Last week, the Internal Revenue Service (the “IRS”) published limited initial guidance regarding key aspects of the changes brought about by the Tax Cuts and Jobs Act of 2017 (the “Act”) to Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), which caps deductible executive compensation at $1,000,000. This alert summarizes IRS Notice 2018-68 (the “Notice”) and suggests action items for public companies in light of this guidance.
Brief Summary of the Act
- Removing the exemption for performance-based compensation from the $1M compensation deduction limitation.
- Expanding the list of executives (or “covered employees”) subject to the $1M deduction cap to include a company’s CFO, in addition to its CEO and three other most highly compensated executive officers. Anyone serving as CEO or CFO at any point during a company’s fiscal year (vs. being in service at year-end only) also became a “covered employee.” Further, once an executive becomes a covered employee under Code Section 162(m) (effective for years beginning January 1, 2017), he or she will now be subject to the Code Section 162(m) $1M deduction limitation in all future years – including after termination of employment or death.
- Grandfathering certain written compensation arrangements in effect on November 2, 2017 that were not previously subject to the $1M deduction limitation, so long as the arrangement is not materially modified. Under the grandfather rule, companies may be able to continue to deduct previously exempt compensation even if in excess of $1M notwithstanding the changes brought about by the Act. For example, arrangements with individuals who were not previously covered (e.g., CFOs) and compensation arrangements previously exempt but not currently exempt (e.g., stock options and other performance-based compensation) may be eligible for grandfather treatment.
- Expanding the companies covered by Code Section 162(m) to include all companies required to file SEC reports under Section 15(d) of the Securities Exchange of 1934, as amended (i.e., public debt issuers).
Recent IRS Guidance
The Notice addresses (i) the amended definition of “covered employee” and (ii) the scope of the grandfather rule for certain outstanding arrangements. Key takeaways include:
- “Covered Employees” and “NEOs” Are Not Synonymous . The IRS emphasizes that “covered employees” subject to the Code Section 162(m) $1M deduction cap may include persons who are not treated as named executive officers (“NEOs”) for proxy statement purposes. Of note, smaller reporting companies (“SRCs”) and emerging growth companies (“EGCs”) are not treated differently from larger companies for Code Section 162(m) purposes. Also, “covered employees” do not need to be employees at year-end. Consequently, “covered employees” for Code Section 162(m) purposes may be different than the individuals disclosed in a company’s SEC filings due to termination or retirement of executive officers during the year or mid-year M&A transactions.
- Grandfather Treatment Narrowly Interpreted . The Notice narrowly interprets a company’s ability to seek grandfather protection for its compensation arrangements. To be eligible,
- The compensation must have been exempt from the Code Section 162(m) $1M deduction limitation prior the Act. Any compensation that was previously captured under Code Section 162(m) will not be eligible for relief.
- The compensation must be subject to a written binding contract in effect on November 2, 2017 pursuant to which the company is legally obligated (e.g., under state contract law) to pay remuneration. The Act applies to any compensation in excess of what the company was legally required to pay on November 2, 2017. Companies will therefore need to analyze the enforceability of a compensation agreement in light of state and other laws as a component of the grandfather determination.
- The compensation arrangement must not have been materially modified on or after November 2, 2017. The IRS states that a material modification occurs when an agreement is amended to increase the amount of compensation payable. As described in greater detail below, compensation arrangements that provide for negative company discretion and/or supplemental compensation will generally result in the loss of grandfather treatment.
- Grandfather Treatment Ends Upon Agreement Renewal (Including Automatic Renewals) . A written binding contract that is terminable by a company without the employee’s consent after November 2, 2017 is treated as renewed on the date of any such termination, if made, would be effective. For example, if a contract automatically extends unless 30 days’ prior notice is given by the company or employee, the agreement is treated as renewed (and grandfather treatment terminated) on the date the termination would be effective if notice were given. An arrangement does not end if the contract is terminated or canceled only by terminating the employment relationship of the employee.
- Grandfather Treatment Precluded to Extent Negative Discretion Retained . As discussed above, to receive grandfather treatment, the compensation must be payable pursuant to a written binding contract in effect on November 2, 2017 that constitutes a legally binding obligation of the company. To the extent that a company retains negative discretion to reduce payments, the IRS views this as lacking a legal obligation to pay, and the compensation is not eligible for grandfather treatment. The Notice suggests that the IRS will view a contract as not being legally binding if a company has the discretion to reduce an award to zero; however, if the company has agreed to compensate an employee with at least a certain base amount of compensation, despite having negative discretion to otherwise reduce the award to that “floor” level, the “floor” portion of the award may be eligible for grandfather treatment.
- Certain Supplemental Agreements Terminate Grandfather Treatment . If a company enters into a side agreement to supplement grandfathered compensation, the grandfathered compensation may lose its special status. To determine whether the supplemental compensation is a material amendment of such grandfathered compensation, the IRS will consider whether the additional compensation is paid on substantially the same elements or conditions as the compensation in the grandfathered agreement. For example, entering into a new executive compensation agreement to annually pay an additional cash sum for service (that exceeds a cost of living adjustment) will be viewed as amending a prior grandfathered employment agreement, terminating grandfather treatment. However, entering into an agreement with an executive to issue a restricted stock award would not terminate treatment of the executive’s grandfathered compensation under his or her employment agreement because the restricted stock award is not based solely on service, as it is for base salary, but service and stock price.
- Annual Cost of Living Adjustments Not Considered a Material Modification . Companies may increase the salaries of executives to reflect cost of living adjustments without losing grandfather treatment. Cost of living adjustments are not considered material contract amendments. But note that while the underlying salary as in effect on November 2, 2017 may be eligible for grandfather treatment (despite the cost of living adjustment), the amount attributable to the cost of living adjustment will be subject to the $1M cap.
- Grandfather Treatment Not Necessarily Lost if Compensation Accelerated or Deferred . The acceleration of compensation may be permitted without loss of grandfather treatment in certain instances where the compensation is discounted to reflect the time value of money. Likewise, so long as no more than a reasonable rate of interest (or an amount tied to a predetermined actual investment) is paid on deferred compensation under a written binding agreement, the compensation paid under that agreement will not lose its grandfather treatment.
- 1993 Transition Guidance . In the Notice, the IRS follows and expands upon its transition rules released in 1993 (the “1993 Guidance”) in connection with the adoption of the Code Section 162(m) $1M deduction limitation with regards to what constitutes a written binding agreement and a material modification. However, it is unclear whether the IRS will interpret specific questions more narrowly going forward given the fact that the Notice includes additional limitations not found in the 1993 Guidance.
In light of the Notice’s guidance, public companies should:
- Identify and Track Covered Employees . Companies should consider which employees may be considered a “covered employee” for Code Section 162(m) purposes, remembering that the analysis is different from determining NEOs. M&A transactions, interim executive positions and smaller public company status may complicate the analysis. Companies will also need to remember that under the new rules, once an executive becomes a “covered employee” under Code Section 162(m), he or she will always be a “covered employee” and his or her compensation will subject to the $1M deduction limitation. For this reason, companies will face additional burdens to maintain accurate records of their covered employees.
- Discern If A Single Compensation Agreement Includes Compensation Elements That Are Eligible for Grandfather Treatment And Others That Are Not . Companies should analyze individual elements of executive compensation arrangements as some agreements may include eligible and ineligible elements for grandfather treatment. For instance, a CEO’s 2016 employment agreement may provide for the payment of a base salary (which would not be eligible for grandfather treatment) as well as payment of a performance-based bonus that qualified for the Code Section 162(m) performance-based compensation exemption prior to the Act.
- Analyze Whether Pre-Existing Arrangements Constitute Written Binding Contracts . Companies should take stock of which of their compensation agreements may be eligible for grandfather treatment. This analysis begins with assessing which, if any, arrangements were exempt from the Code Section 162(m) deduction limitation prior to the Act. For those exempt arrangements, the company must determine whether a written binding agreement exists that legally obligates the company to pay compensation. This analysis will involve a review of state and any other applicable law. Where written, legally binding compensation arrangements exist, the company must finally assess whether there have been any material amendments to the agreement that preclude seeking grandfather treatment.
- Analyze CFO Compensation-Related Agreements . Previously, CFOs were excluded from “covered employee” status. Now that CFOs are captured by Code Section 162(m), companies should take special care to review CFO compensation arrangements and any proposed amendments to such arrangements to determine if grandfather treatment is available.
- Pause Before Amending Executive Compensation Agreements . Even if an executive is not currently a “covered employee,” companies should consider whether the individual is likely to become a “covered employee" before amending his or her compensation arrangements. This is especially true for companies undergoing corporate restructures or management transitions where top-level positions may be eliminated or roles divided, pushing previously fourth or fifth highest compensated employees (other than CEO/CFO) (i.e., individuals previously outside of Code Section 162(m)’s reach) into a top three compensated position and therefore into “covered employee” status.
- Watch for Additional IRS Guidance . The Notice indicates that additional regulations are forthcoming and requests comment by November 9, 2018 on various applications of Code Section 162(m), including in the context of foreign private issuers, initial public offerings and M&A transactions.
Notwithstanding the changes in compensation deductibility made effective under the Act (and further detailed in the Notice), boards should continue to exercise their fiduciary duties in making executive compensation decisions by considering what is in the best interests of their company and its shareholders.