Section 162(m)

Definition

Section 162(m) is a provision of the Internal Revenue Code that limits the tax deductibility of executive compensation to $1 million per year for publicly traded companies. This rule aims to curtail excessive executive pay and encourage better alignment of compensation with company performance. It was introduced as a response to growing concerns about rising executive salaries and the potential disconnect between executive pay and shareholder interests.

5 Must Know Facts For Your Next Test

1. Section 162(m) was enacted as part of the Omnibus Budget Reconciliation Act of 1993 and was designed to limit excessive executive compensation in publicly traded companies.
2. The $1 million limit applies only to certain types of compensation, specifically cash salaries, while performance-based compensation is exempt if it meets specific criteria.
3. In 2017, the Tax Cuts and Jobs Act significantly changed Section 162(m) by eliminating the performance-based exemption, making nearly all executive compensation subject to the $1 million cap.
4. Companies often engage in practices such as structuring compensation packages to minimize the impact of Section 162(m), which can lead to more creative compensation strategies.
5. Critics argue that Section 162(m) may lead to unintended consequences, such as encouraging short-term thinking among executives as they seek to maximize their immediate compensation within the limits imposed.

Review Questions

• How does Section 162(m) influence the design of executive compensation packages in publicly traded companies?
  • Section 162(m) significantly impacts how companies structure their executive compensation packages by imposing a $1 million cap on tax-deductible pay. To navigate this limitation, firms may offer creative compensation arrangements that prioritize performance-based incentives or other forms of remuneration that do not fall under the cap. This can lead to an increased focus on aligning executive pay with company performance to ensure that both executives and shareholders benefit from the company's success.
• Evaluate the effectiveness of Section 162(m) in addressing concerns about excessive executive compensation and its implications for corporate governance.
  • Section 162(m) was intended to mitigate excessive executive compensation by capping tax deductions, yet its effectiveness is debated. While it sets a limit on deductibility, companies often find ways around it by emphasizing performance-based pay or using alternative structures that could diminish its intended impact. Consequently, while Section 162(m) aims to improve corporate governance by holding executives accountable for their compensation relative to company performance, it has also led to complexities that can undermine these objectives.
• Assess the potential long-term effects of the changes made to Section 162(m) by the Tax Cuts and Jobs Act on corporate compensation strategies and executive behavior.
  • The changes to Section 162(m) by the Tax Cuts and Jobs Act could have significant long-term effects on how companies approach executive compensation. With the elimination of the performance-based exemption, nearly all forms of pay are now subject to the $1 million cap, which may discourage firms from tying large portions of executive pay directly to performance metrics. This could lead executives to focus more on short-term gains rather than sustainable growth, impacting overall corporate strategy and potentially influencing shareholder satisfaction negatively as they seek better alignment with long-term business objectives.

Related terms

Executive Compensation: The total remuneration package given to top executives, which may include salary, bonuses, stock options, and other financial benefits.

Tax Deductibility: The ability to deduct certain expenses from taxable income, reducing the overall tax liability for individuals or corporations.

Shareholder Activism: The efforts of shareholders to influence a company's behavior by exercising their rights as owners, often focusing on governance issues such as executive pay.