One of the lesser known sections of the December 2017 Tax Cuts and Job Act, which effectively revamped the tax system, is its effect on executive compensation. Since the bill went into effect, there has been confusion and controversy around the exact interpretation of these new executive compensation guidelines.

Tax Cuts and Jobs Act, Code Section 162(m) contains four main stipulations. First, the section limits the deduction that covered companies may take for annual compensation paid to any individual who has served in the top five most highly compensated roles, including CEO and CFO. Second, once an individual has served in one of those roles, and is thus in a covered position, they will remain a covered employee in all future years, even past termination. Third, the section dictates all compensation to covered employees greater than $1 million will be nondeductible. Finally, Code Section 162(m) dictates which companies will be included in this section. All corporations with publicly traded debt or publicly traded equity are subject to the rule. In addition, foreign private issues are also included in the new definition, which could lead to large private C or S corporations to be subject to the section.

Intuitively speaking, the new stipulations are not that easy to understand. The IRS recently provided guidance in Notice 2018-68 on how the code section would apply. Primarily, the IRS and other experts advise these companies will need to work with their accountants to ensure it is deducting properly based on the executive compensation plan.

Andrew Liazos, a partner at the Law firm McDermott Will and Emery in Boston, provided some clarifying incite based on the IRS update and his own personal knowledge. “What accounting firms need to worry about in part is the preparation of financial statements for these companies,” he said. “One of the items in the financials is something called the deferred tax asset. When there’s a liability obligation for a benefit or compensation plan, that ends up in the liability column, but then that liability really has to be balanced against the fact that there are going to be tax deductions that in many cases will be available when amounts that are liabilities get paid, which is the so-called deferred tax asset.”

Primarily, the IRS guidance provides needed details on the definition of a “covered employee,” which has changed slightly since before the act passed. “That issue in terms of who’s a covered employee has to do with the application of the law going forward to new tax periods,” said Liazos. “It was really dealing with relatively aggressive positions, telling taxpayers who didn’t agree with certain suggestions that had been made. One suggestion that had been made was whether employees not employed at the end of the year would be a covered employee, and the IRS clearly did not agree with that position. So, if you were an executive officer and you are one of the top five people — the CEO, CFO and one of the top three paid people, to be more accurate — if that’s the case, basically they’re going to be covered. They’re going to be a covered employee, whether or not you’re employed at the end of the year. I don’t think that’s a surprising thing at all, but that was part of the guidance.”

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