For federal tax purposes, the Tax Cuts and Jobs Act (Tax Act), enacted in 2017, resulted in significant changes to Section 162(m) of the Internal Revenue Code. Notably, the Tax Act eliminated the qualified performance-based compensation exception to the $1 million annual limitation on the deductibility of compensation paid to a covered employee under Section 162(m), except for compensation paid pursuant to grandfathered contracts (generally, certain written binding contracts that were in effect on November 2, 2017 and not materially modified pursuant to the Tax Act’s transition rule).
Federal tax code changes do not automatically apply to state tax law in certain states (see our blog post on January 23, 2018). Several such states, including California, have maintained corporate income tax laws that reflect an older version of the federal code, so there was potentially a state income tax benefit to continuing to comply with the performance-based compensation exception under Section 162(m) as in effect prior to the 2017 Tax Act.
On July 1, 2019, a new law passed in California (Assembly Bill 91) that selectively conformed the California tax code to some of the federal code changes made by the Tax Act. In particular, the California tax code was conformed to the federal code changes to Section 162(m), effective for taxable years beginning on or after January 1, 2019. The new law generally immediately conforms California’s tax code to the changes made to Section 162(m) by the Tax Act, except that the grandfathering protection applies to written binding contracts in effect on March 31, 2019 (as opposed to November 2, 2017) that are not subsequently materially modified.
To the extent a company paying California taxes had been complying with the design and administrative rules of old Section 162(m) in order to reduce California taxes, it should reassess the company’s executive compensation program in light of the new law, including reviewing in-process performance-based awards to determine whether these arrangements qualify for the new grandfathering exception. It may also be possible for such a company to simplify compensation arrangements going forward, to the extent there were mechanics in place primarily intended to satisfy the requirements for performance-based compensation (for example, an umbrella goal under an annual cash incentive plan). For further guidance on this and related matters, please see our December 20, 2017 blog and our September 2018 publication for more information.
Dina Bernstein has extensive experience advising on all aspects of executive compensation, working with companies on an ongoing basis, as well as in the context of mergers and acquisitions, spin-offs, initial public offerings, and other corporate events. Dina provides guidance to private and public companies across various industries regarding cash and equity incentive compensation arrangements, employment, severance and change in control agreements, overall compensation program design, pay governance practices, taxation, stock exchange listing requirements and securities regulation compliance.
Samantha Nussbaum has consulted on behalf of public and private companies, compensation committees, and senior management on all aspects of executive compensation. Samantha’s consulting and legal background includes advising on executive compensation in the context of mergers and acquisitions, spin-offs, and initial public offerings; executive employment, severance, and change in control agreements; equity incentive plans; deferred compensation; and securities laws, including reporting and disclosure implications.