The Internal Revenue Service (IRS) has issued Notice 2018-68 (Notice) providing guidance on changes in Code Section 162(m) made by the Tax Cuts and Jobs Act of 2017 (TCJA), Public Law 115-17. The Notice has some good news and some not-so-good news, but on balance is helpful, particularly in continuing to respect state law in identifying a “written binding contract” under the grandfather rules.
Overview of Section 162(m) and Notice 2018-68
Section 162(m) sets a $1 million cap on the deduction for compensation paid by a publicly held corporation to a “covered employee.” As in effect before amendment by the TCJA, Section 162(m) excluded performance based compensation from the $1 million cap, including stock options, stock appreciation rights, and amounts paid under incentive plans.
The TCJA amended Section 162(m) to delete the exception for performance-based compensation and to expand the definitions of “covered employee” and affected public corporations, effective for taxable years beginning after December 31, 2017. A grandfather applies to amounts paid pursuant to a “written binding contract” in effect on November 2, 2017, and not materially modified thereafter. Grandfathered amounts are deductible under pre-TCJA law.
The Notice provides guidance on the TCJA definition of “covered employee” and on the scope of the grandfather rules, effective for taxable years ending on or after September 10, 2018 (provided also, of course, that the taxable year began after December 31, 2017).
Amended Definition of Covered Employee
Prior Law and Amendment
Before the TCJA, Section 162(m)(3) defined a “covered employee” as any employee of the taxpayer who on the last day of the taxable year was (1) the CEO, or an employee acting as the CEO; or (2) an employee whose compensation was required to be reported to shareholders under the Securities Exchange Act of 1934 (Exchange Act) by virtue of being one of the three highest compensated executive officers for the taxable year (other than the CEO or CFO). The pre-TCJA Section 162(m) cap did not apply to any individual who was not employed by the taxpayer on the last day of taxable year, and never applied to the CFO. The cap also did not apply to individuals who would be covered employees except for the fact that their compensation was not required to be disclosed to shareholders, for example, because of a short taxable year resulting from a mid-year acquisition.
TCJA: Confusion and Clarification
The TCJA amended the definition of “covered employee” in numerous respects. As interpreted by the Notice, a covered employee is
- Any individual who serves as the CEO or CFO at any time during the taxable year.
- The three highest-paid executive officers during the taxable year (other than the CEO and CFO). The Notice deletes the end-of-year rule for these individuals. Under the Notice, Section 162(m) applies if the individual was among the 3 highest paid executive officers during the taxable year even if no longer employed on the last day of the taxable year, and even if the individual’s compensation is not required to be reported to shareholders under the Exchange Act for the fiscal year. The Notice instructs that the amount of “compensation” paid to an individual for this purpose is to be determined in a manner consistent with applicable SEC reporting guidance (instructions to Items 402(a)(3) and 402(m)(3)). Eliminating the end-of-year rule will identify the same category of employees as the prior law rule in many, but not all, cases. In many instances the highest-paid executive in any year may have had the same status in the prior year. But the new rule will in addition pick up any executive whose income spikes in one year—for example, an executive with a rich termination package in a termination year—who otherwise might never have been a covered employee.
- Any individual who was a covered employee in 2017 or later. Under the “once a covered employee always a covered employee” rule enacted by the TCJA, compensation paid to or on behalf of an individual who was a covered employee in 2017 or later is subject to the $1 million cap. For example, compensation paid in any year after the death of an individual who was the company’s CEO any time in 2018 is subject to the $1 million cap. The Notice clears up one puzzle under the new law, and clarifies that, for purposes of identifying who was a covered employee in 2017, pre-TCJA law applies. For example, an individual who was the company’s CFO in 2017—but is not a “covered employee” in 2018 under the TCJA—is not subject to the “once a covered employee always a covered employee” rule, because the 2017 CFO was not a covered employee under Section 162(m) as in effect during 2017. By contrast, however, an individual who was the company’s CEO on the last day of the company’s taxable year ended December 31, 2017, would be subject to the rule, because the CEO was a covered employee under the law in effect on that date.
The Notice clarifies that any individual who during the year is the CEO or CFO or among the highest-paid executive officers for the year (other than the CEO or CFO) is a covered employee, regardless of whether the individual’s compensation is required to be disclosed in the proxy for the company’s last completed fiscal year. For example:
- If the company’s taxable year does not end on the same date as its last completed fiscal year (for example, following a corporate transaction), the taxpayer must identify the CEO, CFO, and three highest-paid executive officers during the taxable year as covered employees.
- For purposes of identifying the three highest-paid executive officers for a taxable year that does not end on the same date as the completed fiscal year, the Notice requests comments on the application of SEC disclosure rules. Before the issuance of additional guidance, the Notice instructs taxpayers to follow a “good faith reasonable interpretation” of current guidance.
- An individual who satisfies the requirements of the Notice is a “covered employee” of a smaller reporting company or emerging growth company, even if not all individuals identified as covered employees for Section 162(m) purposes are required to be included in the proxy disclosure.
Section IV of the Notice provides that the guidance in the Notice will apply to any taxable year on or after September 10, 2018, and that any future guidance on the definition of “covered employee” will be prospective only. Taxpayers may thus rely on the Notice without concerns about retroactive amendment by future regulations.
Written Binding Contract
Section 13601(e)(2) of the TCJA provides grandfather protection to remuneration provided under a written binding contract in effect on November 2, 2017, that is not materially modified thereafter. The Notice explains this standard as follows:
Remuneration is payable under a written binding contract that was in effect on November 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.
Accordingly, amounts are grandfathered if paid pursuant to an enforceable contract under state contract law. The Notice is consistent with regulations governing the identically worded transition rule for Section 162(m) as initially enacted by the Omnibus Budget Reconciliation Act of 1993 (OBRA). Regulation Section 1.162-27(h) states that the OBRA grandfather did not apply “unless, under applicable state law, the corporation is obligated to pay the compensation if the employee performs services.”
The Notice states that the grandfather also applies to remuneration required to by paid by other “applicable law.” This presumably includes the federal common law of contracts under ERISA, applicable to SERPs and other nonqualified pension plans. Whether “other applicable law” includes law that might compel payment outside of the contract—for example, promissory estoppel or other equitable principles—is not clear.
The Notice has generated confusion about the impact of “negative discretion” on the grandfather rule. It is not unusual for a performance incentive plan to state that awards will be paid to participants upon the occurrence of stated corporate performance metrics, subject to the company’s discretion to reduce such amounts.
Our view is generally that negative discretion should not prevent the grandfather from applying unless the discretion is so broad as to render the promise illusory and the purported contract unenforceable. The question comes down to state contract law (or federal common law, in the case of nonqualified pension plans like SERPs).
Much of the confusion has been generated by Example 3 under Part III.B. of the Notice. Under Example 3, an executive is entitled to a maximum payment of $1.5 million under a performance-based plan. The example states that the compensation committee has the discretion to reduce the bonus to $400,000 “if in its judgment other subjective factors warrant a reduction.” Example 3 further states that the plan “constitutes a written binding contract to pay $400,000.” Under the example, the committee exercises its discretion to reduce the payment to $500,000. The example concludes that of the $500,000 paid, only $400,000 is grandfathered, and $100,000 is not.
This example has been cited as possible evidence that “negative discretion” will prevent the grandfather from applying in almost all situations. In our view, this analysis is off the mark. It is expressly assumed in Example 3 that the amount subject to negative discretion (the amount in excess of $400,000) is not part of the “written binding contract.” Accordingly, Example 3 illustrates only what the general rule has already stated: amounts not paid pursuant to a written binding contract are not grandfathered.
If we analyzed an actual contract under actual state law, a different answer might result. For example, assume the plan states that the company reserves the right to reduce the bonus below $1.5 million under certain enumerated business conditions. In many states, this discretion does not render the promise illusory, but rather creates an enforceable contract as to the full $1.5 million if those enumerated business conditions do not exist. To reduce the bonus below the $1.5 million amount, the company is contractually obligated to determine that the enumerated business conditions have occurred. Its determination is subject to an abuse of discretion standard and the doctrine of “good faith and fair dealing” in many states.
If we change the assumption so that the plan states: “The company reserves the right at its sole discretion to reduce the bonus to $400,000 for any reason or no reason,” even this broader discretion requires analysis of the entire plan under applicable state law to determine whether the $1.5 million promise is enforceable. For example, if the performance metrics are set forth with specificity and communicated to participants in advance of services being performed, particularly where employees have been performing services for years and there has been no past history, or current expectation, of the exercise of negative discretion, under the contract law of some states, an enforceable contract is created as to the entire $1.5 million and the company’s discretion to reduce is bounded by the implied duties of good faith and fair dealing. Under the contract law of other states, however, courts might find that the promise is illusory as to amounts in excess of $400,000.
Moreover, Example 3 is highly unrealistic in an important respect. An incentive compensation plan like the plan in Example 3, with a minimum guaranteed amount of $400,000 (or any other dollar amount), is highly unusual. A typical plan would promise a bonus of, for example, $1.5 million if certain business goals are met, with company discretion to reduce the full amount with no lower limit. In that case, the company would look at plan provisions, participant communications, and past practice to determine whether the entire $1.5 million is subject to an enforceable contract under applicable contract law.
The Notice also addresses whether increases in the amounts promised pursuant to written binding contract in effect as of November 2, 2017—including increases attributable to earnings and cost of living increases—are grandfathered.
Earnings on grandfathered amounts are grandfathered if the participant’s right to earnings is guaranteed by a written binding contract in effect on November 2, 2017. In Example 2 of Section II.B. of the Notice, an employee elects to defer the amount otherwise payable to the employee under the 2016 annual bonus plan, to be paid in a lump sum at separation from service, plus earnings at a stated rate. Example 2 concludes that the 2016 bonus amount, plus earnings are grandfathered. The earnings in Example 2 are based on a predetermined actual investment. It is not entirely clear whether the grandfather applies only to earnings both promised by a contract in effect on November 2, 2017, and based on a predetermined actual investment as in Example 2 (or a reasonable rate of interest). The better argument is that the grandfather should apply to any earnings after November 2, 2017, if the rate of earnings is guaranteed by a written binding contract in effect as of November 2, 2017, even if the rate of earnings is arguably “unreasonable” or untethered to a predetermined actual investment. While supported by the better argument, this position is not expressly supported by Example 2 of Section II.B of the Notice.
If earnings are not guaranteed by a contract in effect as of November 2, 2017, they are not grandfathered. Examples 4 and 5 in Section II.B. suggest that if a company has discretion to eliminate crediting future earnings, such that earnings are not subject to a written binding contract under applicable law, such earnings are not subject to grandfather protection.
If earnings are not grandfathered, the issue is whether any increase to the grandfathered amount based on earnings accrued after November 2, 2017, constitutes a “material modification” that invalidates the entire grandfather protection. Notice 2018-68 addresses this issue by expressly stating that earnings added to grandfathered amounts are not a material modification if based on a “reasonable rate of interest” or a “predetermined actual investment.”
For example, assume a typical nonqualified 401(k) plan, in which notional earnings are credited to track actual earnings in actual investment funds, and the plan sponsor has the right to change the benchmark investment funds as to future earnings. Based on Notice 2018-69, it would appear that in this instance the earnings on the grandfathered account balances are not themselves grandfathered. However, a change in the earnings benchmark should not constitute a material modification, as long as plan earnings are based on a reasonable rate of interest or the earnings on a predetermined actual investment fund, and so the change should not jeopardize the grandfather for the account balance as of November 2, 2017.
The Notice further clarifies that an increase in a grandfathered amount is not a “material modification” if it is based on a “reasonable” cost of living increase. In Example 10 of Section II.B, a $40,000 increase in a grandfathered amount is not a “material modification” and therefore does not jeopardize the grandfather, because it is based on a reasonable cost of living increase. While not jeopardizing the grandfather, however, the $40,000 increase is not itself grandfathered and is itself subject to the deduction limitations of Code section 162(m). While not stated in Example 10, it may presumably be inferred that, were a cost of living increase guaranteed in the contract in effect as of November 2, 2017, the $40,000 increase would also be exempt from the $1 million cap of Section 162(m). (Confusingly, Example 10 describes the deduction for the $40,000 cost of living increase as “disallowed” even though it is nowhere stated that compensation exceeds $1 million. Presumably later guidance will clarify this).
If there is a non-grandfathered increase in a grandfathered amount, and the increase does not constitute earnings based on a reasonable interest rate or a predetermined actual investment, or a reasonable cost of living increase, the increase is a “material modification” and generally causes grandfather protection to be lost for the entire underlying amount. Specifically, the increase forfeits the grandfather if paid on the basis “of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract.”
For example, in Example 10 of Section II.B, the increase to a grandfathered salary amount in excess of a reasonable cost of living increase forfeits the grandfather as to the entire salary amount because the increase is based on “substantially the same elements or conditions” as the guaranteed salary amount.
In contrast, Example 11 states that providing an equity grant instead of an increase in salary would not jeopardize grandfather protection for the salary amount, because the equity grant is not paid on the basis of substantially the same elements or conditions as the salary. Rather, the equity grant is paid on the basis of both the stock price and the employee’s continued service.