The Internal Revenue Service (the “IRS”) recently issued Notice 2018-68 (the “Notice”) providing much-anticipated guidance on certain aspects of the “Tax Cuts and Jobs Act” (the “Act”) enacted in December 2017, which, among other things, expanded the scope of the deduction limit under Section 162(m) of the Internal Revenue Code (“Section 162(m)”). We discuss the Act in our December 2017 OnPoint, Focus on ERISA - Tax Reform Includes Benefits and Compensation Provisions, which outlines some of the key amendments to Section 162(m). Generally, Section 162(m) limits the amount of deduction by a public corporation for compensation paid to a “covered employee” for the applicable taxable year to US$1 million. The Act, among other things, expanded the definition of “covered employee” and removed exceptions to the deduction limit for commission and performance-based compensation. The Act also provided for transition relief for any “written binding contract” in effect as of November 2, 2017 that is not materially modified on or after such date.
Notably, the Notice provides some clarity to how the transition relief applies (or does not apply) in a variety of circumstances. One key example provided in the Notice indicates that a bonus plan that reserves the employer’s ability to exercise unfettered negative discretion is tantamount to there being no “written binding contract,” regardless of whether such discretion is actually exercised, because the employer could essentially choose to pay nothing under such bonus plan even if certain objective performance goals are satisfied. This approach would seemingly (but arguably not unexpectedly) eliminate from any transition relief arrangements providing Compensation Committees with so-called “negative discretion” that has no limits. The Notice also clarifies that a written binding contract that is renewed after November 2, 2017 is not eligible for the transition relief and describes a number of arrangements that would be treated as being renewed (such as an employment agreement that is automatically renewed unless either party to the agreement provides a notice of non-renewal).
With respect to the “covered employee” definition under the amended Section 162(m), the Notice clarifies that an employee who otherwise meets the definition of a “covered employee” does not need to be serving as an executive officer at the end of the corporation’s taxable year. In addition, for purposes of Section 162(m), the amount of compensation used to identify the three most highly compensated executive officers is determined using the SEC rules. The Notice further clarifies that any “covered employee” for the taxable year beginning after December 31, 2016 (as determined pursuant to Section 162(m) prior to the Act’s effective date) will continue to be a “covered employee” for taxable years beginning in 2018 and beyond.
While the IRS’s approach in the Notice is not necessarily surprising it does serve to limit significantly the ability to rely on the Act’s transition relief for many common compensation arrangements. The Notice offers limited initial guidance and the IRS anticipates issuing further guidance in the form of proposed regulations, which will incorporate the guidance provided in the Notice as well as address other key questions, such as, for example, how certain covered employees should be identified for a public corporation whose fiscal year does not coincide with its taxable year.
The issues addressed in the Notice will apply to any taxable year ending on or after September 10, 2018.