With tax reform now approved and expected to soon be signed into law, companies are evaluating year-end strategies for 2017 bonuses in light of the reduction in the corporate tax rate beginning next year and changes to the deductibility of compensation provided to certain executive officers. This memo provides a brief summary of possible actions and issues to consider. The tax bill and its implications are complex, and the appropriate course of action varies from company to company based on numerous circumstances related to existing policy, governance considerations and the predictability of payouts expected to occur in 2018 that are potentially deductible with respect to the 2017 tax year. Companies should consult closely with tax counsel.
Assuming the new tax law goes into effect, companies are likely to be better off deducting bonus expense in 2017 because:
- In the case of bonuses not subject to Section 162(m), the deduction will be more valuable in 2017 than 2018 because of the decrease in corporate tax rates from 35% to 21%, and
- Effective for taxable years beginning after 2017, there is an elimination of the performance-based compensation exception to 162(m)’s general rule that compensation over $1 million paid to named executive officers cannot be deducted.
In addition, executives in states with high tax rates may also prefer taking receipt of income in 2017 because the ability to deduct state and local income taxes is limited starting in 2018. However, accelerating payments into 2017 raises several issues, most notably potential compliance challenges under 162(m) and external optics considerations.
Company Bonus Deduction
Businesses are generally able to deduct bonuses earned during a tax year if the “all-events test” is satisfied during the year and bonuses are paid within 2 ½ months after the end of the year (i.e., March 15 for calendar year companies). Under the all-events test, a liability is deductible in the year in which:
- All events have occurred to establish the company’s liability,
- The amount of the liability can be determined with reasonable accuracy (e.g., bonus amount is determinable), and
- Economic performance has occurred (e.g., employment of bonus recipient through required date).
Some companies satisfy the all-events test by administering their bonus plans on a purely mechanical basis and requiring that participants be employed only through the end of the performance period in order to receive payouts. Other companies satisfy the test by approving a “minimum” bonus pool in December, to be paid in the following year. The pool is often set at 75-95% of the expected bonus payout to reflect that full-year results are not yet known and account for possible forfeitures. This pool can be established for all bonus participants (i.e., 162(m) covered employees and others).
Section 162(m) Bonus Considerations
The tax bill eliminates the performance-based compensation exemption for taxable years beginning after 2017. There is, however, transition relief for payment under a “binding contract” in effect on November 2, 2017 if not later materially modified. Some practitioners have expressed concern that, except for plans where there is an automatic payout tied to formulaic criteria, bonuses paid to covered executives may not be grandfathered as a binding contract. This concern raises the importance of ensuring that bonuses are potentially deductible for a company’s 2017 tax year, as described above with regard to the all-events test. Assuming so, deductions for 162(m) covered employees would presumably be available if paid within 2 ½ months of the close of the fiscal year and in compliance with the “performance-based compensation” provisions under 162(m).
It is also possible that bonuses that are accelerated into 2017 may be deductible under 162(m) so long as acceleration does not change the value of the award. There are other technical issues, including the requirement under the current 162(m) rule that payout cannot occur until the committee has certified that the performance criteria has been met. Award determination must also be based on the objective formula set at the beginning of the performance period.
It bears emphasis that a key consideration if a company is accelerating payment based on results prior to completion of the year-end audit is that there should be certainty that actual results will support the amount of the accelerated payout.
Long-Term Incentive Compensation Considerations
It is expected that stock options or performance shares granted prior to November 2, 2017 will continue to generally qualify as deductible compensation under the 162(m) grandfather rule because most are structured to qualify for grant date accounting, which generally requires all material terms and conditions to be defined up-front.
Companies may also explore moving deductibility of time-vested restricted stock awards/units from 2018 into 2017 by approving a minimum payout amount prior to year-end. For example, if the aggregate projected value of RSUs vesting prior to March 15, 2018 is $100 million (based on number of units x current stock price), then it could be reasonable to set a minimum payout of $60 million to deduct a portion of the RSU value in 2017. Here, there should be a fairly large cushion to allow for possible forfeitures and change in share price and the approved minimum RSU payout must be delivered by March 15 as in the bonus example. In addition, since RSUs may not be deductible for 162(m) officers, the resolution approving a minimum amount should specify allocation first to non-Section 162(m) participants.
Similar to the acceleration of bonuses, we recommend caution with regard to accelerating the vesting of outstanding equity awards. Doing so raises numerous considerations including loss of retention power and possible adverse reaction from investors.
 The all-events is satisfied only if the full pool is in fact paid, so any amount attributable to terminated employees must be re-allocated and paid to other participants.
Kenneth H. Sparling
Ken Sparling’s assignments have been with both public and privately-held companies in various industries. His consulting engagements focus on all aspects of executive and board compensation including annual and long-term incentive programs, employment agreements and change-in-control arrangements. Ken holds an MBA from University of Chicago and is an author and frequent contributor to the firm’s technical papers and studies.
Dave Gordon’s practice as an executive compensation consultant stretches back over a decade. He has covered a variety of industries, including extensive experience with financial institutions and utilities. In addition to engagements for his own clients, based on his years of experience as an executive compensation lawyer, he acts as the senior resource on numerous technical issues for the Firm. He frequently acts as an expert witness, where his prior background as a lawyer litigating executive compensation cases gives him a unique perspective when called upon to perform services as an executive compensation expert witness.
Bindu M. Culas
Bindu Culas has over 15 years of experience advising clients on the US and international legal, tax and regulatory aspects of designing and structuring equity incentive programs, employment agreement, and severance and change-of control plans. Bindu has worked with both domestic and foreign publicly traded and privately held companies as well as pre-IPO companies.