cuts and Jobs Act, executive compensation has received relatively little attention from the mainstream media. Yet the new law raises a number of questions with respect to performance-based incentives.
Many companies — including a majority of large ones — have rolling performance measurement periods of at least three years. That is, top executives’ pay is determined each year in part by performance metrics relative to established goals for the preceding three or more years.
Given the big drop in the corporate tax rate starting this year, established bottom-line-based goals such as earnings per share — a common metric for determining long-term incentive pay — will in most cases be much easier to attain at the end of performance periods already in progress, notes Steve Seelig, executive compensation counsel for Willis Towers Watson.
Companies presumably will adjust for the change when establishing performance measures for multi-year periods that begin this year. One obvious potential tactic would be de-emphasizing EPS in favor of pre-tax earnings metrics like operating income or EBITDA, which are also commonly used measures for determining executive compensation.
But what, if anything, companies will do to alter executive pay for periods already in progress remains to be seen.
Regardless, the new tax law may spur fundamental changes in how some companies pay executives, according to Seelig.
Under Section 162(m) of the Internal Revenue Code, companies can claim a maximum $1 million tax deduction on compensation paid to a “covered employee,” which until now has included the CEO and the three other most highly paid executives other than the CFO. (Under the new law, covered employees include the CEO, CFO, and the three top-earning executives.)
Until now, performance-based pay was exempt from the $1 million limitation. That provision, part of the Tax Reform Act of 1986, has driven many companies to cap executive salaries at $1 million and provide any additional pay under performance programs.
But the Tax Cuts and Jobs Act eliminates that exception, making performance-based executive compensation also subject to the $1 million deductibility limit.
On the surface that would appear to have a negative effect on companies. But they’re probably not looking at it that way, according to Seelig. “You have to take into account the entirety of the tax reform,” he says. “If a company is paying a lower tax rate, the executive pay on which they’re not getting a tax deduction may not be a painful amount.”
At the same time, Seelig suggests, some companies may follow the lead of Netflix, which announced on Dec. 29 that it will convert some performance-based pay for top executives to straight salary.
“We don’t think that moving away from performance criteria is going to be a trend,” says Seelig. “It’s something shareholders have demanded and proxy advisers have looked for in making their recommendations on whether shareholders should vote yes or no [on executive pay packages].”
Netflix was able to make the move because it’s a high-performing company with exceptional shareholder relations, Seelig notes, adding that “it’s certainly possible” that similarly situated companies will do the same.
Tax-law changes also may lead to companies discretionarily granting executives greater performance-based pay than is stipulated in their compensation agreements.
Section 162(m), which establishes the $1 million deductibility limitation, remains in place. But much of the section lays out the conditions under which performance-based pay qualifies for an exception to the limitation. All of that is now moot, because under the new law no performance-based pay qualifies for an exception.
One of the now-moot rules denied companies the discretion to increase executives’ performance-based pay above what the previously stated objective criteria called for.
“Compensation committees are going to have much greater ability to use their discretion this year if the company does great but an executive’s compensation plan is maxed out,” says Seelig.
The Section 162(m) deduction limit applies to all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs).