As previously discussed here, Section 162(m) of the Internal Revenue Code, as amended (the “Code”), limits the deductibility of compensation paid by publicly traded employers to $1 million for any covered employee. As also discussed in our prior alert, Code Section 162(m) was amended at the end of 2017 to make substantial changes, including expanding the definition of public company, modifying the scope of covered employees, eliminating the performance-based compensation and commission exceptions; and exempting from the new rules certain “grandfathered plans”.

The question of what constitutes a grandfathered plan and when a contract is materially modified such that it can no longer benefit from the grandfathering rule (and thereby becomes subject to Code Section 162(m), as modified) remained largely open – and subject to much guesswork in the executive compensation community – until recently issued IRS guidance (Notice 2018-68, which was released last week).

Notice 2018-68 contains a brief description of the grandfathered rules (which is marginally helpful) as well as eleven examples focused on the topic (which are more helpful, but not incredibly favorable to employers). For example, only by reading the examples does it become clear that amounts subject to negative discretion (the ability of the employer to unilaterally decide to reduce compensation) will not be considered grandfathered.

As reiterated in this new guidance, the starting place for any grandfathering analysis is the determination of whether there was a written binding contract in effect on November 2, 2017, that created a legal obligation on the company under any applicable law (for example, state contract law) to pay the compensation under such contract if the employee performs services or satisfies the applicable vesting conditions.

Assuming there is a legally binding obligation to pay the compensation existing as of the requisite date, the next step is to determine if/when the contract has been materially modified. Recall, the grandfathering protection for legally binding plans and/or agreements is applicable only until such contracts are materially modified. A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee (with special rules to determine whether an acceleration or deferral of payment results in an increase in the amount of compensation). Again, the rule appears simple as written, but is very complicated in application as demonstrated by the examples in the Notice. For example, a provision that automatically renews or extends an employment agreement will generally be treated as a material modification.

Given the intricacies of the material modification provisions (and the nuances embedded in the eleven examples), employers would be best served to check with their executive compensation legal counsel if/as any change is made to executive compensation agreements (e.g., employment agreements, severance agreements, non-qualified deferred compensation plans). Note, this is a case where it behooves an employer to be overly cautious (better safe than sorry) because even small changes may trigger the cessation of grandfathered status.

Notice 2018-68 also addresses the definition of “covered employee” in some detail. Again, the examples are more helpful than the written description of the rule, but the key take-aways are: (1) that the SEC’s rules do not serve as the sole basis for interpreting Section 162(m), and (2) under certain circumstances, executives can be covered employees even when disclosure of their compensation is not required under the SEC rules.