H.R. 1, the “Tax Cuts and Jobs Act,” released by the House Ways and Means Committee late last week, includes tax provisions that, if enacted, would affect every individual and corporation. Several of the changes proposed relate to executive compensation and have the potential to profoundly influence pay plan design. We don’t foresee these proposals, if enacted in their current form, as changing the fundamental focus on pay for performance. But we do think that because use of deferral techniques, including the use of stock options, would be banned (except for some private companies), companies would need to recalibrate their pay delivery timing to meet these restrictions.

Tax exempts would have a different set of challenges, as the potential for excise taxes would loom for those organizations that pay over $1 million to their five top-paid executives.

The executive compensation proposals were included because the House was seeking additional sources of revenue to help offset the costs of reductions in tax rates for corporations, and other changes that would decrease revenues. In addition to the estimated revenue to be raised, we’ve pointed out the other policy considerations the House committee put forth for these proposals, and our initial reactions.

It is important to remember that the introduction of this bill was just the beginning of the legislative process for tax reform. We expect the bill to change as it moves through the Ways and Means Committee, to the House floor and through the Senate. We will be monitoring the process and will provide updates on compensation-related developments.

Corporate Executive Compensation Provisions

The potential impact of these two main proposals mesh with one another, as we will note below. Let’s look at each one separately:

Changes to 162(m) and the performance-based compensation exception

The proposal would do away with the performance-based compensation exception to the $1 million pay cap under current Code Section 162(m). It would also expand the definition of a “covered employee” – which currently includes only the CEO at the end of the year and the three highest compensated officers during the year – so that it would also cover the CFO at the end of the year. It also provides that an employee in that group during any year would continue to be a covered employee as to any compensation paid by the company in future years, including after retirement, to the individual or the employee’s beneficiaries. Thus, $1 million would become a hard cap on deductible compensation, and it would apply to a much larger group of employees. These changes would be applicable to taxable years beginning after December 31, 2017.

Rationale:  The proposal adopts the common wisdom that the current law’s performance-based compensation exception has caused publicly-traded corporations to shift away from cash compensation in favor of stock options and other forms of performance pay. The proposal then posits that this shift has created a “perverse” focus on quarterly results by some executives, rather than the long-term success of the company, and may have caused a few executives to manipulate results. The Joint Committee on Taxation (JCT) maintains that this provision would increase revenues by $9.3 billion over 2018-2027. 

Our initial reaction: While the conclusion that executives are more focused on performance-based pay and short-term results may, in some cases, be true, in our experience, committees diligently create a portfolio of compensation elements designed to balance their executives’ focus as is most appropriate for their circumstances. 

We question whether changing the tax rules to eliminate favorable tax treatment for performance-based pay would change the way companies design pay programs to incentivize executive behavior. Most companies have tended to follow the crowd since the advent of say-on-pay voting to craft their pay portfolios to focus on pay for performance, as demanded by shareholders and proxy advisors. In the current say-on-pay environment, we expect they would continue to do so, at least in the short term.

Whether this change may cause executive salaries to start creeping upward is another question to ponder. Our most recent research finds that CEO salary has remained fairly flat. However, when all compensation in excess of $1 million is made nondeductible, executives could ask for a higher share of fixed pay. We anticipate that it is unlikely compensation would skew toward a greater share of fixed pay, although a move to modest salary increases would not surprise us.

Later, we’ll discuss how the portfolio of short- and long-term compensation may change, as it also relates to the change in the deferred compensation rules.

Without the need to meet the performance-based pay exception, companies would no longer need to get shareholder approval of their plans for 162(m) purposes, nor would compensation committees need to set performance goals within the first 90 days of the performance period. They also would no longer be limited to using negative discretion only in making their bonus and LTI payout determinations. This would free up the process quite a bit, and would also remove the need for companies to use umbrella plans to help them cope with the negative discretion rule. Depending on how the current plan is written, an amendment may be required to remove the 162(m)-related provisions. This could mean that a company would have to continue to follow the more restrictive terms of its plan, limiting the use of positive discretion until it could be amended and approved by shareholders, as required under listing exchange rules.

In turn, this may lead to a more transparent proxy disclosure because, in the absence of umbrella plans, companies would need to disclose the objective terms of their real incentive plan goals in the footnotes to their Grants of Plan Based Awards table. Currently, it is sometimes difficult to distinguish between the umbrella plan and the plan within a plan. 

There would also likely be changes to the Securities and Exchange Commission proxy disclosure rules that may change some behaviors. Under current rules, 162(m) compliant plan payouts can be disclosed in the Non-Equity Plan Compensation column so that exercises of negative discretion do not appear to be upward adjustments of bonuses under an umbrella plan. With the demise of the 162(m) performance-based pay exception, we would anticipate the current disclosure regime would change so that if an annual bonus is paid above the objectively measured maximum, we would expect it would be required to appear in the Bonus column of the Summary Compensation Table. 

For 2017, the performance-based pay exception would continue to apply, but there are mechanical questions that companies would need to work through with their tax advisors. Many companies seek to fix a portion of their bonus pools before the end of the taxable year in order to take a tax deduction in that year, even though they are permitted to pay the bonus within two and a half months after year-end. In this case, a 2017 tax year deduction should be available for most of the 2017 bonus pool under existing corporate tax rates. However, for the portion of 2017 compensation paid to the top executives, the compensation committee must certify under Code section 162(m) that the results set forth under the plan have been attained, and many companies currently wait until post-year end to do so, when their audited financials are made available. Companies need to explore how current practices work, and whether there is a way to preserve the 162(m) tax deduction, which could have significant value, by meeting the certification requirement during 2017.

Although this is just a proposal, companies should begin to check the terms of their shareholder approved 162(m) plans. The main issue to focus on is whether the plan itself has 162(m) compliance baked in, or whether compliance with 162(m) is to be determined on a grant by grant basis. That is, some plans contemplate that every grant made to a “covered employee” must meet the requirements of 162(m), particularly the requirement that only “negative discretion” can be exercised for any grant made. 

Beyond 2018, companies may need to contend with the likelihood that if the proposal passes, long-term performance shares that vest after the end of 2017 would not be tax deductible. Whether or not companies can truncate a performance period and measure pro-rata actual performance for those grants during 2017, and still meet the requirements of current 162(m)(4), has long been a point of debate for tax advisors. Beyond whether that approach can work are the shareholder optics of doing so, each of which would require a great deal of study before being undertaken.

Elimination of the nonqualified deferred compensation (NQDC) rules

The proposal would make sweeping changes to the tax treatment of nonqualified deferred compensation. Rather than permitting some employees to defer compensation outside a qualified retirement plan until a future date, new Code section 409B would tax employee compensation (and earnings) as soon as no substantial risk of forfeiture exists for that compensation (i.e., receipt of the compensation is not subject to future performance of substantial services). Code section 409A would be repealed. The new rules would apply to cash-based programs, SERPs and equity-based compensation, including stock options and stock appreciation rights. However, there would be an exception for bona fide vacation and sick plans and short-term deferrals. A substantial risk of forfeiture would exist only if based on the requirement for the future performance of services, but would not exist solely because it consists of a covenant not to compete.

The provision would be effective for NQDC amounts attributable to services performed after 2017, although a limited grandfather rule would apply the current-law rules (i.e., Code section 409A) to NQDC amounts attributable to services performed before 2018 until the last tax year beginning before 2026, at which time such arrangements would become subject to the new provision. Thus, a current deferral that would be distributed in 2020 under and existing plan would continue to be deferred until that date, but a deferral that was scheduled to be paid in 2030 would have taxation accelerated to 2025.

Rationale:  The proposal’s goals are more straightforward than those supporting the 162(m) changes.  The focus is on changing the disparate coverage for highly compensated employees under NQDC plans, and removing an area of extreme complexity under current law, something those who work with Code section 409A are familiar. There is real money attached to this proposal.  According to JCT, the provision would increase revenues by $16.2 billion over 2018-2027.

Our initial reaction: This rule would impact every form of nonqualified deferred compensation: bonus deferral plans, executive pensions, 401(k) excess plans and equity-based compensation whose delivery date is delayed beyond vesting. 

  • Employee Deferrals: Where these programs consist of deferrals of employee compensation, the straightforward answer is that employees would simply not have the advantage of deferring that compensation any longer. Employers would need to consider, though, whether and how they would make those employees whole in exchange for losing the benefits inherent in the power of making before-tax deferrals.
  • Grandfathered Amounts: For amounts that are grandfathered because they are attributable to services rendered before 2018, the straightforward answer is that payouts can be made under an existing distribution regime, as long as it is before 2026. Existing deferrals would presumably continue to be subject to 409A, so that if employees want to delay distributions until 2025, they can do so under those strict subsequent deferral rules.
  • Employer Deferrals, including Executive Pensions (SERPs): For programs that provide an employer contribution or match to fund the benefit, the employer would also have to consider how to make their employees whole. Although current cash compensation or equity grants can be expensive, key executives may expect them. Grants of equity that have a retention feature that vest over a long period of time so that tax is delayed until future vesting, may be a middle ground.
  • Severance:  Severance benefits would be taxed at termination of employment, even though payments are constructed to be made over time. This could create a disconnect between the timing of when employees are taxed and the company desire to distribute severance periodically to better enforce a covenant not to compete, or other restrictions.
  • Stock options and other equity-based compensation: Stock options and other equity-based compensation-like restricted stock units (RSUs) would be taxed as they vest. For stock options, the tax would be applied whether or not they are exercised at vest, which really changes the equation for their viability. Employees like that they have the ability to exercise options when most appropriate, and employers like them because their perceived value to employees can be far higher than their accounting costs. But if it turns out they are taxed in the same manner as a restricted stock grant, at vesting, we question if they would continue to make sense. Granting a full value share would now have the same tax timing, but would be far less dilutive to shareholders, so the expectation would be that shareholders would be less enthusiastic about authorizing option grants. And if the shareholder vote for new share authorizations is more painful for companies that grant options, we think they would consider moving away from using them.
  • Private company exception: During the bill’s markup, House Ways and Means Committee Chair Kevin Brady (R-TX) introduced an amendment to provide a limited exception to proposed Code section 409B, for stock and RSU grants made by private companies.

    The amendment is nearly identical to a bill introduced during the last Congress, which we blogged about last year: “Proposed legislation would ease liquidity concerns for private companies wanting to issue equityExecutive Pay Matters, October 10, 2016. The tax deferral period can last up to five years after a stock option or RSU is no longer subject to a substantial risk of forfeiture. For this deferral to be permitted for its employees, a company must provide some form of equity to 80 percent of all employees, but grant levels can vary, as long as each employee receives at least a de minimis number of grants.

Changes to compensation programs for tax-exempt organizations

Under the proposal, tax-exempt organizations would be subject to a 20 percent excise tax on any compensation in excess of $1 million paid to covered employees. Additionally, tax-exempt organizations would be subject to a “golden parachutes” regime, imposing a 20 percent excise tax on amounts in excess of three times a covered employee’s base amount that is paid upon separation from service.  Covered employees would include any current or former employee who is one of the five highest compensated employees during the current tax year or for any preceding taxable year beginning after 2016. Compensation is defined broadly, generally to include all wages paid to the executive during the year. These provisions would apply to taxable years beginning after December 31, 2017.   

The opportunity to defer compensation for tax-exempt employees under Code section 457 would cease, except for state and local governments. 457(b) plans would not be available for amounts deferred for services performed after December 31, 2017, and all deferred compensation provided by such employers attributable to services performed after 2017 would be taxable when vested under the general rules of new Code section 409B.

Rationale: The proposal notes that tax-exempt organizations are relieved of federal tax obligations because they use their resources for specific purposes that promote public good and that excessive executive compensation arguably diverts resources from those purposes. The current limitation on private inurement, which can result in an organization losing its tax exemption, is not considered effective in preventing excessive compensation at tax-exempt organizations. The proposal also notes that adoption of the additional taxes for executives is consistent with the limitation on deductibility of executive compensation for publicly traded companies. And because of the major tax subsidy given to tax exempts, the arguments for discouraging excessive compensation is even stronger for them than it is for publicly traded companies. According to JCT, the provision would increase revenues by $3.6 billion over 2018-2027.

Our initial reaction:  As a threshold matter, we would observe that the proposal does not impact the current intermediate sanctions regime under IRC section 4958, so that tax-exempt employers would still seek to establish a rebuttable presumption of reasonableness for compensation paid to “disqualified persons” (a larger group than the covered employees affected by the proposed legislation) by getting an opinion from a qualified expert. 

It is not at all clear that tax-exempt employers would react immediately to this change by limiting compensation to covered employees to avoid the 20 percent tax, if it resulted in them paying below market compensation. Still, there is a compelling rationale for organizations to take a close look at this change, not merely because of the magnitude of the tax, but because their preference to pay an additional tax rather than to reduce pay for these individuals could become public. The importance of public perception certainly would vary among tax-exempt sectors. In such cases, the “reasonableness” opinion obtained for compensation decisions to meet the “intermediate sanctions” rebuttable presumption standard may prove useful to help explain why pay levels would remain above $1 million.  

We do not expect the new “golden parachute” regime would have a major impact on the severance pay tax exempts provide covered employees since, in most cases, organizations do not have in place severance plans that exceed three times an individual’s compensation. But exposure to this rule is very fact specific, so that organizations are advised to do the math to see if there may be additional tax exposure.

Taking away the ability to make pre-tax deferrals or receive employer contributions in 457(b) plans would be problematic for many tax-exempt employers, since the plans typically cover a large group of management and highly paid employees accustomed to the tax benefits available under the plan. As with for-profits (which would no longer be able to provide NQDC in a tax-efficient manner), there would be an expectation that the employer would provide a replacement or enhance another benefit.

Profound changes would require thoughtful questioning

When considered in tandem with the 162(m) changes, we think the changes to the NQDC rules would require companies to answer a variety of questions. The following are the ones that come immediately to mind – there are many others that will come to light in the coming weeks:

  • What immediate steps must I take to maximize my tax deductions for 2017 and assure that the maximum amount of my employees’ NQDC qualifies for grandfathering?
  • For future years, would the absence of a tax deduction for all elements of pay over $1 million, so that all elements of pay are on equal footing, influence the executives’ pay mix?
  • With stock options far less valued, what type of equity grants should I consider in the future? Do I believe that stock options are performance-based compensation, and is my substitute equity performance-based?
  • How does the loss of the NQDC tax deferral benefit impact my employees and former employees, and what substitutes are available?
  • How do I manage my prior 162(m) compliant plan in a new environment? Do I continue to follow the existing rubric or simplify it?  Would such changes require shareholders to vote on plan amendments?
  • How would any changes to how the programs work impact proxy disclosure?


Steve Seelig 

Steve Seelig

Willis Towers Watson

Puneet Arora 

Puneet Arora

Willis Towers Watson

Bill Kalten 

William Kalten

Willis Towers Watson

Steve Seelig, Puneet Arora and William Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email steve.seelig@willistowerswatson.com, puneet.arora@willistowerswatson.com, william.kalten@willistowerswatson.com or executive.pay.matters@willistowerswatson.com.