The Internal Revenue Service (IRS) published proposed regulations on December 20, 2019, under Section 162(m) of the Internal Revenue Code (Code), which implement the amendments to Section 162(m) set forth by the 2017 Tax Cuts and Jobs Act (the 2017 Tax Act). The proposed regulations incorporate guidance provided by Notice 2018-68 that was published on August 21, 2018, and further clarify the definitions of the terms “publicly held corporation” and “covered employee” and the application of the grandfather rule under Section 162(m).

As a follow-up to our previous LawFlash, which analyzed the provisions of Notice 2018-68 in detail, we have outlined below key provisions of the proposed regulations.

Overview of Section 162(M) and the Proposed Regulations

Code Section 162(m) disallows a tax deduction by a publicly held corporation for a covered employee’s compensation to the extent that such compensation for the taxable year exceeds $1 million. Among other changes, the 2017 Tax Act amended Section 162(m) to remove the exception for performance-based compensation from the non-deductibility limit. The 2017 Tax Act also amended the definitions of “covered employee,” “publicly held corporation,” and “applicable employee remuneration” under Section 162(m). On August 21, 2018, IRS released Notice 2018-68 to set forth guidance on the amended rules. The December 20, 2019, proposed regulations incorporate most of the guidance provided in Notice 2018-68 and further elaborate on the key terms of Section 162(m), with a number of examples.

A 60-day comment period has commenced, and IRS will accept comments until February 18, 2020. Subsequently, a public hearing will be held on March 9, 2020, and suggestions for topics to be discussed at the hearing will be accepted until February 18, 2020.

Publicly Held Corporation

Prior to the 2017 Tax Act, Code Section 162(m)(2) defined “publicly held corporation” as a corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act). Under amended Section 162(m)(2), the definition of publicly held corporation has been expanded to include (i) a corporation with any class of securities (not limited to a class of common equity securities) that is required to be registered under Section 12 of the Exchange Act as of the last day of the corporation’s taxable year, and (ii) a corporation that is required to file reports under Section 15(d) of the Exchange Act as of the last day of the corporation’s taxable year. Thus, Section 162(m) now applies to many corporations that have not traditionally considered themselves “public.” As the proposed regulations make clear, a corporation is not considered publicly held if its obligations to file reports under Section 15(d) of the Exchange Act are suspended as of the last day of the corporation’s taxable year. Similarly, if a corporation voluntarily registers its equity securities under Section 12 of the Exchange Act but is not required to file reports under Section 15(d) of the Exchange Act, the corporation is not considered a publicly held corporation for purposes of Section 162(m).

The proposed regulations include detailed rules for determining when subsidiaries, foreign private issuers, publicly traded partnerships, affiliated groups, disregarded entities, and qualified Subchapter S subsidiaries are considered publicly held corporations for purposes of Section 162(m), based on whether the entity or a member of its affiliated group issues securities required to be registered under Section 12 of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act. Examples include:

  • Foreign private issuers: Foreign issuers often access the US capital markets by listing their securities in the form of American Depository Receipts (ADRs). Foreign issuers may be required to register their ADRs under Section 12 of the Exchange Act, which triggers the applicability of Section 162(m). In the event that a foreign issuer qualifies for an exemption under Rule 12g3-2(b) of the Exchange Act, such as because its ADRs are quoted on the Over the Counter Bulletin Board, such a foreign issuer is not considered a publicly held corporation for purposes of Section 162(m) (as long as it is not required to file reports under Section 15(d) of the Exchange Act). If a foreign issuer incorporates a subsidiary in the United States to issue debt securities that are guaranteed by the foreign issuer, both the foreign issuer and its subsidiary corporation will be treated as publicly held corporations because they are required to file reports under Section 15(d) of the Exchange Act.
  • Publicly traded partnerships: A publicly traded partnership that is treated as a corporation under Code Section 7704 is a publicly traded corporation subject to Section 162(m), if its securities are required to be registered under Section 12 of the Exchange Act or it is required to file reports under Section 15(d) of the Exchange Act as of the last day of its taxable year.
  • Subsidiaries that file reports under Section 15(d) of the Exchange Act: A subsidiary corporation that is owned by a publicly held corporation is considered a separate publicly traded corporation subject to Section 162(m) if the subsidiary is required to file reports under Section 15(d) of the Exchange Act. A publicly held parent corporation and its publicly held subsidiary will each have its own set of covered employees for purposes of Section 162(m), and the nondeductible amount is determined separately with respect to each publicly held corporation.
  • Affiliated groups: An affiliated group of corporations for whom a covered employee performs services must prorate the deduction disallowance under Section 162(m) based on the amount of compensation paid by each corporation (special rules apply when there is more than one publicly held corporation in the affiliated group).
  • Newly public companies: The proposed regulations eliminate the transition relief for a privately held corporation that becomes a publicly held corporation. The Section 162(m) limit applies to any compensation that is otherwise deductible for the taxable year ending on or after the date on which the corporation becomes a publicly held corporation, effective for corporations that become publicly held on or after December 20, 2019.
  • Disregarded entities: If a disregarded entity owned by a privately held corporation is an issuer of securities subject to the requirements of Section 12(b) or the entity is required to file reports under 15(d) of the Exchange Act, the privately held corporation is treated as a publicly held corporation for purposes of Section 162(m).

Covered Employees

The proposed regulations generally follow the guidance set forth in Notice 2018-68, which was analyzed in detail in our previous LawFlash, for determining covered employees.

A covered employee means the following:

  • Any individual who serves as the principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year.
  • The three highest compensated officers for the taxable year, excluding the PEO and PFO, determined pursuant to the rules under the Exchange Act, regardless of whether their compensation is required to be disclosed in the proxy for the last completed fiscal year. If the taxpayer’s taxable year does not end on the same date as its fiscal year, the three most highly compensated executive officers should be identified based on compensation for the taxable year.
  • Any individual who was a covered employee in 2017 or later. An employee does not have to be employed at the end of the taxable year to qualify as a covered employee.

The term “covered employee” also includes an individual who was a covered employee of a “predecessor of a publicly held corporation” for any preceding taxable year beginning in 2017 or later. A predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation within 36 months of the due date for the corporation’s last federal income tax return that it previously filed as a publicly held corporation. The proposed regulations provide examples as to how corporate acquisitions, spinoffs, and other reorganizations affect the status as a predecessor of a publicly held corporation.

Applicable Employee Remuneration

Compensation that is subject to Section 162(m) means the aggregate amount of remuneration for services performed by a covered employee in any capacity, regardless of whether the services were performed during the taxable year. Compensation includes the amount paid to a beneficiary on behalf of a deceased covered employee. Compensation is not limited to payments for services performed as an employee, so that director fees and payments to an independent contractor constitute compensation under Section 162(m). If a covered employee terminates employment and returns to provide services to a publicly held corporation in any capacity, such as a director or independent contractor, any deduction for compensation paid to the covered employee is subject to the Section 162(m) limit.

Special rules, including transition rules, apply to compensation paid by a partnership to a covered employee of a publicly held corporation. When a partnership pays a covered employee of a publicly held corporation for his or her services, compensation includes a distributive share of the partnership’s deduction attributable to the publicly held corporation. The publicly held corporation must aggregate (i) the distributive share of the partnership’s deduction for compensation expense paid to the covered employee, and (ii) the corporation’s otherwise allowable deduction for compensation paid directly to the covered employee in order to determine the amount of allowable deduction under Section 162(m). The rules applicable to compensation paid by a partnership to a covered employee of a publicly held corporation will apply to any deduction for compensation paid by a partnership that is otherwise allowable for a taxable year ending on or after December 20, 2019, but will not apply to compensation paid pursuant to a written binding contract in effect on December 20, 2019, that is not materially modified thereafter.

Grandfather Rule

The proposed regulations incorporate the grandfather rule set forth in Notice 2018-68, with further clarifications. Under the grandfather rule, the 2017 Tax Act changes do not apply to remuneration that is provided pursuant to a written binding contract that was in effect on November 2, 2017, and that is not materially modified after that date. For purposes of the grandfather rule:

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.

The proposed regulations have numerous examples of situations that may or may not affect the grandfather rule. Examples include the following.

Clawback Provisions. The proposed regulations address how a clawback policy can affect grandfathered compensation. If, under applicable law, a corporation has contingent discretion to recover compensation, for example based on a material restatement of financial statements or gross misconduct, a clawback provision will not adversely affect the grandfather merely because the corporation could potentially recover an amount upon the occurrence of a specified event. However, if a specified event occurs (e.g., material restatement of financial statements or a felony conviction), the corporation will have to determine how its discretion or obligation to recover compensation affects grandfathered amounts at that time. If a specified event occurs and the corporation is required, or has discretion, to recover a certain amount of grandfathered compensation, that portion of the compensation will no longer be grandfathered. Any portion of grandfathered compensation that the corporation remains obligated to pay under applicable law will continue to be grandfathered.

Earnings on Grandfathered Amounts. Earnings credited on grandfathered amounts after November 2, 2017, are grandfathered only if the corporation is obligated to pay the earnings under applicable law, pursuant to a written binding contract in effect on November 2, 2017. Under Code Section 409A, a nonqualified plan that is terminated (outside the context of a change in control) generally must postpone distribution for 12 months after the plan termination date. The proposed regulations provide that, with respect to a nonqualified deferred compensation plan, if the corporation is obligated under applicable law to continue to credit earnings on benefit accruals for 12 months following termination of the plan, such earnings will be grandfathered.

Severance Agreements. Severance payments are grandfathered only if the amount of severance is based on compensation elements that the employer is obligated to pay under a written binding contract in effect on November 2, 2017, that is not materially modified. Each component of a severance formula must be analyzed separately to determine the grandfathered amounts. For example, if the amount of severance is calculated as the sum of final base salary plus bonus, both components of severance are grandfathered only if, under applicable law, the corporation is obligated to pay both portions pursuant to a written binding contract in effect on November 2, 2017. If salary is increased by an amount that exceeds a reasonable, annual cost-of-living increase, the salary component of the severance payment will be considered materially modified, thus losing the grandfathered status.

Material Modification. A modification of a written binding contract that accelerates vesting is not considered a material modification.

When there is more than one written binding contract involved (or a single written document composed of multiple contracts), a material modification of one written binding contract does not automatically cause a material modification of the other contracts, provided that the modification of one contract affects only the amount payable under that particular contract.

Negative Discretion. Corporations often retain discretion to reduce compensation that is otherwise payable upon the occurrence of certain conditions. Negative discretion has the potential to render a written contract nonbinding, depending on applicable law. The proposed regulations clarify that, if compensation arrangements purport to provide the corporation with a wider scope of negative discretion than is permitted under applicable law, the negative discretion will be taken into account only to the extent that the corporation may exercise the negative discretion under applicable law.

Deferral Under Section 409A

Under Section 409A, a nonqualified deferred compensation plan can provide for deferral of compensation to the extent that it is reasonably anticipated, at the time of the scheduled payment, that a deduction with respect to such compensation would not be permitted under Section 162(m). The proposed regulations acknowledge that the interplay between Section 409A and Section 162(m) could require that a significant period of time pass before non-grandfathered amounts are deductible, and could create situations where a non-grandfathered payment would never become deductible. Under the proposed regulations, a service recipient may defer the scheduled payment of grandfathered amounts under this provision of Section 409A without delaying payment of the non-grandfathered amounts, and the delay of the grandfathered amounts will not be treated as a subsequent deferral election under Section 409A. In addition, under the proposed regulations, a deferred compensation plan may be amended to remove a provision requiring the corporation to delay payment if it is reasonably anticipated, at the time of the scheduled payment, that the deduction would not be permitted under Section 162(m). Such an amendment will not be considered a material modification for purposes of the grandfather rule and will not be considered an impermissible acceleration under Section 409A. The plan must be amended by December 31, 2020, and any amounts that would be payable on or before December 31, 2020, according to the amended plan must be paid by December 31, 2020.

Until the IRS issues new regulations under Section 409A to incorporate these modifications, taxpayers can rely on the guidance laid out in the proposed regulations under Section 162(m) for any taxable year beginning after December 31, 2017.

Applicability Dates

The proposed regulations supersede Notice 2018-68. Therefore, taxpayers can no longer rely on Notice 2018-68 for taxable years ending on or after December 20, 2019, which is the date of the proposed regulations’ publication. The proposed regulations will largely apply to compensation deductible for taxable years beginning on or after the publication date of the final rules. Before the final rules are published, the proposed regulations will set the governing standard, and taxpayers can rely on the proposed regulations.

The proposed regulations provide several special applicability dates, including the following. Note that some of the applicability dates contain special grandfather provisions.