1. What big changes are in store for Section 162(m) in the current tax bills? The final tax bill includes these major changes to Section 162(m):

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1 SECTION 162(M) FAQS - TAX CUTS AND JOBS ACT December 22, 2017 Below are some questions and answers regarding how the final Tax Cuts and Jobs Act, passed by both houses of Congress, will alter the landscape of Code Section 162(m), the $1 million annual cap on deductibility of executive compensation. The tax bill was signed into law by President Trump on December 22, What big changes are in store for Section 162(m) in the current tax bills? The final tax bill includes these major changes to Section 162(m): The performance-based compensation exception would be scrapped The CFO would be returned to the group of covered employees, as was the case prior to 2008 Once an executive is a covered employee in any year (starting in the current year, 2017), compensation will be subject to Section 162(m) in all future years, including after termination Section 162(m) will now apply to companies with only debt securities registered with the SEC 2. How bad is this? Medium bad. The final tax bill lowers the top tax bracket for corporations to 21%, so the same companies that will lose deductibility under Section 162(m) will, on a net basis, have much lower taxes even with the added 162(m) pain. Nevertheless, the changes will raise the after-tax cost of executive compensation, and that should be of concern to the compensation committees and board. 3. What performance-based awards are affected? Stock options, SARs, performance-based equity awards, and annual incentive awards are commonly covered by the performance-based awards exception under Section 162(m). All will now be subject to the $1 million cap on deductibility in the same way base salary is currently treated.

2 4. When would the 162(m) changes kick in? For fiscal years that begin after December 31, Calendar year fiscal year companies will have only a few weeks before coming under the new regime. A company with a June 30 fiscal year will have more time to acclimate. 5. How would the changes affect old awards and deferrals that result in compensation in future years? The final tax bill (unlike some early versions) grandfathers compensation resulting from a written binding contract that was in effect on November 2, 2017, provided that the compensation is not materially modified thereafter. Grandfathering means that the compensation will be treated under 162(m) as disregarding the changes made in the tax bill. Thus, if the grandfathered arrangement qualified as performance-based, it will remain fully deductible, even if performance conditions and vesting requirements are met in 2018 or later. Similarly, if the grandfathered arrangement does not qualify as performance-based but the payout occurs after the executive s employment has ended, it will remain deductible without limitation under 162(m). Note that awards subject to negative discretion, which permit a company to reduce or eliminate the payout regardless of the level of performance achieved, probably are not grandfathered, because there would have been no legally binding right to the compensation as of November 2, Should a company accelerate payouts of 2017 annual incentive, to pay before year end? For many companies, annual incentives won t need to be accelerated into the current fiscal year to gain a 162(m) advantage. The main reason is that many companies take the necessary steps so that annual incentive payouts made within 2.5 months after the end of a fiscal year are deductible in the just ended fiscal year. If a company does not normally take the necessary steps to qualify post-year-end payouts as deductible in the just-ended year, it should consider doing so if the payout qualifies under 162(m) (or is an award to the CFO) and would save taxes. To qualify annual incentive awards for tax deduction by the company in the performance year rather than the year of payout, the company has to meet the IRS s all events test, meaning that all events necessary so that the company is legally committed to paying out the bonuses must have occurred by the end of the fiscal year. Until the IRS shined a spotlight on this issue a few years ago, it was widely believed that the only necessary step was to pay out bonuses within 2.5 months after year end. While payment within 2.5 months is necessary, other steps usually are needed to meet the all events test. We explain further in Question 10 below.

3 7. What about equity compensation? Because equity awards generally should qualify for grandfathering, there is not a compelling 162(m) reason to exercise options in 2017 or attempt to accelerate the vesting and settlement of other awards into For companies currently taxed at a high marginal tax rate, there could be some tax benefit to exercises in 2017, with the deduction reducing income that otherwise would be taxed at a 35% rate. The CFO might be a special case meriting acceleration of awards into the current fiscal year, because the CFO is outside of the sweep of 162(m) in 2017 but will not be in Also, if an equity award is yet to be made to the CFO, he or she could be granted restricted stock and file an 83(b) election in the current fiscal year as another way to get one last tax deduction under the old rules. 8. What about the two other ways commonly used to avoid lost tax deductions under 162(m)? Payments to an executive who terminates before the last day of the fiscal year are not subject to 162(m) Deferral of compensation until termination of employment has been a widely used technique to avoid the 162(m) deductibility cap Both no longer will work. Covered employees will include anybody who was the CEO or CFO in any fiscal year (at any time, not just at year-end) beginning on or after January 1, 2017, including interim holders of those titles, plus anybody who was one of the three other most highly compensated executive officers for any post-2016 fiscal year. Once a covered employee, always a covered employee, even after termination. One new technique we may see is for post-termination compensation to be structured in a way that keeps it largely within the $1 million threshold each year. This would likely be done by spreading payments out over multiple years (creating 409A deferred compensation, which is its own can of worms). 9. Wait, I thought the tax bills were going to kill non-qualified deferred compensation? Yes, the original tax bills would have, but those provisions were dropped by the time the bill became final. Code Section 409A lives on.

4 10. What steps should a company take to make sure annual incentive awards are deductible as 2017 compensation (even if paid in early 2018), so that the 162(m) performance-based exception will apply to that compensation? Assuming a company has a December 31 fiscal year, here is a high level overview of the steps to be taken to meet the IRS s all-events test: 1. Determine whether annual incentives paid in early 2017 were claimed as deductible in If so, do the same things again, but check your work the IRS already is giving close scrutiny to all events compliance, and your process for the 2017 tax year may come under the IRS microscope. 2. Determine whether the plan or award terms make the award forfeitable if the executive quits or is terminated before payout, which means that there remains service-based vesting into If so, either this vesting will have to be moved up to December 31 or the company will have to commit (through a board or committee resolution) to pay out a certain level of bonuses to a defined group of employees including the executive. Note companies currently are looking at the broader question of locking in 2017 tax deductions for bonuses to broader groups of employees in order to get the advantage of higher 2017 marginal tax rates (i.e., a 2017 tax deduction is more valuable than a 2018 tax deduction). 3. Determine whether 162(m) and other performance goals to be met for the 162(m) payouts are purely objective. If so, resolutions committing the company to pay out the award can be based on the mechanical determination of the payout (the year-end accrual), using final year-end numbers and the payout grid previously authorized. Those final year-end numbers probably will only be known weeks into the next year, but the compensation committee certification (required under 162(m)) at that point should be a purely ministerial act this is OK under the all-events test. (But, you still need to consider the steps below other than step (4).) 4. If step (3) is not available to you, for example because there are some aspects of the award that are subjective, the compensation committee probably will have to determine and certify before year-end that some level of the performance goals have been met, specifying a dollar level of payout to which the company is committed (probably at a conservative level based on projected results, such as 80% of the currently projected payout). Watch out the plan and award terms may have language that precludes taking this action (for example, stating that this determination has to be based on audited numbers, or stating that it will be made after the end of the performance year, etc.) Whether that language can be amended must be considered (don t amend

5 anything that affects grandfathered awards see Question 5 above). The compensation committee will require that management express a high degree of confidence as to full year results before it irretrievably commits to paying a high level of bonuses. 5. If a bonus pool approach is taken (as in the case where service-based vesting remains in place until a payout date in 2018), the resolutions should specify that any forfeited bonus amounts can only be reallocated to other participants the money cannot flow back to the company. No reallocation to a 162(m) covered employee can result in a payout beyond the 162(m) maximums or beyond the level earned based on the 162(m) performance goals. 6. The resolutions must waive any discretion that the committee (or board or company) could exercise in 2018 to reduce the funding pool. Here again, the plan or award terms may be inconsistent, preserving such discretion (usually only negative discretion in 162(m) plans) in language that arguably does not allow a waiver. Think broadly there may be other discretion that must be cut off by year end, such as the ability to make discretionary adjustments. Consider whether amending inconsistent plan or award language can fix the problem (but don t let the amendment disturb grandfathered awards see Question 5 above). 7. Be careful to identify the correct decision-maker(s) the compensation committee or the board to take the needed actions. Committee action is required for 162(m) matters. If a funding pool is created for a wider group of employees, carefully consider and specify what plans are covered and what subsidiaries or business units are covered. For farflung plans, the compensation committee or board may not be the true authorized decision maker, so documentation by others in management may be needed. 8. We have learned that, in examinations, the IRS may consider whether the company s year-end commitments have been communicated to participants, as a sign that there really was a commitment. 9. The above steps need to be taken by year end. Resolutions adopted earlier could allow the committee or board to revisit the issues up to the end of the year. 10. Any annual incentives or bonuses meant to meet the all-events test then have to be paid out by March 15.

6 11. We are a public company with a subsidiary that is a debt-only public company. Do the 162(m) changes pick up executives of our subsidiary who are not also executives of the parent company, such as the CFO? Apparently yes. Existing regulations treat a subsidiary with publicly held equity securities (usually common stock) as being separately subject to 162(m). If any subsidiary executives would first become subject to 162(m) in 2018, and their compensation levels could exceed $1 million, it may be advisable to pay out 2017 bonus in a way that qualifies it as deductible in Have any other 162(m) issues emerged from the tax bill? Yes. Companies with deferred tax assets or deferred tax liabilities will have to revalue those when the bill is signed. If that happens in 2017, the revaluation of deferred tax assets could result in a reduction in net income; revaluation of deferred tax liabilities could have a surprising and positive effect on net income. If net income (or earnings per share or other related items) are used as the performance goals for annual bonuses or long-term incentive awards, adjustments may be needed. However, 162(m) plans may limit the ability to make such adjustments. We have published a Short Take discussing this issue in more detail. Note: If the tax bill is signed in 2018, this problem should be largely avoided.