Takeaways

Tax Cuts and Jobs Act altered rules on deductibility of certain exec comp payments.
Section 162(m) may cover employees who are not included in the officers captured by SEC executive compensation disclosures.
Because grandfathering relies on principles of state contract law, public companies are advised to consult with counsel to determine the scope of protected payments.

On August 21, 2018, the IRS published Notice 2018-68, which provides initial guidance on Section 162(m) of the Internal Revenue Code (Section 162(m)) as amended by the Tax Cuts and Jobs Act of 2017 (TCJA). Section 162(m) generally limits a publicly held corporation’s deduction for compensation paid to covered employees to $1 million during the taxable year. TCJA significantly changed the scope and operation of Section 162(m), but added a transition rule that grandfathers certain outstanding arrangements (grandfather rule). Notice 2018-68 provides guidance for identifying covered employees and the operation of the grandfather rule of Section 162(m) through a series of questions and conclusions. Significantly, the questions and conclusions regarding negative discretion and deferred compensation and whether there is a binding written contract under state law admit to different conclusions than those offered by the IRS. Clients will want to work with counsel to analyze their arrangements to determine the extent to which payments are grandfathered as written, binding contracts. Separate from the grandfather issue, companies may change their approach to severance and deferred compensation payments by making them in installments of less than $1 million a year to avoid the loss of deductions.

Covered Employees

Misalignment with SEC Rules

The Section 162(m) deduction rules apply to covered employees. While the U.S. Securities and Exchange Commission (SEC) rules relating to executive compensation disclosure use a modified end-of-the-year requirement, Notice 2018-68 clarifies that an employee need not be serving the corporation at the end of the year in order to be a covered employee. Anyone who serves as the principal executive officer, principal financial officer or one of the three most highly paid executive officers during the year is considered a covered employee for such year, for tax years beginning on or after January 1, 2018.

Under SEC rules, up to five executive officers can be required to disclose their compensation in the proxy. In a scenario where a corporation’s top three paid officers of the year other than the principal executive and financial officers retire before the end of year, the SEC rules would only capture two out of the three such officers, while the covered employee rules would capture all three. Thus, officers of a publicly held corporation can be covered employees even if the SEC rules do not require disclosure of their compensation.

The TCJA specifically adds a corporation’s principal financial officer back to the list of covered employees. The notice provides guidance on whether any of his or her compensation arrangements are subject to the grandfather rule, as described below. A grandfathered employment agreement would follow the rules of the pre-TCJA Section 162(m). Therefore, because a corporation’s principal financial officer was not considered a covered employee under prior law, the salary paid under the principal financial officer’s agreement during the term of the agreement would not be subject to the Section 162(m) deduction limits.

Clients will want to work with counsel to analyze the principal financial officer’s arrangements to determine the extent to which payments are grandfathered.

Lookback Rule

Notice 2018-68 also confirms that the pre-TCJA rules for identifying covered employees govern when applying the lookback rule to 2017. This lookback rule provides that a covered employee for any tax year beginning after December 31, 2016 will remain a covered employee in all future years. Therefore, a corporation’s executive officer who terminates employment before the end of 2017 would not be considered a covered employee in future years, since under the pre-TCJA rules the officer would not be a covered employee for 2017.

Grandfather Rule

The grandfather rule provides that Section 162(m)’s deduction rules do not apply to compensation paid under a “written binding contract” in effect on November 2, 2017, provided the contract is not “materially modified” after such date. Compensation is payable under a written binding contract only to the extent that the corporation is obligated under state law to pay the compensation under the contract if the employee satisfies the applicable service or other vesting conditions.

Negative Discretion

The notice does not directly address compensation arrangements intended to meet the performance-based requirements of pre-TCJA Section 162(m) that permit negative discretion by the compensation committee. An example in the notice assumes that the compensation committee has an unambiguous right to reduce the payment to a certain floor and the discretion is in fact exercised. Only the amount up to the floor is considered paid under a “written binding contract” and grandfathered. This example would seem to imply that no amounts payable from a performance-based compensation arrangement that provides for negative discretion would be grandfathered unless there is an unambiguous floor on the amount of negative discretion that can be exercised. In practice, however, negative discretion is often never exercised and when it is, it is pursuant to specific objective rules the compensation committee follows. In addition, for performance-based equity awards, outside auditors often become comfortable that the retention of negative discretion, if not exercised, can be disregarded in the determination of grant date valuations.

Clients will want to carefully review their plans to determine if there is a binding written contract under state law, notwithstanding the presence of negative discretion.

Employment Agreements

If an employment agreement were entered into and in effect as of November 2, 2017, the agreement would be considered a written binding contract and grandfathered under Section 162(m) for the remainder of its term. If the employment agreement is automatically renewed after November 2, 2017, when the corporation has the discretion to avoid renewal, the agreement’s grandfathered status ends on the effective date of renewal. However, if the employee has the right to require renewal unilaterally and exercises that right, the grandfathering continues.

Stock Options and Stock Appreciation Rights (SARs)

Amounts payable under stock options and SARs granted before November 2, 2017 that qualify as exempt performance-based compensation will generally be treated as payable under a written binding contract and exempt from the Section 162(m) deduction limit. All approvals for the grants as required under applicable law must have been secured on or before November 2, 2017. For example, a pre-November 2, 2017 employment agreement providing for a stock option or SAR grant “subject to approval of the board of directors” is not considered a written binding contract under Section 162(m) if the board of directors did not approve the grants after November 2, 2017.

Even if a restricted stock grant qualified as a written binding contract, it is still subject to the Section 162(m) deduction limit because it did not qualify as performance-based compensation exempt from Section 162(m) under the pre-TCJA rules.

Nonqualified Deferred Compensation Plan Earnings

Whether a voluntary contributory nonqualified deferred compensation plan is considered a written binding contract will depend on when the deferred amounts accrue under the plan and the provisions of the plan. The Notice offers a question that concludes that if a plan permits amendments at any time that eliminate future earning credits, only the account balance credited as of November 2, 2017 is grandfathered. Any later earnings on these amounts are not grandfathered, unless that right to earnings is expressly reserved.

But this cannot be the correct conclusion. It is unlikely that an executive would not have an enforceable right to earning credits after November 2, 2017, particularly since the executive must wait for payment of the deferred compensation (unless the arrangement and all similar arrangements are terminated). Compensation earned after November 2, 2017 may be subject to the TCJA, but clients and their counsel should be able to become comfortable, depending on the contract language, that the right to earnings on previously earned amounts is a binding right that accrued under state law on November 2, 2017.

Material Modification

Notice 2018-68 provides that a material modification generally occurs when the contract is amended to increase the amount of compensation payable to the employee. A written binding contract that is materially modified will be treated as a new contract entered into as of the date of the material modification. Amounts received by employees under written binding contracts before a material modification continue to be grandfathered. Amounts received after the material modification will be subject to the Section 162(m) deductions limit.

However, the notice provides that the following actions are not considered increases in compensation: (i) an accelerated payment that is discounted for the time value of money; (ii) a deferred payment that includes earnings at a reasonable rate of interest or predetermined actual investment; or (iii) payment of increased compensation or additional compensation that is equal to or less than a reasonable cost of living increase.

Nothing in the notice suggests that these actions must be in the binding contract before November 2, 2017. For now, the ability to draft an acceleration or deferral mechanism or cost of living credit into grandfathered compensation arrangements without becoming a material modification may be important for planning considerations.

Path Forward

Notice 2018-68 notes that its guidance is expected to be incorporated into proposed regulations, and the portion of the regulations reflecting this guidance will apply to any taxable year ending on or after September 10, 2018. The notice requests comments regarding specific matters including the application of Section 162(m) to foreign private issuers, the extent to which the initial public offering transition rule will continue to apply under Section 162(m), and how covered employees should be treated in a corporate transaction that closes midyear.

These and any accompanying materials are not legal advice, are not a complete summary of the subject matter, and are subject to the terms of use found at: https://www.pillsburylaw.com/en/terms-of-use.html. We recommend that you obtain separate legal advice.