The stock market gains since the presidential election in early November have signaled optimism for 2017, but the optimism assumes change — maybe a lot. Because of the change anticipated, CFOs will need to be more involved with their companies’ incentive compensation programs in 2017 and beyond.
Probable tax law, healthcare and other regulatory changes in 2017 will make business forecasting, budget planning, and incentive goal setting more difficult than in the past.
Some of the possible changes include:
Possible Domestic Business Tax Law Changes
- Lower income tax rate
- Elimination of special interest provisions or preferences
- Elimination of alternative minimum tax (AMT)
- Immediate deduction of new investments
- Net operating loss carryforwards (indefinitely), but no carrybacks
Possible International Business Tax Changes
- Territorial (rather than worldwide) tax scheme
- Exports not taxed, imports taxed
- 100 percent exemption for dividends from foreign subsidiaries
- Repatriation tax for funds/assets outside the U.S.
Possible Other Regulatory Changes
- Employer healthcare design and cost
- Brexit implementation
- Global trade policy
- Geopolitical events and foreign policy
The date any tax or other legislation may be enacted and effective is a further element of uncertainty. The operational and financial changes may be effective immediately, and others may take an extended time period to be implemented by companies. Uncertainty abounds.
Incentive Plan Uncertainties — Aligning Executive and Performance Expectations
Incentive compensation plans will need to navigate this uncertain environment. Most incentive plans are based on operating plans or budgets, or even multi-year strategic plans.
Most incentive plan performance targeting reflects management expectations of operations for the year or another performance period (e.g., three years). Short- and long-term incentive plan performance targets usually reflect performance expectations at the beginning of the performance period (namely, at the beginning of 2017). These expectations are generally formed and documented in the first 90 days of the performance period. Because of the possible tax and regulatory changes, the possibility of significant tax or regulatory reform makes the expectations for 2017 nearly impossible to gauge in the first 90 days.
Even if the company’s incentive plan performance metrics are tax neutral (e.g., earnings before taxes), broader operational or financial changes the company might take in response to the tax or regulatory changes could result in different performance results than expected earlier. Most companies will want flexibility or discretion to make incentive plan payments consistent with actual performance.
Incentive Plan Uncertainties — Securing the Federal Tax Deduction
But for any publicly listed company, the flexibility and use of discretion in an incentive plan can make it challenging to secure the federal tax deduction for the amounts paid to senior executives. Section 162(m) of the federal tax code provides that any compensation paid to senior officers (the CEO and three other highest-paid officers, excluding the CFO) in excess of $1 million is not deductible unless it is performance based. The exception for performance-based pay includes the following:
- Performance goals and related amounts are determined by a compensation committee comprising at least two independent directors;
- The material terms such as performance goals are disclosed and approved by shareholders;
- Performance goals are predetermined, written, objective, not qualitative;
- The goals must also be substantially uncertain at the time they are set, not subject to upward discretion, but may be subject to downward discretion;
- A third party should be able to determine the award based on the plan provisions and financial results; and
- The committee certifies that the written, predetermined and objective goals have been met.
For the compensation earned under an incentive plan to be fully deductible under federal tax law, any performance goal (both the degree of performance and amount of pay) must be fixed in the first 90 days of the performance period (or the first quarter of the performance period, if other than a year’s duration). Given the uncertainty in the legislative possibilities for 2017, trying to fix performance expectations in the first 90 days of 2017 looks problematic.
A Solution — An “Umbrella Plan”
A solution to this problem is to build enough discretion into the incentive program for 2017 to respond to changes as they materialize during the year. Most incentive plans reserve the capability to use negative discretion — the discretion by the company to decrease the amount of the payment even though the reported goal performance as originally estimated would indicate a higher payment. This discretion may be helpful, but it may not be enough flexibility for 2017.
Companies are better advised in 2017 to use a technique known as a “plan within a plan” or an “umbrella plan” to gain greater flexibility. Under a typical umbrella plan, a pool equal to 5 percent (only illustrative) of the company’s earnings is determined, and each covered executive is allocated a portion of the pool — for illustration, the CEO is allocated 1 percent of the pool and other executives are allocated their (lesser) percentage.
This allocation creates as large an amount as the company would want to pay each executive. Then, based on actual performance, the company may adjust downwards any executive’s pay to reflect corporate or personal performance without losing the federal income tax deduction. This negative discretion allows for an adjustment to reach the appropriate amount, yet preserves deductibility.
Under an alternate umbrella plan design, the company sets a lower threshold of performance permitting payment of a range of payment values — for example, a $0.50 earnings per share incentive plan goal allows the payment of incentive amounts. The company then looks at actual performance at the end of the year and adjusts the payout to a value that is consistent with operating results judged in light of the entire performance period’s facts and circumstance. Typically, the company has developed a budget at the beginning of the performance period to guide and inform the year-end adjustments, so the process is not entirely freehand.
CFO’s Key Role
Using an umbrella plan will help the company gain the flexibility needed to manage expectations for pay and performance alignment, and sustain a federal tax deduction. The CFO has an important role in the company’s use of an umbrella plan. First, the CFO needs to offer input into the design of the umbrella plan, confirming that the predetermined level of performance is adequate to fund incentive compensation amounts, and that the minimum amount is both reasonably achievable and substantially uncertain (the standard for maintaining deductibility) at the time the performance goal is set.
Secondly, the CFO must help prepare a credible budget or other guide that may be used at the end of the year for comparison to help explain the year’s performance and why and how results differed from what had been expected at the beginning of the year.
Finally, the CFO needs to help other stakeholders — such as the board of directors and shareholders — understand how the actual performance should be viewed. Was there value creation from an intrinsic or economic perspective even though the reported numbers or results were affected by tax law or other regulatory changes?
Alvarez & Marsal Taxand Says:
Some companies have made use of an umbrella plan for years. Most companies have discretion to adjust payments downward but have not gone the distance to use the full umbrella concept. Because of the high-dynamic environment expected in 2017 and beyond, 2017 may be the year to embrace the umbrella plan concept. For a company that does so, the CFO will need to play an important role in the process.