The Internal Revenue Service (IRS) issued Notice 2018-68 (Notice) on August 21, 2018, clarifying changes made to Section 162(m) of the Internal Revenue Code (Section 162(m)) by the Tax Cuts and Jobs Act of 2017 (TCJA). The Notice is not as favorable or expansive as many had hoped in clarifying the TCJA because the IRS narrowly interpreted certain provisions of the TCJA that were otherwise beneficial to employers and indicated that further guidance should be expected in proposed regulations. As a result, more executive compensation arrangements will be subject to the Section 162(m) deduction limit.
Section 162(m) imposes a $1 million cap on the deductibility of compensation paid to certain executives by a public company. Prior to the passage of the TCJA, Section 162(m) included an exclusion from the $1 million cap for commission-based and qualified performance-based compensation.
As discussed in our prior client alert (found here), for tax years beginning after December 31, 2017, the TCJA amended Section 162(m) so that it will cover more executive officers and will no longer include the exceptions for commission-based and qualified performance-based compensation.;
The TCJA provides an important transition rule (commonly referred to as the grandfather rule) for compensation offered under a "written binding contract" in effect on and not "materially modified" after November 2, 2017. Compensation covered by the grandfather rule is subject to the old Section 162(m) rules (ie, prior to the enactment of the TCJA). Notably, the newly-issued Notice addresses key questions regarding the scope of this grandfather rule.
Many existing arrangements with so-called negative discretion are not grandfathered
The Notice strictly interprets what constitutes a written binding contract for purposes of the grandfather rule. For purposes of the grandfather rule, the Notice provides that compensation is considered payable under a written binding contract that is in effect on November 2, 2017 only if the employer is obligated under applicable law (including state law) to pay such compensation under the contract if the employee performs services or satisfies applicable vesting conditions.
The Notice further provides that compensation will not be considered payable under a written binding contract if the employer is not obligated to pay it under applicable law. Therefore, a compensation arrangement with discretion for the employer to reduce or eliminate an employee's compensation (which is often referred to as "negative discretion") will not be eligible for the grandfather rule for the portion over which the employer has discretion. For example, if an employer retains negative discretion to reduce a $1.5 million performance-based bonus under a written contract in effect on November 2, 2017, to an amount not less than $400,000, any amount paid in excess of $400,000 will not be grandfathered and excluded from the $1 million deduction limit as qualified performance-based compensation as permitted under the old Section 162(m) rules,
For many employers, existing performance-based equity awards (eg, performance shares and performance stock units) and annual bonus plans often include negative discretion terms without minimum earned payment floors and, therefore, will not be grandfathered from the new Section 162(m) rules. Accordingly, employers who desire to rely on the grandfather rule and take a corporate income tax deduction for a pre-existing compensation arrangement that includes a negative discretion clause should assess whether those payments (in whole or in part) are legally binding.
Compensation contracts that are renewed or extended are not grandfathered
The Notice provides that a written binding contract is not grandfathered if it is renewed after November 2, 2017. The Notice further clarifies that a written binding contract that is terminable or cancelable by the employer without the employee's consent after November 2, 2017 is treated as renewed as of the date that any such termination or cancellation, if made, would be effective.
Thus, for example, if the terms of a contract provide that it will be automatically renewed or extended as of a certain date unless either party provides notice of termination of the contract at least 30 days before that date, the contract is treated as renewed as of the date that termination would be effective if that notice were given. Similarly, for example, if the terms of a contract provide that the contract will be terminated or canceled as of a certain date unless either party elects to renew within 30 days of that date, the contract is treated as renewed as of that date (unless the contract is renewed beforehand, in which case, it is treated as renewed on that earlier date). A contract, however, is not treated as renewed if upon termination or cancelation of the contract the employment relationship continues but would no longer be covered by the contract and payments made with respect to such employment are not made pursuant to the contract (and are not grandfathered).
Increases in compensation are deemed material modifications
Under the TCJA, a contract that is "materially modified" after November 2, 2017 loses its grandfather status.The Notice clarifies that a "material modification"occurs if the contract is amended to increase the amount of compensation payable. Amounts received subsequent to a material modification are treated as paid pursuant to a new contract and, therefore, will be subject to the post-TCJA rules of Section 162(m). The IRS has provided examples in the Notice of what actions constitute a material modification, but the extent of what an employer may do without materially modifying an agreement remains to be seen.
The IRS notably provides in the Notice that the adoption of a side agreement that provides for increased compensation, or the payment of additional compensation, is a material modification of a written binding contract if the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the prior contract.
The Notice also clarifies that acceleration of a payment under a contract is a "material modification" unless the payment is discounted to reasonably reflect the time value of money. With regard to deferrals of compensation, the Notice provides, however, that a deferral is not considered a material modification under Section 162(m), provided that any increase (or decrease) in the amount payable on a deferred basis is based on either a reasonable rate of interest or a predetermined actual investment.
Other clarifications to Section 162(m) in the Notice
Prior to the TCJA, Section 162(m) applied solely to a public company's CEO (or an individual acting in such a capacity) and next three highest-paid executive officers (excluding the CFO) holding office on the last day of the company's taxable year. The TJCA modified the personnel subject to Section 162(m) and expanded the category of employers subject to the new 162(m) rules.
Under the TCJA, for tax years beginning after December 31, 2017, the group of covered employees additionally includes the CFO or an individual acting in such a capacity (along with the CEO and the next three highest-paid executive officers other than the CEO and CFO, or an individual acting in such capacity). If any executive is a covered employee under Section 162(m) in 2017 or any later tax year, the executive is considered a covered employee under Section 162(m) for all future tax years.
The Notice confirms that, under the new Section 162(m) rules, an executive is a covered employee even if he or she is not serving as an executive officer at the end of a taxable year. The Notice further clarifies that an executive can be a covered employee under Section 162(m) even if his or her compensation is not required to be reported under Securities and Exchange Commission (SEC) rules. This clarification likely means that a public company that delists and goes private or that is acquired in an M&A transaction (and is no longer publicly traded) may continue to be subject to Section 162(m) in the year that such a transaction occurs. It also likely means that smaller reporting companies and emerging growth companies, who have reduced disclosure burden under SEC rules, will have to determine the executive officers who are subject to Section 162(m) separate and apart from the SEC rules.
Action items for employers
- Employers who are relying or were expecting to rely on the TCJA's grandfather rule should carefully review their compensation arrangements in light of the new guidance in the Notice.
- Before the end of 2018, public company employers should make a list of covered employees who are subject to Section 162(m) and maintain this list in their corporate records.
- Employers may want to consult with executive compensation counsel on how they might restructure their compensation arrangements to avoid the $1 million deduction cap of Section 162(m).
- Changes to employment agreements with covered employees should be carefully reviewed with executive compensation counsel to consider the impact of Section 162(m) on such arrangements.
- Be on the lookout for additional guidance from the IRS regarding Section 162(m) because the Notice requests comments from taxpayers and provides that regulations incorporating the issues covered in the Notice are forthcoming. In particular the IRS expects to deliver additional guidance regarding the application of Section 162(m) to foreign private issuers, the extent to which the "IPO transition rule" applies under Section 162(m), and the effect of Section 162(m) to compensation paid to covered employees in M&A corporate transactions.