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Why Was Pay for Performance Killed Under the New Tax Act and What Can Companies Do About This?

Most of us would agree that paying employees according to their performance is a good thing. But of course we would also agree that employees should not be paid unless there are measurable results relative to pre-determined performance measures.

For several years, most publicly-held companies have been required to disclose plans upon which payments would be made, if the company was interested in receiving a tax deduction, for payments made to selected senior executives in excess of $1 million. Almost without exception major corporations have designed and disclosed such plans in accordance with these provisions of the former legislation.

However, “pay for performance” may have been finally given a deathblow under the H.R.1 tax law passed December 2017, informally called the Tax Cuts and Jobs Act. Simply put, companies can no longer deduct payments in excess of $1 million regardless of whether the plan is formalized and publicly disclosed as was required previously.

The elimination of the deductibility of pay to the most senior executives in a publicly-held corporation will mean that companies will have less motivation to implement performance-based incentive plans now that the company will be losing tax deductions for such payments to its senior executives. (Incidentally a “grandfather” provision allows payments made under a written binding contract in effect as of November 2, 2017, to continue to be deductible as long as the plan elements are not modified after that November 2 date.)

So what are companies likely to do, or alternatively what are its options?

First, a company could keep the prior plan in effect, never modifying it, so as to retain tax deductibility. This approach assumes that changing economic conditions and the competitive environment including presumably changes in any stated peer company selections and comparisons under the plan do not imply needed modifications.

Second, a company can change its plan(s) as it deems appropriate as conditions change thus disregarding the loss of tax deductions under the assumptions that the benefits of a modified plan outweigh the additional costs.

Third, a company can simply avoid the exercise of modifying or designing a new plan (including associated monetary and temporal costs) and pay as it sees fit to its executives, (of course losing tax deductions), an alternative that few companies probably would be willing to reveal to shareholders (or employees).

Fourth, a company could somehow implement a new plan, lose tax deductions, and adjust executive pay levels by the loss of the associated tax deduction; such an approach would be designed so that the cost to the company is the same as it was prior to the tax law change. Problematically, of course, is that any such adjustments must keep in mind competitive practices that are likely not to be static.

In any case, Company Boards and Compensation Committees will need to keep close watch on both competitive practices and motivational considerations, and make important decisions regarding this matter soon, particularly as proxy season is fast approaching which will require appropriate communication with shareholders.

Author of the article
Robert A. Coscarello, MBA
Robert A. Coscarello, MBA
Robert Coscarello is a full-time faculty member at the Pepperdine Business School. Since 2009 he has conducted numerous courses in International Business and Human Resources at the Masters level. He has over 30 years of management consulting experience working with global clients as well as 20 years experience as a country manager and regional manager, with the leading consulting firms, McKinsey and followed that at Towers Perrin. He is a retired Towers Perrin senior partner. At Towers Perrin, Bob served as Managing Director of the Latin America/Caribbean Region where he initiated, managed, and grew Towers Perrin's fastest growing region. He was a leader of the Total Rewards practice at Towers Perrin and Executive Compensation at McKinsey. Also at McKinsey he held the position of senior engagement manager (associate principal) on various general management consulting assignments in a wide variety of Fortune 100 companies.
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