Today, we will discuss the vexing issue of annual or long-term incentive plans that were made before November 2, 2017, and that satisfied the performance-based compensation requirements of pre-Tax Cuts and Jobs Act of 2017 (TCJA) provisions of 162(m), but reserved to the company or the compensation committee the ability to exercise “negative discretion” to reduce the incentive payout indicated by the formula. Pursuant to pre-TCJA Section 162(m), many performance-based compensation plans and agreements included the discretion to reduce (but not increase) payouts of incentive compensation such as annual performance bonuses and performance share awards. Notice 2018-68 indicated that the existence of such discretion could reduce or even eliminate the amount of compensation that a company is obligated to pay pursuant to a written binding contract, thus reducing or even eliminating the amount of the incentive compensation that remains exempt under the grandfathering provisions from the $1 deductibility limit of Section 162(m).

This was surprising, given that the existence of negative discretion provisions in compensation plans and agreements was attributable to the pre-TCJA Section 162(m). That is, IRS created the incentive for companies to add it – and now it is punishing companies for having added it. Executive compensation professionals urged that, consistent with fairness and common sense, these negative discretion provisions generally be disregarded in determining the amount of compensation a company is obligated to pay pursuant to an otherwise grandfathered contract. Unfortunately, the proposed regulations did not adopt this approach.

However, the preamble to the proposed regulations includes an interesting and potentially important statement. “The Treasury Department and the IRS are aware, however, that compensation arrangements may purport to provide the corporation with a wider scope of negative discretion than applicable law permits the corporation to exercise. In that case, the negative discretion is taken into account only to the extent the corporation may exercise the negative discretion under applicable law.” [Emphasis added.] Therefore, some performance-based awards that reserve to the board or compensation committee the right to reduce individual or group payouts below the target levels actually achieved, still may be protected by the grandfathering provisions of the statute.

Believe it or not, we are less than one-half way the important issues addressed by the new Proposed Regulations issued by IRS and the Treasury Department on the changes to Code Section 162(m) made by the TCJA. I will continue by focusing on one aspect of the proposed regs at a time.