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17.8 Tax deduction limitations related to compensation
Publication date: 31 Dec 2022
us Income taxes guide
The tax deduction that an employer is eligible for related to compensation may be subject to certain limitations. One limitation is the "million-dollar" limitation, established by IRC Section 162(m), which provides that, for public companies, the annual compensation paid to individual covered employees in excess of $1 million during the taxable year is not tax deductible. All individuals who hold the position of either chief executive officer or chief financial officer at any time during the taxable year are covered employees. Covered employees also include the company's three highest paid executive officers. The executive officers and the amount of compensation for the year are determined under the applicable SEC rules. Any individual who is deemed a covered employee will continue to be a covered employee for all subsequent taxable years (i.e., they remain a covered person indefinitely).
On March 11, 2021, the American Rescue Plan Act of 2021 (ARPA) was signed into law. The APRA expands the scope of the individual employees subject to the limitation under IRC Section 162(m) to include the five highest paid employees in addition to the CEO, CFO, and the three highest paid executive officers. However, these employees would not be subject to the ‘once a covered employee, always a covered employee’ treatment that continues to apply to the CEO, CFO, and three highest paid executive officers. The provision is effective for tax years beginning after December 31, 2026. Reporting entities should consider the tax effects of awards that may be subject to the expanded IRC Section 162(m) limitation as information becomes available indicating certain employees may become covered employees under the expanded scope.
If annual compensation includes both cash compensation and stock-based-compensation, a company should first assess whether or not a covered employee's compensation will be subject to the Section 162(m) limitation. The anticipated effect of the Section 162(m) limitation should be considered using one of three methods (as discussed below) when recognizing deferred tax assets for awards that may be subject to the limitation. The selection of a method is an accounting policy that should be applied consistently.
We believe that any of the following approaches, if followed consistently, would be acceptable for determining whether a deferred tax asset should be recorded for stock-based compensation that is subject to the IRC Section 162(m) limitation:
- The impact of future cash compensation takes priority over stock-based-compensation awards. For example, if the anticipated cash compensation is equal to or greater than the total tax-deductible annual compensation amount for the covered employee, an entity would not record a deferred tax asset associated with any stock-based-compensation cost for that individual.
- The impact of the stock-based compensation takes priority over future cash compensation and a deferred tax asset would be recorded for the stock-based compensation up to the tax deductible amount.
- Prorate the anticipated benefit of the tax deduction between cash compensation and stock-based compensation and reflect the deferred tax asset for the stock-based-compensation award based on a blended tax rate that considers the anticipated future limitation in the year such temporary difference is expected to reverse.
Example TX 17-3 illustrates accounting for the tax effects of awards that may be subject to the IRC Section 162(m) limitation.
EXAMPLE TX 17-3
IRC section 162(m) limitations
IRC section 162(m) limitations
Company USA enters into a three-year employment contract with its CEO, who is a “covered employee” as defined by IRC Section 162(m). The terms of the contract include $1 million of cash compensation to be paid annually. Additionally, 100,000 shares of non-vested restricted stock are granted in year 1 and cliff vest in two years (i.e., the restricted stock will vest and become tax deductible on the first day of year 3). The fair value of the stock on the grant date is $10 per share for a total fair value of $1 million. Assume the fair value of the stock remains constant and the applicable tax rate is 25%.
How would Company USA account for the tax effects of awards that may be subject to the IRC Section 162(m) limitation?
Analysis
As the restricted stock does not vest until year 3, the CEO’s compensation in years 1 and 2 are not subject to the limitation (it does not exceed $1 million). In year 3, the total compensation for tax purposes would be the $1 million cash compensation and the $1 million in restricted stock, which the CEO will be deemed to have received based on vesting. The deferred tax analysis under each of the three methods is as follows:
(1) Cash compensation takes priority – Available tax deductions are first allocated to cash compensation. As the $1 million in cash compensation would fully absorb the Section 162(m) limitation in year 3, the entire $1 million of stock-based compensation would be considered non-deductible. As a result, the stock-based compensation would not give rise to a temporary difference, and no DTA should be recognized. The effective tax rate would be higher in years 1 and 2 under this approach as the book stock-based compensation charge would not result in a deferred tax benefit.
(2) Stock-based compensation takes priority – Available tax deductions are first allocated to stock-based compensation. As the $1 million in stock-based compensation would be fully deductible under the Section 162(m) limitation in year 3, the stock-based compensation recorded for book purposes in years 1 and 2 ($500,000 per year) would give rise to a temporary difference, and a DTA should be recognized. The cash compensation in year 3 would be considered non-deductible. The effective tax rate impact from the Section 162(m) limitation is recognized entirely in year 3.
(3) Pro rata allocation between cash and stock compensation – Available tax deductions would be allocated between cash compensation and stock-based compensation on a pro rata basis. As both cash compensation and stock-based compensation are expected to be $1 million in Year 3 (total compensation of $2 million), the available $1 million of tax deductions would be allocated 50:50. Thus, while the stock-based compensation recognized for book purposes in Years 1 and 2 would give rise to a temporary difference, only 50% of the total compensation would be recognized as a deferred tax asset. Therefore, the deferred tax benefit in Years 1 and 2 ($500,000 × 50% × 25% = $62,500 in each year) result in a total DTA at the end of year 2 of $125,000. The $125,000 DTA would reverse in year 3 when the stock-based compensation is deducted on the tax return. Under the pro rata approach, the effective tax rate impact from the Section 162(m) limitation is spread over all three years.
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