We expect that the Tax Cuts and Jobs Act (“the Act”) will be signed into law by the end of this week. The Act would make significant changes to Section 162(m) of the Internal Revenue Code, all of which would be effective for taxable years beginning on and after January 1, 2018. These changes potentially affect all awards payable in and after 2018, unless the company takes action now.

• Eliminates the current exception for performance-based compensation (and the separate exception for commissions). Elimination of the performance-based exception would cause the $1 million deduction limit to apply to stock options, stock appreciation rights, performance stock units and performance shares granted to top officers of public companies.

• Includes a company’s chief financial officer as a “covered employee” subject to the $1 million deduction limit.

• Adopts a “once covered, always covered” rule. If an officer is a covered employee at any time on or after January 1, 2017, that individual’s compensation from the same company would remain subject to the deduction limit in perpetuity, including for payments made after the officer resigns from the company, dies, or is otherwise no longer a covered officer.

• Extends Section 162(m) to foreign companies publicly traded through American depositary receipts (ADRs), and companies that have publicly traded debt, even if they have no publicly traded stock.

• Imposes an excise tax on certain tax-exempt organizations with respect to compensation in excess of $1 million that is paid to a covered employee.

The Act includes a transition provision, which will exempt from the above changes compensation under a written binding agreement that was in effect on November 2, 2017 and was not subsequently amended in any material respect. Despite a purported “clarification” added in the Conference Committee Report, the intended scope of the transition provision is not entirely clear, but it grandfathers certain compensation from the new restrictions.

What to Do Next?

1. Accelerate deductions to 2017.

Take action by December 31, 2017, to accelerate the accrual of deductions into 2017 for cash bonuses payable on or before March 15, 2018, and certain equity grants payable in 2018 (such as restricted stock units and performance stock units). If available, accelerated deductions are more valuable than the transition rule because acceleration supports the 35% deduction available in 2017, in lieu of a 21% deduction or (for executive compensation not exempted from Section 162(m)) a 0% deduction in a future year. And acceleration avoids the uncertainties of the transition rule’s scope.

To accelerate deductions into 2017, we recommend that a company consider the following:

• Make sure the company takes all actions indicated by IRS guidance as necessary to support a 2017 accrual.

• Make sure the company does not certify that any particular amount will be paid to Section 162(m) covered employees. Otherwise the accrued compensation may fail to qualify as performance-based under the current version of Section 162(m). If the company approves a minimum payment amount that applies to Section 162(m) covered employees and other employees, consider adding a “stacking” rule specifying that payments will be applied first to Section 162(m) covered employees, then to other employees. If the company’s total payments exceed the minimum payment amount, this may enable the company to deduct more of the excess payments at 21% instead of 0%.

• If accruing pay that is not performance-based, remember that the accrual (as allocated among individual employees) may cause compensation attributable to one or more Section 162(m) covered employees to exceed the $1 million threshold in 2017.

2. Determine whether the transition rule applies.

For outstanding performance-based awards that cannot be accrued in 2017, determine whether the awards qualify for the Act’s transition rule, which would permit the awards to remain eligible for the Section 162(m) performance-pay exception.

• The Conference Committee Report notes that a plan may qualify for the transition rule even if an employee is not yet eligible for the plan or has not accrued any benefits, provided there is a “written binding agreement,” and as of November 2, 2017, the employee was employed by the company and had the right to participate in the plan. The transition rule may potentially cover awards issued and/or benefits earned in future years under plans that qualify for the transition rule.

• The language in the transition rule (as “clarified” by the Conference Committee Report) is identical to the transition rule that appeared in the 1995 Treasury Regulations under Section 162(m). Those regulations deferred to state law to determine whether, under state law, the company was “obligated to pay the compensation if the employee provided the services.”

• Therefore, an award may not qualify as a “written binding agreement” if the compensation committee retains the discretion to not pay an award, to reduce the amount of an award, or even to amend or terminate the plan under which the award was granted (which are all common features of awards under Section 162(m) plans and grants).

• If an award is subject to discretion, amending the award now to curtail the discretion is unlikely to turn the award into a “written binding agreement” for purposes of the transition rule. Such an amendment effectively might increase the compensation payable to a top executive, and therefore may be a “material modification” that disqualifies the award from the transition rule.

• Because state law controls what constitutes a written binding agreement, the transition rule may apply differently to awards paid to, say, an executive in California compared to one, say, in Delaware.

3. Review and revise plan documents and award agreements to preserve flexibility for awards not eligible for the transition rule.

Current and future plans and awards that do not qualify for the transition rule may be designed or modified without regard to the requirements of Section 162(m)’s performance-based compensation exception. For example, the following features will be permissible, to the extent the terms of the plan or award so permit:

• The compensation committee may exercise positive discretion to increase award amounts, and will not be required to formally certify performance after the end of the performance period.

• Awards may be based entirely upon subjective performance criteria.

• Performance criteria may be modified during the performance period (e.g., to reflect events that were not anticipated at the time of grant).

• “Umbrella” plans that qualify covered employees for a maximum award amount may not be necessary.

• Companies may issue stock options with an exercise price that is less than the stock’s fair market value on the grant date (although Section 409A generally would require a fixed exercise date for any such options).

• Of course, companies should continue to consider ISS’s and shareholders’ reactions to any modifications to provisions that move away from a performance-based compensation structure.