On August 21, 2018, the IRS issued its initial guidance on the amendments to Section 162(m) made by the Tax Cuts and Jobs Act, in the form of Notice 2018-68. The guidance is fairly limited and does not completely address some of the questions it takes on. Notably, the guidance on what compensation will not be subject to the amended Section 162(m) under the grandfather rule may be very restrictive with respect to performance-based compensation that is subject to negative discretion, depending on the extent to which that discretion may be exercised under applicable law.
As a reminder, Section 162(m) limits the deduction for compensation paid to certain employees of companies with publicly traded equity or debt (“covered employees”) to $1 million per year. Among other things, the amendments to Section 162(m) eliminated the exception from that limitation for performance-based compensation and redefined covered employees so that once an employee becomes a covered employee, he or she remains one, even after termination of employment. Similar to Section 162(m) as originally enacted, the amendments provide for grandfathering of compensation paid pursuant to a “written binding contract” in effect on November 2, 2017 that is not modified in any material respect. The key areas addressed by the guidance are how covered employees are identified and what compensation will be eligible for grandfathering.
The Notice is quite clear with respect to identifying covered employees. Identification of covered employees is now divorced from the SEC compensation reporting requirements, except that the amount of compensation used in identifying covered employees is determined in the same way as for SEC reporting purposes. Under the new rules, covered employees for a year include anyone who was a principal executive officer (PEO) or chief financial officer (CFO) at any time during the year and the three other executive officers who had the highest compensation, regardless of whether they were employed on the last day of the year or whether their compensation was required to be reported. In addition, any covered employees from previous years, beginning in 2017, would also be covered employees. For purposes of determining those prior year covered employees for 2017, the Notice helpfully clarifies that the rules in effect prior to the 162(m) amendments apply. The Notice also addresses identification of covered employees when a public company has a short tax year differing from its fiscal year due to a transaction.
The guidance on grandfathered compensation is not as clear, perhaps because identifying compensation a company might be required to pay an executive under a contract is a matter of contract law. For instance, the examples provided make it clear that compensation will not be considered paid pursuant to a written binding contract to the extent the company could have lawfully exercised its discretion to pay less. In Example 3 of Section III.B. of the Notice, the arrangement, which would qualify as performance-based under Section 162(m), provided that if a specific performance goal were met, the company could pay out as much as $1.5 million, but could use its discretion, based on subjective factors, to pay out as little as $400,000 to a covered employee. The company paid out $500,000, and the IRS concluded that only $400,000 would be considered grandfathered. It is important to note that it is not completely clear that the absence of a minimum payment amount would mean that no compensation would be considered payable pursuant to a written binding contract; that is a matter of applicable law (e.g., state contract law). Example 3 states as a fact that the employer had the ability under applicable law to exercise discretion to pay out as little as $400,000. This leaves open the possibility that, under applicable law, even with discretion in the written compensation agreement to pay nothing when performance goals are met, the employer might be required to exercise available discretion under the contract pursuant to a duty of good faith and fair dealing, which might mean that some amount would be considered to be payable pursuant to a written binding contract. The Notice applies the same analysis to whether earnings on a deferred payment would be grandfathered: the lawful exercise of discretion to eliminate earnings credits would take the earnings out of grandfathered status. Although many deferred compensation contracts include such discretion, there may be other provisions in the arrangement that could be read to override certain exercises of such discretion, or applicable law might require the exercise of discretion be in good faith.
One troubling part of the Notice’s discussion of grandfathering concerns material modifications, which can eliminate grandfathered status for compensation. The Notice, similar to the guidance provided for Section 162(m) as initially enacted, provides that a material modification is one that increases the compensation payable under an otherwise grandfathered agreement, and indicates that acceleration or delay of payment, so long as the payment is appropriated reduced if accelerated and is not increased beyond a stated interest rate, fixed index or similar objective investment rate of return, will not be a material modification. However, the examples do not clearly address compensation paid pursuant to an existing written binding contract that is deferred past termination of employment, where the contract is later materially modified. Example 2 of Section III.B. of the Notice allows deferred compensation that is otherwise grandfathered (a bonus earned in 2016), to be paid in 2020 without being subject to the deduction limits of amended Section 162(m). However, in Example 10 of Section III.B., an amendment to an otherwise grandfathered employment agreement that provides for a large increase in compensation (a material modification) causes any payments made pursuant to that contract after the amendment to be subject to the new Section 162(m) rules. This Example should be clarified to address that amounts paid pursuant to the terms of the contract prior to the amendment but paid after the amendment (whether deferred or simply paid after the amendment under normal practices) can retain grandfathered status.
Treasury and the IRS acknowledged the limited nature of the guidance provided and requested comments on additional issues to be addressed by guidance. Treasury and the IRS anticipate that the guidance in the Notice will incorporated into proposed regulations, which will provide additional guidance.