We’re receiving a growing number of questions from companies interested in easing their employees’ tax burden in 2013 by paying their 2012 calendar-year bonuses before year-end. Aside from some of the tax-related challenges detailed below, the threshold question compensation committees should consider involves the optics of this decision. Our view is that, although the acceleration is doable and a tax-efficient delivery of compensation is generally preferable, the challenges of explaining the company’s rationale to shareholders, as well as managing and administering an accelerated year-end schedule, are likely to outweigh the benefits of saving executives money. We recognize, however, the school of thought that bonus accelerations may not need to be disclosed to shareholders in a company’s proxy or 10-K, particularly if named executive officers (NEOs) do not participate. In short, there may be more flexibility for an approach covering high earners who aren’t NEOs.
For those who wish to explore the tax implications of this strategy, one issue is whether accelerated payments to top executives would remain tax deductible under the 162(m) “performance-based compensation” exception. A second issue would arise where there are existing nonqualified plan deferral elections in place to delay payment of the 2012 bonus to a later year.
What’s the Issue?
Some clients contemplating the implications of November’s presidential election believe it’s likely that the Bush tax cuts will expire in 2013, resulting in higher tax rates for their higher-paid employees. This could mean that the top marginal income tax rate will increase from 35% to 39.6% unless Congress intervenes.
From a corporate perspective, the tax code recognizes that it is administratively difficult for companies to pay annual performance bonuses before year-end and permits a tax deduction if they are paid within two and a half months after the end of the bonus year, subject to some additional requirements. The same rule applies to settlement of performance shares. Virtually every company uses this rule of convenience. But, for high-income taxpayers to take advantage of potentially lower 2012 tax rates, this regime would need to change so that bonuses are paid during 2012, rather than after year-end.
Doing so would raise an overarching question about changes in tax accounting methods, an issue best discussed with tax advisors. Assuming that hurdle is met, and companies can reasonably value bonus amounts due before the year-end books are closed, there are two other issues that must be confronted: 162(m) and 409A of the tax code.
$1 Million Pay Cap Under Section 162(m)
The first potential challenge is whether companies can meet the “performance-based compensation” exception to the $1 million deduction cap for bonuses paid before year-end to the CEO and three highest paid executive officers (other than the CFO) listed on the company proxy. The complication that arises is whether the compensation committee can certify in writing prior to payment of the compensation that the performance goals were satisfied. The committee cannot approximate that the goals have been met; there has to be an actual performance period that is measured. A similar analysis would apply where companies want to settle performance shares before the end of a multi-year performance period.
How easy it is to accomplish this early certification will depend on the type of performance metrics being used. A performance target such as a revenue goal in excess of 105% of the prior-year level might be measurable if attained before the early payment date. By contrast, a performance goal based on net results, such as earnings per share for a calendar year, might be more difficult to certify before year-end with the uncertainty of events that may occur during the last weeks of the year. Adding to the mix is the open question of whether the IRS agrees that certification can take place before the end of the original measurement period.
Another approach might be to simply truncate the performance period so that it ends, using the above example, on December 15 instead of December 31. However, it’s unclear under the tax regulations, which require that a performance goal for an annual bonus be set by the 90th day from the start of the year, whether the length of the performance period must also be specified on that date. Said differently, can you change a one-year performance period to something shorter during the course of the performance year? The regulations are not clear on this issue.
Assuming the certification hurdle can be met, another arcane — and unresolved — regulatory question is whether the entire bonus can be paid before year-end. Reg. section 1.162-27(e)(2)(iii)(B) provides:
“If compensation is payable upon or after the attainment of a performance goal, and a change is made to accelerate the payment of compensation to an earlier date after the attainment of the goal, the change will be treated as an increase in the amount of compensation, unless the amount of compensation paid is discounted to reasonably reflect the time value of money.”
It’s not clear to us what this regulation is trying to address. Does it endorse early payments like the ones we are suggesting? Does it apply to all situations where a payment is being made earlier than two and a half months from year-end or only when a specified payment date is being overridden by an earlier payment? These are open questions.
Also keep in mind that accelerated or discounted payments must comply with the terms of the executive bonus plan, so the company would need to make sure that the plan at least grants the authority for the compensation committee to pay the bonuses early.
409A Deferral Elections Must Be Honored
Section 409A would come into play in situations where executives have previously elected to defer payment of bonuses earned for 2012 performance under a nonqualified deferred compensation plan. In general, these elections must be in place at least six months before the end of the performance period and may have been made before the start of 2012. Because we’re now well past the end of that six-month period, several potential arguments for revoking existing elections are no longer available, so we see little hope of changing deferral elections currently in place.
In short, early payouts during 2012 of deferred compensation are generally not permissible.
Proxy and 10-K Disclosures
We believe that accelerating NEO bonuses would be considered “material” and, thus, would need to be disclosed in the Compensation Discussion and Analysis section of the proxy. This will be a matter of judgment to be resolved with SEC counsel. Of course, the CD&A disclosure issue would be moot if NEOs are excluded from the accelerated bonus payout.
However, even if the NEOs are included, we don’t believe the pre-year-end payment would change any of the required tabular proxy disclosures. For example, Summary Compensation Table disclosure of Non-Stock Incentive Plan Compensation or Bonuses is based on compensation earned for the year, regardless of when it’s paid. Other tables would similarly be crafted the same way regardless of payment timing. Similarly, because the tax deduction timing rules permit bonus payments made within two and a half months of year-end to be deducted in the year in which they were earned, we don’t see the 10-K financials being any different if the payments are made before the end of the year.
Ultimately, companies will want to give all of the implications of bonus acceleration careful thought before deciding on a course of action.
Steve Seelig and Russ Hall are executive compensation experts in Towers Watson’s Research and Innovation team, based in Arlington, Virginia and White Plains, New York. Email firstname.lastname@example.org, email@example.com or firstname.lastname@example.org.