Tax reform impact on compensation arrangements and effective strategies under the new tax rules:
Hi, I'm Gina Klein, a Director in PwC's People and Organization practice.
And I'm Nicole Berman, a Director in our National Office.
Tax reform will have a broad impact for many companies.
Today we'd like to focus specifically on a few areas where tax reform will impact compensation arrangements and effective strategies under the new tax rules.
So Gina, let's get started.
First off, tax reform significantly limits the deductions allowed by companies for compensation paid to top executives. Under the old law, PUBLIC companies could not take tax deductions for compensation over 1 Million dollars paid to the CEO and the three next highest paid officers. However, this limitation excluded grants of performance based equity and bonus arrangements.
Under tax reform there are a number of changes.
First, the scope of the entities subject to the executive compensation limitation has been expanded to now include all companies that have traded debt, and foreign corporations that trade in the US through American Depository Receipts. Previously, it only applied to certain US public companies.
Second, in addition to the CEO and the three next highest paid officers - the CFO is now subject to the rules. Once an employee is covered by the rules, the employee will permanently be subject to them, even if they change roles and would no longer be considered one of the top officers, - or even if they terminate their employment.
And third, tax reform eliminates the performance based exception mentioned earlier.
So Gina, just to make sure, on a go-forward basis, does the One Million dollar limit apply to all forms of compensation?
Yes, that's correct.
So if an executive’s total compensation package is over One Million dollars, anything over the One Million dollars - even their stock options and bonus plans with performance targets – will not be deductible going forward. This will be a big change for companies and may result in redesigning executive compensation plans.
The last area to highlight related to the limits on deductions of executive compensation is the grandfathering provision.
It states that if a payment in a future year is pursuant to a written binding contract that was in effect as of November 2, 2017, that contract is grandfathered and can be viewed under the lens of the old law.
So, does that mean any award granted before November 2, 2017 is easily excluded from this limit?
Unfortunately, no. There are a lot of unanswered questions related to the grandfather provision. For example: Many plans have negative discretion - meaning the board could decide to reduce an officer's award below what the formula would otherwise call for under the plan. It is currently unclear whether that discretion may keep the plan from being considered a "written binding contract".
Gina, in addition to the consequences of tax reform on executive compensation deductions, companies also need to think about the related impact on their deferred tax assets or "DTAs". For example, companies may need to reduce their DTAs for deductions they previously expected to receive but won’t be entitled to under the new rules.
Let's switch gears for a minute, and talk about another area in which tax reform is impacting compensation arrangements.
Many compensation plans have conditions for vesting based on metrics that will be impacted by tax reform – For example: Employees may earn a stock compensation award if "after tax net income" or "earnings per share" reach a particular level. If the award has multi-year targets that were set prior to tax reform, targets in the future years may no longer be appropriate given the significant reduction in corporate tax rates from 35 Percent down to 21 Percent. That is, a company's after tax results may be more favorable than it initially planned solely due to the rate reduction. As a result, the employee may achieve higher bonus targets than may otherwise have been earned.
A company may consider changes to the targets to provide appropriate incentives for employees and that will likely have accounting consequences.
So Nicole, what should companies be thinking about?
The first step in determining the accounting is to understand the original terms of the award. For some awards, an adjustment of the target is permitted or even required, while for others a change may be made at the company's discretion. From an accounting perspective, if a company changes the performance targets for its share based compensation plan to better align it with its projections under tax reform, modification accounting will be required. The impact on the timing and amount of compensation cost recognized in the financial statements will depend on the changes made, the legal requirements and the terms of the original award. There could be incremental compensation to recognize or a new "measurement date" depending on those facts and circumstances. Companies should also remember that even if they raise the performance targets, they will still have to recognize, at a minimum, the compensation expense employees would have earned under the original terms for equity awards.
It's an anti-abuse provision in the accounting guidance, also known as a "floor" such that a company can't just modify an award to make the target harder - to avoid taking compensation expense.
We are also seeing a big push to maximize deductions at the higher tax rate in the current year before the reduction in the corporate rate takes effect.
That is right.
Some companies are thinking about making bigger contributions to their defined benefit pension plans. Companies get tax deductions when they make contributions to their pension plans within 8 ½ months after year end. So calendar year-end companies have the opportunity until September 15 to make a contribution to their plan and take advantage of the 2017 tax deduction at the 35 Percent tax rate.
In addition to that, non-calendar year-end companies may also consider a similar opportunity with their bonus plans, including in some circumstances with stock-based arrangements. Typically a bonus is earned in one year, but paid and deducted early in the subsequent year. Non calendar year-end companies should consider whether to take action before year-end to finalize the bonus and satisfy requirements to get the deduction prior to year-end. This may be an opportunity for these companies to get a tax deduction at a higher blended rate than the twenty one percent rate.
Great point Gina. Thank you.
That wraps up our summary of the impact of certain aspects of tax reform on executive compensation and other related topics. For more information on any of the topics highlighted today, you can read our In depth on accounting considerations of US tax reform, available on CFOdirect.com.
We also have People and Organization Insights, and many other resources on our Tax reform readiness webpage.
Thanks for joining us!