IRS Guidance on Section 162(m) Tax Reform

Jean M. McLoughlin is partner and Ron M. Aizen is counsel at Davis Polk & Wardwell LLP. This post is based on a Davis Polk memorandum by Ms. McLoughlin and Mr. Aizen.

On August 21, 2018, the IRS issued Notice 2018-68, which provides initial guidance on two aspects of the amendments to Section 162(m) of the Internal Revenue Code made by the Tax Cuts and Jobs Act (TCJA):

  • how to identify the expanded group of employees who are covered by new Section 162(m); and
  • how a plan or agreement can qualify as grandfathered from new Section 162(m).

This post summarizes this guidance, as well as the additional aspects of new Section 162(m) on which the IRS is seeking comment.

Key takeaways from the notice include the following:

  • Umbrella plans or agreements that provide for negative discretion to reduce compensation do not qualify as grandfathered from new Section 162(m); and
  • A grandfathered employment agreement that provides for auto-renewal at the end of the term, unless either party elects not to renew, loses its grandfathered status for amounts earned after the renewal date.

The notice applies to any taxable year ending on or after September 10, 2018.

The notice includes 14 examples, which are reproduced in the appendix to the complete publication.

Overview of Section 162(m)

Section 162(m), which became effective in 1994, provides that a publicly traded corporation may not deduct compensation in excess of $1 million per year paid to any “covered employee” of the corporation. Before the TCJA was enacted in December 2017, the deduction limitation:

  • excluded “qualified performance-based compensation” and certain commissions;
  • covered compensation payable to a company’s CEO and each of the company’s next three most highly compensated executive officers for the taxable year, other than the CFO; and
  • generally applied only to companies with publicly traded equity securities. The TCJA expanded the scope of Section 162(m) by:
  • eliminating the exclusions for “qualified performance-based compensation” and commissions;
  • broadening the covered employee group; and
  • expanding the types of covered companies.

The TCJA’s changes apply to compensation for taxable years beginning after December 31, 2017, except for compensation payable pursuant to a “written binding contract” (generally, as determined under applicable state law) in effect as of November 2, 2017, when the TCJA’s changes were proposed.

For a summary of the TCJA’s changes to Section 162(m), see our memorandum from January 31, 2018.

Who Are “Covered Employees”?

The $1 million deduction limit under Section 162(m) applies to employees who are considered “covered employees” for the taxable year for which the deduction would otherwise be taken.

New 162(m) expanded the definition of covered employees by:

  • expressly including the CFO; and
  • providing that, if an individual was a covered employee during any taxable year beginning on or after January 1, 2017, the individual is a covered employee for all subsequent years, even after the individual terminates employment. [1]

The IRS notice provides guidance on how to identify covered employees.

Does an employee need to serve as an executive officer at the end of the taxable year to be a covered employee?

No. In the notice, the IRS explains that the statutory provisions do not impose an end-of-year requirement, and that the legislative history does not indicate that Congress intended for such a requirement to apply.

The IRS also dismisses the assertion made by some commentators that an end-of-year requirement should apply because the SEC rules relating to executive compensation cover the three most highly compensated executive officers other than the CEO and CFO who were serving as executive officers at the end of the last completed fiscal year. The IRS points to the SEC rules that require disclosure for certain individuals who were not serving as executive officers at the end of the last fiscal year (e.g., the up to two additional individuals who would have been among the three most highly compensated executive officers, other than the CEO and CFO, had they been serving as executive officers at the end of the last fiscal year).

Can an employee be a covered employee even if the employee’s compensation is not required to be disclosed under SEC rules?

Yes. The IRS, again pointing to the statutory language and the legislative history, determined that executive officers of publicly held corporations can be covered employees even if their compensation is not required to be disclosed under SEC rules (e.g., executive officers of a corporation that does not file a proxy statement for a year because it delists its securities).

So, who are covered employees?

The notice provides that—in addition to the CEO and CFO and the covered employees from prior years— the covered employees for a taxable year are the three most highly compensated employees who acted as executive officers at any time during the taxable year, regardless of whether they were serving as executive officers at the end of the year, and regardless of whether their compensation is required to be disclosed for the year under SEC rules.

The notice includes an example, which assumes the following:

  • six individuals (other than the CEO and CFO) served as executive officers during a taxable year;
  • the three individuals with the highest compensation for the year retired before the end of the year;
  • the other three individuals served as executive officers at the end of the year.

The covered employees include the three retirees and not the three continuing employees. This is the case even though:

  • the three retirees were not serving as executive officers at the end of the year;
  • one of the retirees (the one with the lowest compensation for the year among the three retirees) did not appear in the Summary Compensation Table for that year; [2] and
  • the three continuing employees appeared in the Summary Compensation Table for that year.

Are covered employees different for a smaller reporting company or emerging growth company?

No. The notice clarifies that, for purposes of determining the covered employees under new Section 162(m), it does not matter whether a company is a smaller reporting company or emerging growth company under SEC rules. Even though smaller reporting companies and emerging growth companies generally are required to disclose compensation for fewer individuals than other public companies, the covered employees for all public companies are the CEO, CFO and three other most highly compensated executive officers.

Who are the covered employees when a company’s fiscal year and taxable year do not align?

In certain situations, for example following a corporate transaction, a company’s fiscal year and taxable year do not align, leaving a question as to how the company should determine its three most highly compensated executive officers (other than the CEO and CFO). The IRS notice states that, until additional guidance is issued, companies should make this determination based on a reasonable good faith interpretation of the statute, taking into account the guidance provided under the notice.

Grandfathered Arrangements

The TCJA provides that a “written binding contract” in effect on November 2, 2017 (the date the TCJA was initially proposed) is grandfathered from new Section 162(m), unless and until it is materially modified or renewed. The IRS notice released on August 21, 2018 provides some clarification about the applicability of the written binding contract exception, as summarized below.

If an agreement is automatically renewed, does it lose the grandfather?

Generally, yes. Many employment and similar agreements provide for a term that is automatically renewed on a specified date unless either party gives prior notice of non-renewal. The IRS notice makes clear that an agreement whose term automatically renews after neither party gives notice of non-renewal becomes ungrandfathered on the date that the agreement would have expired had such notice been given. [3]

The notice includes an exception whereby, if an agreement provides that the employee, in his or her sole discretion, may elect to renew or not renew the term, the agreement is not ungrandfathered on that date if the employee makes that election. Given that agreements rarely provide the employee with such an election, few agreements are likely to qualify for this exception.

Can an agreement with an indefinite term qualify for the grandfather?

Yes. If an agreement that otherwise qualifies for the written binding contract exception provides for an indefinite term and can only be terminated by ending the employment relationship, the agreement remains grandfathered until and unless it is terminated or materially modified.

When is an agreement materially modified?

An agreement is materially modified when it is amended to increase the amount of compensation payable under the agreement. If a grandfathered agreement is materially modified, amounts paid after the modification date are treated as paid under a new agreement and do not qualify for the written binding contract exception to new Section 162(m). Amounts paid before the modification date remain grandfathered.

Is acceleration of compensation a material modification?

If a grandfathered agreement is modified to accelerate the payment of compensation, the agreement is considered materially modified and therefore is ungrandfathered, unless the amount of compensation paid is discounted to reasonably reflect the time value of money.

Is deferral of compensation a material modification?

If a grandfathered agreement is modified to defer compensation, and if the amount paid at the end of the deferral period does not exceed the original amount deferred, the agreement is not considered materially modified. If the amount paid at the end of the deferral period exceeds the original amount deferred, the agreement is considered materially modified, unless the additional amount paid is based on either a reasonable interest rate or a predetermined investment reference.

Is a salary increase a material modification?

Yes, unless the increase does not exceed a reasonable cost-of-living increase. The notice includes an example involving a grandfathered employment agreement with a CFO that provides for a $1.8 million salary. In 2019, the company increases the CFO’s salary by $40,000. Because the $40,000 increase does not exceed a reasonable cost-of-living increase, the agreement is not considered materially modified, and only the additional $40,000 is subject to the deduction limit.

The example further provides that in 2020, the company increases the CFO’s salary to $2.4 million. Because the $560,000 increase exceeds a reasonable cost-of-living increase, the agreement is considered materially modified, and the entire $2.4 million is subject to the $1 million deduction limit.

However, the grant of additional compensation of a type not provided in a contract will not constitute a material modification. The notice provides an example in which, rather than the salary increases to the CFO described above, the company grants the CFO a restricted stock award subject to continued employment through the end of the term of the employment agreement. This restricted stock grant would not materially modify the employment agreement because any additional compensation paid to the CFO under the grant is not paid on the basis of substantially the same elements or conditions as the salary (i.e., because the compensation attributable to the restricted stock grant is based on stock price and continued employment).

Can compensation paid to an employee who becomes eligible to participate in a plan or arrangement after November 2, 2017 be grandfathered?

Yes, as long as the plan or arrangement was binding on November 2, 2017 and, on that date, the employee either was employed by the company or had the right under a written binding contract to participate in the plan or arrangement. [4]

Is the failure to exercise negative discretion a material modification?

No. The notice provides an example of a bonus plan that was in effect on November 2, 2017 and that was structured to comply with the “qualified performance-based exception” under old Section 162(m). The plan provides that the CEO will receive a bonus of $1.5 million for 2017 if specified objective performance goals are achieved, subject to the compensation committee’s ability to reduce the payment, in its discretion based on subjective factors, but not below $400,000. The performance goals are met, and the committee exercises its discretion to reduce the bonus to $500,000. The committee’s failure to exercise negative discretion to reduce the payment to $400,000 (rather than $500,000) is not a material modification. Therefore, the $400,000 minimum payment is not subject to the deduction limit, and the remaining $100,000 is subject to the limit.

As a practical matter, this exception will not generally provide any relief, because most negative discretion plans permit the compensation committee to reduce the objectively determined amount to zero. The notice suggests that such arrangements likely do not qualify for the grandfather, because they likely are not “written binding contracts” under applicable law (i.e., because there is no minimum amount that is guaranteed to be paid if the performance goals are achieved).

Is compensation grandfathered if it is subject to board approval obtained after November 2, 2017?

No. The notice provides an example of an employment agreement in effect on November 2, 2017 that provides for grants of equity awards on January 2, 2018, subject to approval by the board of directors. Had these grants been made before November 2, 2017, they would have constituted qualified performance-based compensation under old Section 162(m). However, because under applicable law these potential grants did not constitute a written binding contract on November 2, 2017 given the board’s discretion to withhold approval, compensation attributable to the grants is subject to the deduction limit.

Effectiveness and Future Guidance

When does the guidance become effective?

The IRS and Treasury Department expect to incorporate the guidance in the notice in future regulations that will apply to any taxable year ending on or after September 10, 2018. Any additional guidance or regulations released by the IRS that expand the definition of “covered employee” or that restrict the application of the definition of “written binding contract” will only apply prospectively.

What topics has the IRS requested comment on?

In the notice, the IRS requests comment on the applicability of the following:

  • the definition of “publicly held corporation” to foreign private issuers, including the reference to issuers that are required to file reports under Section 15(d) of the Securities Exchange Act of 1934;
  • the definition of “covered employee” to an employee who was a covered employee of a predecessor of the publicly held corporation;
  • new Section 162(m) to corporations immediately after they become publicly held, either through an IPO or a similar business transaction; and
  • the SEC executive compensation disclosure rules for purposes of determining the three most highly compensated executive officers when a corporation’s taxable and fiscal years do not align.

Comments may be submitted through November 9, 2018.

The complete publication, including appendix, is available here.

Endnotes

1Although new Section 162(m) provides that the covered employees for 2017 remain covered employees permanently, they are determined under old Section 162(m). I.e., they are the CEO who was serving at the end of 2017, plus the three next most highly compensated executive officers (other than the CFO) who were actively serving in their executive officer roles at the end of 2017 and whose compensation was required to be disclosed in the Summary Compensation Table in the 2018 proxy statement.(go back)

2This seems to contradict the statutory language that “covered employees” include employees whose “total compensation…for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employees being among the 3 highest compensated officers for the taxable year” (Section 162(m)(3)(b)).(go back)

3The notice does state that an agreement is not treated as terminable or cancelable if it may only be terminated by terminating the employment relationship, which raises the question of the treatment of an employment contract that provides for severance upon the employer’s election not to renew the contract. If this type of contract were deemed the same as a contract that could only be terminated by the employer by terminating the employment relationship, then it would still be eligible for grandfather status even though it includes an automatic renewal feature. However, the guidance does not provide clarity around this question.(go back)

4The text of the notice provides that, on November 2, 2017, the employee must either be employed by the company or have the right under a written binding contract to participate in the plan or arrangement. However, the notice includes an example of an employee who, on November 2, 2017, was both employed by the company and had the right under a written binding contract to participate in a deferred compensation plan. The example concludes that a payment to the employee under the plan qualifies as grandfathered. Although not entirely clear, because the example does not state that both conditions must be met for the payment to be grandfathered, and because the text of the notice states that only one of the conditions must be met, it appears that the grandfather should apply if either condition is met.(go back)

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