It is a hard and fast rule in tax law that deductions for salaries and pay packages are limited to "reasonable compensation." What is reasonable depends on the situation. The owner-employee of a small business has different responsibilities from the CEO of a large multinational company. The Tax Cuts and Jobs Act imposed a new limitation on the deduction for compensation for publicly held corporations.

Basic dollar limit

A publicly held corporation cannot deduct more than $1 million in compensation for each covered employee. Prior to the TCJA, a covered employee was limited to the chief executive officer as of the end of the year and four of the most highly compensated employees of the corporation in addition to the CEO.

Before the TCJA, compensation for this limit included payments related to personal services other than commissions and performance-based payments. Compensation did not include contributions to qualified retirement plans (including salary reduction contributions) and tax-free fringe benefits, such as health coverage.

New excessive employee compensation rules

For a corporation's tax year beginning after December 31, 2017, covered employee includes an employee who is the principal executive officer (PEO) or principal financial officer (PFO) at any time during the year, as well as the three highest compensated officers for the year other than the PEO or PFO, or an individual acting in such capacity. And the category of covered employee also includes anyone who was a covered employee for any prior year beginning after December 31, 2016. Thus, the category of covered employee is no longer limited to five individuals; it can be more.

Also, the exclusion for commissions and performance-based payments has been repealed. Now, all payments--in cash or otherwise--that are paid for services are taken into account (other than retirement plan contributions and tax-free fringe benefits). There's also an exclusion for compensation payable under a contract that was binding on February 17, 1993, or compensation paid before a corporation became publicly traded.

Transition rule

Payments in excess of the $1 million can continue to be fully deductible under a transition rule. If there was a binding contract in effect on November 2, 2017, that is not modified after this date, then compensation won't be subject to the $1 million limit. The IRS has provided guidance on this transition rule.

Bottom line

For privately held businesses, compensation to top employees is deductible to the extent it is considered reasonable. For publicly held corporations, compensation to the expanded category of covered employees is subject to a $1 million limit, although payments under the transition rule are exempt from this limit.