IRS Releases Initial 162(m) Guidance
Kelley Drye Client Advisory
IRC §162(m) limits a publicly held corporation’s ability to take a tax deduction for compensation paid to covered employees in excess of $1 million. As mentioned in our January 2018 Client Advisory, the Tax Cuts and Jobs Act (“Act”) repealed the exception to §162(m) for qualified performance-based compensation and expanded the applicability of §162(m) by broadening the definitions of covered employee and publicly held corporation. These changes generally apply to tax years beginning on or after January 1, 2018, but certain payments are exempt under a transition rule. The IRS recently issued Notice 2018-68 (“Notice”) to provide guidance on the identification of covered employees and the operation of the transition rule. This Client Advisory highlights some of the guidance provided.
Covered ExecutivesFor purposes of determining covered employees for any tax year, the Act provides that any executive (i) who is the principal executive officer (“PEO”) or principal financial officer (“PFO”) of the publicly held corporation at any time during the taxable year, or an individual acting as such, or (ii) whose total compensation for the taxable year is required to be reported to shareholders under SEC rules by reason of such executive being among the three highest compensated officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity), is a covered executive. Moreover, any individual who was a covered employee for tax years beginning on or after January 1, 2017, remains a covered employee for subsequent tax years.
The Notice provides that an executive does not have to serve as an executive officer at the end of the taxable year to be a covered employee, and that an executive whose compensation is not required to be disclosed under SEC rules may nevertheless be a covered employee – e.g., where an employer delists its securities and does not have to file a proxy statement for the year in question or where an employer is subject to the scaled disclosure rules for smaller reporting companies or emerging growth companies. The Notice also provides that, for tax years beginning before January 1, 2018, covered employees are determined under pre-Act provisions.
Transition GuidanceAlthough the Act’s amended provisions apply beginning 2018, transition relief is provided for payments made pursuant to a written binding contract in effect on November 2, 2017 that, but for the Act’s amendments, would not have been subject to §162(m), provided that the contract is not materially modified. To assist employers in determining which payments are “grandfathered” (i.e., subject to §162(m) rules as in effect prior to the Act’s amendments, including the exception for qualified performance-based compensation and the inapplicability of §162(m) to any compensation paid to a corporation’s PFO), the Notice provides the following:
- Binding Obligations. The Notice indicates that a written binding contract is in effect on November 2, 2017 only to the extent that the employer is legally obligated (e.g., under state contract law) to make payment if the executive performs services or satisfies any applicable vesting conditions. Amounts in excess of that legal obligation and amounts that may be paid, reduced or eliminated in the employer’s discretion would generally not be grandfathered. Unfortunately, many incentive plans include “negative discretion” provisions and, as a result, amounts outstanding as of November 2, 2017 may not be able to rely on the exception for qualified performance-based compensation - even if the employer never exercised such “negative discretion” in the past. An example provided in the Notice highlights that an equity award granted under a binding contract in effect as of November 2, 2017 but conditioned on Board approval after that date may not be grandfathered. This suggests that equity grants subject to Compensation Committee approval may not be grandfathered as well. Further guidance from the IRS on this point would be welcome.
The Notice also provides that if a compensation plan or arrangement is binding, the amount required to be paid as of November 2, 2017 to an executive pursuant to such plan or arrangement will be grandfathered even though the employee was not eligible to participate in such plan or arrangement as of that date, provided the executive was employed on November 2, 2017 or had a right to participate in such plan or arrangement under a written binding contract as of that date.
- Renewals. Binding written contracts in effect on November 2, 2017 will cease to be grandfathered upon being renewed after November 2, 2017. For example, if an employment agreement with a corporation’s PFO provides that it will be automatically renewed or extended as of a specified date after November 2, 2017 unless either the corporation or the PFO provides notice of termination at least 30 days before such date, the employment agreement will be deemed to have been renewed and, therefore, will lose its grandfathered status, on the date that the employment agreement would have terminated if either party had provided notice of termination. This rule does not apply to contracts that can only be terminated by terminating the employment relationship, and it does not apply to contracts that are terminable at the sole discretion of the employee.
- Material Modification. Grandfathered payments will lose that status if the underlying contract is materially modified, but only amounts paid after the material modification are affected. The Notice provides that a material modification occurs when the contract is amended to increase the amount of compensation payable or to accelerate the payment (unless the accelerated payment is discounted to reasonably reflect the time value of money). Normally, the deferral of a payment will not result in a material modification, provided that the earnings on the deferred amount are based on a reasonable rate of interest or a predetermined actual investment subject to gains and losses. However, if the plan or arrangement can be unilaterally terminated by the employer or amended to eliminate or reduce future accruals, only amounts accrued prior to November 2, 2017 will be grandfathered.
The adoption of a supplemental agreement that provides for increased or additional compensation will be considered a material modification if the facts and circumstances demonstrate the additional amount is paid on the basis of “substantially the same elements or conditions” as the amount payable under the original contract. Examples in the Notice indicate that an amendment to a grandfathered employment agreement with a PFO to substantially increase the PFO’s base salary would be a material modification of the contract that would cause the PFO’s entire base salary to become subject to §162(m). However, the examples further provide that a grant of restricted stock (which itself would be subject to §162(m)) in lieu of the proposed salary increase would not constitute a material amendment of the employment agreement and, therefore, would not cause the PFO’s salary to become subject to §162(m), because the restricted stock would be paid based on both stock price and continued service through the vesting date and not on the basis of substantially the same elements or conditions as the payment of the PFO’s salary. In addition, a supplemental payment that does not exceed a reasonable cost-of-living increase over the preceding year’s payment would not constitute a material modification. This would include an annual salary increase that does not exceed a reasonable cost-of-living increase. Although the cost-of-living increase would be subject to §162(m), it would not cause the portion of the salary in effect on November 2, 2017 to become subject to §162(m).