On December 16, 2019, the Department of the Treasury (Treasury Department) and Internal Revenue Service (IRS) released long-awaited proposed regulations under Section 162(m) of the Internal Revenue Code implementing changes made by the Tax Cuts and Jobs Act (TCJA). The TCJA changes were generally effective for taxable years beginning after December 31, 2017, and these proposed regulations provide much-needed guidance to employers and their advisors.
Section 162(m) disallows the deduction by a “publicly held corporation” for certain compensation paid to a “covered employee” to the extent that the compensation for the year exceeds $1 million. The TCJA amended the definitions of publicly held corporation and covered employee and expanded the types of compensation that are subject to the deduction limit (primarily by eliminating the exception for performance-based compensation and commissions). It also provided that these changes would not apply to compensation paid pursuant to a written binding contract that was in existence on November 2, 2017, and that was not materially modified after that date (generally known as the grandfathering rule).
On August 21, 2018, the Treasury Department and IRS issued Notice 2018-68 (the Notice), which provided interim guidance on the grandfathering rule and changes to the definition of covered employee. Significantly, the Notice interpreted the grandfathering rule narrowly. Under the Notice, an amount is paid pursuant to a written binding contract that was in effect on November 2, 2017, only to the extent that applicable law (generally state law) would require the employer to pay the amount under a written contract in place on that date. If the employer has discretion not to pay an amount (or is not otherwise legally obligated to pay the amount), then the amount generally is not grandfathered under the Notice.
The proposed regulations provide guidance on the following topics, among others
- the grandfathering rule,
- changes to the definition of publicly held corporation,
- changes to the definition of covered employee, and
- changes to the definition of the compensation subject to the deduction limit.
Although many stakeholders asked the Treasury Department and IRS to relax the grandfathering standard set out in the Notice, the proposed regulations adopt the rule in the Notice without change. The preamble explains that the Treasury Department and IRS considered requests to (i) grandfather amounts based on compensation costs accrued under Generally Accepted Accounting Principles (GAAP) and (ii) ignore any discretion that an employer might not have to pay an amount (often referred to as negative discretion), but these proposals were rejected.
The position taken in the proposed regulations on the grandfathering rule is disappointing. The application of state law to compensation agreements can require time-consuming, fact-intensive analysis, and it can lead to inconclusive and inconsistent outcomes, depending on the applicable state law. The proposed rules, however, do provide some helpful examples on how to apply the grandfathering rule to different types of arrangements, including multi-year employment agreements, severance agreements, bonus plans, clawback policies, account-balance and non-account balance deferred compensation plans and equity compensation plans. They also clarify that earnings in an account-balance arrangement that accrue after the earliest date on which the arrangement could be amended to reduce or eliminate earnings (or the earliest date on which the entire arrangement could be terminated in accordance with its terms and applicable law) are generally not grandfathered.
The proposed rules also include additional guidance on when a written binding contract is materially modified for purposes of the grandfathering rule. While the regulations adopt the basic standard in the Notice – that is, that a contract is materially modified if it is amended to increase the amount of compensation payable – they offer some new rules that are generally helpful to employers. First, they provide that an amendment to a written binding contract accelerating the vesting of restricted stock, stock options, stock appreciation rights or other compensation arrangements generally will not be treated as a material modification for purposes of the grandfathering rule.
Second, the regulations propose an ordering rule for payments that consist partly of grandfathered amounts and partly of non-grandfathered amounts. Under this rule, if amounts payable under a nonqualified deferred compensation plan include both grandfathered amounts and amounts that are not grandfathered, and the amounts are payable in installments (rather than a lump sum), the amounts paid first will be treated as grandfathered, up to the total amount grandfathered under the plan. The amounts not grandfathered will be treated as paid only after all grandfathered amounts are paid.
Publicly Held Corporations
Before the TJCA, Section 162(m) defined a publicly held corporation as any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act). The TCJA expanded that definition to include (i) a corporation with any class of securities (not just common equity securities) required to be registered under Section 12 of the Exchange Act and (ii) a corporation that is required to file reports under Section 15 of the Exchange Act.
Based on the legislative history of the TCJA, the proposed regulations provide that an S corporation, a qualified subchapter S subsidiary (a QSub), a foreign private issuer1 and a publicly traded partnership can be publicly held corporations for purposes of Section 162(m) if they issue securities required to be registered under Section 12 of the Exchange Act or are required to file reports under Section 15 of the Exchange Act. Likewise, the proposed regulations provide that a corporation that owns a disregarded entity is a publicly held corporation if the disregarded entity issues securities required to be registered under Section 12 of the Exchange Act or is required to file reports under Section 15 of the Exchange Act. The proposed regulations also include a variety of rules to prevent companies from using partnership structures to avoid being subject to Section 162(m).
Although the proposed rules take an expansive view of the types of entities that can be publicly held corporations, they emphasize that only an entity that is required to register its securities under Section 12 or file reports under Section 15 of the Exchange Act is a publicly held corporation. An entity that registers securities or files reports voluntarily is not a publicly held corporation. Likewise, an entity is not a publicly held corporation if its filing requirement is suspended, automatically or otherwise.
The proposed regulations, like the current regulations under Section 162(m), provide that a publicly held corporation includes an affiliated group of corporations as defined in Section 1504 (without regard to Section 1504(b), meaning that foreign entities are generally included in the affiliated group). However, unlike the current regulations, the proposed regulations specifically provide that a publicly held corporation includes a privately held parent if it has a publicly held subsidiary. The current regulations are silent on this issue. The proposed regulations also provide that, if an affiliated group includes two or more publicly held corporations, Section 162(m) applies separately to each of the publicly held corporations.
The proposed regulations, like the current Section 162(m) regulations, also provide that an entity’s status as a publicly held corporation is determined as of the last day of the entity’s table year. Accordingly, whether an entity is a publicly held corporation depends on whether it is required to register securities under Section 12 or file reports under Section 15 of the Exchange Act as of the last day of its taxable year.
Before enactment of the TCJA, the covered employees of a publicly held corporation included (i) its chief executive officer (or an individual acting in that capacity) and (ii) the employees whose total compensation for the taxable year was required to be reported to shareholders under the Exchange Act because the employees were among the four highest compensated employees for the taxable year (other than the chief executive officer). Due to the wording of the statute and certain changes in the Exchange Act reporting rules, this definition did not include the chief financial officer as a covered employee.
The TCJA expanded the definition of covered employee to include (i) any employee serving as the principal executive officer at any time during the taxable year or individual acting in that capacity (PEO), (ii) any employee serving as the principal financial officer at any time during the taxable year or individual acting in that capacity (PFO), (iii) any employee whose compensation for the taxable year is required to be reported to shareholders under the Exchange Act because the employee is among the three highest compensated officers for the taxable year (other than the PEO and PFO) and (iv) any individual who was a covered employee of the publicly held corporation (or a predecessor) for any preceding taxable year beginning after December 31, 2016.
The proposed regulations, like the Notice, take the position that a covered employee includes any individual who is among the three highest compensated officers for a taxable year (other than a PEO and PFO) even if the employee’s compensation is not required to be reported to shareholders under the Exchange Act. The regulations also provide that covered employees are not limited to individuals who were employees on the last day of the taxable year. Under the proposed regulations, an individual would be a covered employee if he or she meets the requirements to be a covered employee at any time during the taxable year. The compensation used to identify the three highest compensated officers is determined under the rules for Exchange Act reporting.
Although the proposed regulations generally define covered employees broadly, they emphasize that only the executive officers of a publicly held corporation can be covered employees. Whether an individual is an executive officer is determined under the Exchange Act rules.
The proposed rules emphasize that a person who is a covered employee for a taxable year remains a covered employee for all future taxable years, even if the employee terminates employment. Accordingly, a former employee can be a covered employee under the new rules.
The proposed regulations also include detailed rules for determining when a publicly held company is a “predecessor.” As noted above, a covered employee includes an individual who was a covered employee of the publicly held corporation “(or any predecessor)” for a taxable year beginning after December 31, 2016. The proposed regulations provide that a publicly held corporation is a predecessor if it was previously a publicly held corporation, then went private, and then becomes publicly held again within a specified period of time. The proposed rules also describe when a publicly held corporation is treated as a predecessor in the context of a corporate reorganization, a corporate division, a stock acquisition and an asset acquisition.
Compensation Subject to Deduction Limit
Before enactment of the TCJA, the compensation subject to the deduction limitation under Section 162(m) was defined as the total amount of compensation allowable as a deduction for the taxable year, but excluding any compensation paid as a commission and performance-based compensation. The TCJA eliminated the exceptions for commissions and performance-based compensation, and added a rule clarifying that the deduction limit applies to the compensation of a covered employee, even if it is paid to a person other than the covered employee, including after the death of the covered employee.
As noted above, the proposed regulations include rules intended to prevent the use of partnerships to avoid the deduction disallowance under Section 162(m). In this regard, the proposed regulations include new rules for determining the compensation subject to the deduction disallowance when a partnership pays compensation to the covered employee of a publicly held corporation. Under these rules, the publicly held corporation must take into account its distributive share of the partnership’s deduction for compensation expense paid to the corporation’s covered employee and aggregate that distributive share with the corporation’s otherwise allowable deduction for compensation paid to the covered employee. Importantly, the proposed rules provide some limited transition relief for this rule. Under the proposal, this rule would not apply to compensation paid pursuant to a written binding contract in effect on December 20, 2019, that is not materially modified after that date.
The regulations are generally proposed to apply to compensation that is otherwise deductible for taxable years beginning on or after the date that final regulations are published. However, a number of key provisions, including the grandfathering rule, are proposed to be effective as of September 10, 2018, the date on which the Notice was published. Other key provisions are proposed to be effective on the date that these proposed regulations are published in the Federal Register. Taxpayers are permitted to rely on the proposed rules immediately, provided that they apply the proposed rules consistently and in their entirety.