On August 21, the IRS issued Notice 2018-68 to provide guidance on changes to Internal Revenue Code Section 162(m), enacted by the Tax Cuts and Jobs Act of 2017 (TCJA). Section 162(m) generally limits the tax deduction available to public companies for compensation paid to certain executives to $1 million per year, per executive.
As discussed in our previous alert, Section 162(m), as amended by the TCJA, generally eliminated the performance-based compensation exemption to the $1 million per executive limit. However, it provided a transition rule under which compensation payable under a written binding contract that was in effect on November 2, 2017 and that is not materially modified after that date (Grandfathered Compensation) would not be subject to Section 162(m), as amended by the TJCA. The revisions to Section 162(m) also expanded the set of executives whose compensation is subject to the $1 million limit (Covered Employees) and broadened the definition of publicly held corporations that are subject to the $1 million limit. The Notice provided at least some insight into each of these areas.
The Notice provides guidance on what is considered a written binding contract and what will be considered a material modification to such a contract for purposes of determining Grandfathered Compensation. The Notice makes clear that a $1 million base salary paid to a CEO pursuant to a written agreement from 2016 would not be considered Grandfathered Compensation because base salary of a CEO would not have been exempt under the old Section 162(m) rules. However, base salary under the same 2016 contract with a CFO would be exempt because the CFO would not have been a Covered Employee under the old rules. That said, renewal provisions in executive compensation arrangements of Covered Employees should be examined closely to determine if, and for how long, a given arrangement would retain its grandfathering. Also, the Notice makes clear that care should be taken in amending any grandfathered arrangement to determine that the amendment is not a material one that would eliminate otherwise Grandfathered Compensation. For example, if a restricted stock unit award agreement would have been considered performance-based compensation under prior law and it is either materially modified or the company uses retained negative discretion to reduce the amount that would otherwise have been delivered under the applicable performance condition, the entire restricted stock unit grant may no longer be considered exempt Grandfathered Compensation.
Another big takeaway from the Notice is that rules of the Securities and Exchange Commission (SEC) will not, unless otherwise specifically noted in Section 162(m), be dispositive in determining whether a particular executive is a Covered Employee. For example, smaller reporting companies are generally required by the SEC to list a principle executive officer and only the two other highest-paid officers; nonetheless, the Notice makes clear that, even if not required to be reported by SEC rules, the principle executive officer, the principle financial officer and the next three highest-paid officers will now be considered Covered Employees.
With respect to companies that are subject to Section 162(m), pursuant to the Notice, a public company that does not file a proxy statement in a given year (for example due to a going-private transaction or de-listing) would still be subject to Section 162(m) for that year. The Notice also provided some clarity as to the results in the year of acquisition under Section 162(m) in certain other corporate transactions.
While the guidance is certainly helpful in addressing some of questions raised by the TCJA in this space, the IRS reserved on certain other issues, including the applicability of Section 162(m) to foreign private issuers and the application of Section 162(m) to companies that have recently gone public, such as through an initial public offering. The IRS anticipates that the guidance in the Notice will be incorporated into future regulations that will apply to taxable years ending on or after September 10, 2018.