The passage of the Tax Cuts and Jobs Act, which limits the tax deductions that businesses can claim for certain employee benefits, is likely to cause some employers to revisit their executive compensation programs.
The legislation changes the taxation of executive compensation in several ways. Most significantly, it:
- Amends Internal Revenue Code Section 162(m)—which prohibits publicly held companies from deducting more than $1 million per year in compensation paid to senior executive officers—to eliminate the exemption for commission- and performance-based pay. The legislation also expands the scope of covered individuals to include CFOs, along with an organization's CEO and three highest-paid employees, beginning in 2018.
A transition rule applies to remuneration provided under a written binding contract that was in effect on Nov. 2, 2017, and was not modified in any material respect after that date.
"The exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined" when section 162(m) was enacted in 1993, explained John Lowell, a partner with October Three Consulting in Atlanta. "Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay—some only very loosely incentive-based—without limits while taking current deductions."
Removal of the exclusion for performance-based pay "is by no means the end of the need to align executive pay and performance," said Deb Lifshey, managing director of pay consultancy Pearl Meyer & Partners in New York City. "Clearly, shareholders and proxy advisors will continue to scrutinize programs for pay and performance alignment."
- Creates a 20 percent excise tax for nonprofits—including 501(c)(3) and 501(c)(6) organizations—on the compensation of the five highest-paid employees who earn more than $1 million. The compensation is treated as paid when there is no substantial risk of forfeiture.
Win Some, Lose Some
Other changes that will affect executive compensation include the reduction of the top federal income tax bracket from 39.6 percent to 37 percent, leaving top earners with additional net income. In addition, far fewer households with earnings between $200,000 and $500,000 will be subject to the Alternative Minimum Tax. However, for highly compensated employees in high tax jurisdictions, deductions for state, local and property taxes will be capped at $10,000.
Steps to Consider
Compensation advisers are recommending that employers:
- Review compensation arrangements.
Affected employers should "be prepared to convene their compensation committees—possibly during this holiday season—to make important decisions on compensation arrangements for their top officers," advised Melissa Ostrower, a principal with Jackson Lewis in New York City, and Alec Nealon, of counsel at the firm.
In particular, "tax-exempt entities should review their existing executive compensation arrangements now and consider whether any changes should be made," they recommended. "Tax-exempt entities should consider including protective language in any new executive compensation arrangements that would allow them to modify or reduce compensation to the extent needed to avoid the new excise taxes."
- Consider accelerating bonus deductions.
The final bill provides for a 21 percent corporate tax rate beginning in 2018, down from the current 35 percent rate. The bill would not change the treatment of bonus deductions, "but lower corporate rates may encourage companies to accelerate bonus deductions into 2017," said Carol Silverman, a principal with HR consultancy Mercer in New York City.
Bonuses are generally deducted in the year paid and most employers pay bonuses in the year after the employee performs the services being rewarded. However, except for companies using accrual-basis accounting, "businesses can deduct amounts for bonuses earned in the performance year if the bonus is paid within 2½ months of year-end, as long as performance-related goals are met before year-end and the amount can be determined with reasonable accuracy," Silverman noted.
"Deductions in 2017 are worth more than they are in 2018," said Lifshey. "Generally, bonus payments made by March 15, 2018, are deductible in 2017 and would not need to be accelerated to take advantage of 2017 deductions."
"Companies are also considering accelerating vesting or payment of equity awards into 2017," Lifshey added.
If either cash or equity awards are accelerated to 2017, "companies must make sure all section 162(m) requirements are met," Lifshey advised. These requirements include certification of performance during the period by the compensation committee, which also may require a special meeting.
Accelerated payments and deductions should be consistent with company policies, and may be limited by accounting and other tax rules under section 409A, Lifshey said.
Altered Tax Rates and Withholding
Income tax bracket adjustments for tax year 2018 were issued on Oct. 19 by the IRS in Revenue Procedure 2017-58. However, the Tax Cuts and Jobs Act significantly alters tax brackets and income ranges starting Jan. 1, 2018.
Under the new tax legislation, the number of tax brackets remains at seven but the tax rates are lowered and income ranges are different.
- Current tax rates: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, 35 percent and 39.6 percent.
- New tax rates: 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent and 37 percent.
Tax Withholding for 2018 Is Changing
The IRS said it expects to issue initial guidance on new withholding tables for payroll systems in January 2018, "which would allow taxpayers to begin seeing the benefits of the change as early as February."
Many employees may need to file new W-4 forms, but it isn’t clear when new ones will be ready.
"We are taking the initial steps to prepare guidance on withholding for 2018," the IRS said in a statement shortly before the congressional vote. The IRS also said it "will be working closely with the nation's payroll and tax professional community during this process."
HR compensation and payroll managers should consult with their payroll vendors to ensure that their systems are appropriately adjusted in light of the forthcoming IRS guidance.
The new tax rates and related salary ranges will affect employees' tax withholding decisions. The IRS encourages wage earners to consider a tax withholding checkup. By adjusting Form W-4, Employee's Withholding Allowance Certificate, taxpayers can ensure that the right amount is being withheld from their paychecks so that they don't overpay on taxes during the year, to be refunded after filing their tax returns, or pay too little and face an unexpected tax bill.
The level of income that is subject to a higher tax bracket also can influence how much salary to defer into a traditional 401(k) plan, which reduces taxable income for a given year by the amount contributed, or whether to participate in a nonqualified deferred income plan, if that option is available through the employer.
The Tax Cuts and Jobs Act also states that among other income tax adjustments for 2018:
- The deduction for personal exemptions, which had been $4,050 for 2017, is suspendeduntil taxable years after Dec. 31, 2025.
- The standard deduction for single taxpayers and married taxpayers filing separately rises to $12,000 from $6,350.
- The standard deduction for married taxpayers filing jointly returns rises to $24,000 from $12,700.
- The standard deduction for heads of household rises to $18,000 from $9,350.