Long-awaited guidance on Section 162(m) of the Internal Revenue Code (the “Code”), has finally arrived. On August 21, 2018, the IRS issued Notice 2018-68, which provides guidance on certain changes made to Section 162(m) by the Tax Cuts and Jobs Act (the “Act”). The guidance is limited to (a) the identification of covered employees and (b) the so-called “Grandfather Rule.” The Notice does not address all of the issues raised by the Act’s changes to Section 162(m) and it makes clear that the Grandfather Rule will be narrowly interpreted. The guidance is effective for tax years ending on or after September 10, 2018 and will be incorporated into future regulations. The material provisions of the guidance are summarized below.
Identification of Covered Employees
Under Section 162(m), as amended by the Act, a “covered employee” means a public corporation’s (1) principal executive officer (PEO), (2) principal financial officer (PFO), and (3) three highest paid officers (other than the PEO and PFO) whose compensation for the tax year is required to be reported in the company’s proxy under the securities laws (or whose compensation would be required to be reported if the company was required to file a proxy for such year). If a person is a covered employee for any tax year beginning after December 31, 2016, the person will remain a covered employee for all future tax years. This is a departure from the requirements of Section 162(m) prior to the amendments, where the status of a person as a covered employee for any tax year was based only on his or her status on the last day of such tax year.
The Notice confirms the following points relating to the identification of covered employees:
- Covered employees for tax years beginning prior to January 1, 2018 are to be determined under the provisions of Section 162(m) as in effect prior to the Act. Covered employees determined under the pre-Act provisions of Section 162(m) for the 2017 tax year will be considered covered employees for all future tax years.
- No end of year requirement applies for purposes of determining whether an employee is a covered employee for such year under Section 162(m) as amended by the Act. For example, an individual who serves as the PEO for a brief period during a tax year, but who is no longer the PEO at the end of the tax year, will still be considered a covered employee for that year and all future years.
- Officers of public corporations can be covered employees even when disclosure of their compensation is not required under the securities rules—such as when a proxy is not required. The compensation to be used for determining the three most highly compensated officers is to be determined consistent with the securities rules.
- If an employee becomes a covered employee solely as a result of the amendment of Section 162(m) by the Act (as is the case with PFOs), payments made to such individual pursuant to a written binding contract in effect on November 2, 2017 will not be subject to Section 162(m), subject to the modification rules described below. All payments under the written binding contract are covered by this rule, whether or not they were intended to be performance-based compensation under Section 162(m) as in effect prior to the changes made by the Act.
The Act provides that compensation paid pursuant to a written binding contract that was in effect on November 2, 2017 and that is not materially modified in any material respect on or after such date will be “grandfathered” and will continue to be analyzed for purposes of Section 162(m) pursuant to the rules that were in effect prior to the changes made by the Act (the “Grandfather Rule”). In particular, prior to the Act, compensation that satisfied the requirements for “performance-based compensation” was excluded in determining whether a covered employee’s compensation exceeded the applicable $1,000,000 deduction limit (the “performance-based compensation exception”). The Act eliminated the performance-based compensation exception for any compensation payable beginning with the 2018 tax year. However, compensation that continues to satisfy the performance-based compensation exception as in effect prior to the Act and that is paid pursuant to a written binding contract that satisfies the Grandfather Rule will continue to be fully deductible (subject to the modification rules described below).
There has been a significant amount of uncertainty regarding the application of the Grandfather Rule, particularly with respect to what constitutes a “written binding contract” and a “material modification.” Although the new guidance does not completely clarify these matters, it sheds light on the following issues:
- Compensation is payable under a written binding contract in effect on November 2, 2017 only to the extent that the company is obligated under applicable law (emphasis added) to pay the compensation under the contract if the employee performs the services or satisfies the applicable vesting conditions.
- Most incentive plans (for example, annual bonus plans) that were designed to comply with the performance-based compensation exception authorize an administering committee, in its discretion, to reduce (but not increase) the amount of compensation payable under the plan. In particular, negative discretion was a key component of “umbrella” plans pursuant to which a large pool was established based on the satisfaction of established performance targets and the pool was “allocated” among executives. In actual practice, however, actual compensation was paid based on satisfaction of underlying targets (usually different from the targets used to determine the size of the pool) that were more indicative of the performance of the company’s business performance and the amount of compensation actually payable to an executive was significantly lower than the allocated portion of the pool (that is, the allocated portion of the pool was reduced to match the underlying targets and compensation limitations). Frequently, the amount payable pursuant to the underlying targets was also subject to further discretionary reduction. Under the new guidance, whether such plans will fit within the Grandfather Rule will depend on the type and level of discretion reserved as well as the application of state laws to the payments under the plan. In any event, all plans, including in particular umbrella plans will need to be carefully analyzed to determine whether and to what extent the compensation payable thereunder can fit within the Grandfather Rule.
- A written binding contract that was in effect on November 2, 2017 and that is materially modified on or after that date is taken out of the Grandfather Rule as of the date of the material modification. Any amounts payable under the contract prior to the date of the material modification are covered by the Grandfather Rule and the contract, as modified, is treated as a new contract as of the date of the material modification.
- Material modifications include:
- Compensation Increases. An amendment to a contract to increase the compensation payable under the contract is a material modification. Similarly, a supplemental agreement that provides for increased compensation is treated as an amendment of the original contract if the facts demonstrate that the compensation under the supplemental agreement is paid on substantially the same conditions as the compensation under the original contract. Supplemental payments consisting of reasonable cost of living increases from the prior year are not considered a material modification.
- Payment Acceleration and Deferral. An amendment to accelerate payment is a material modification unless the payment is discounted to present value. An amendment to defer payment is a material modification unless earnings on the deferred amount are based either on (a) a reasonable interest rate or (b) a pre-determined actual investment subject to gains and losses.
- Renewal. The renewal of an existing contract is a material modification.
- A contract that is terminable or cancelable by the company without the employee’s consent after November 2, 2017 is treated as renewed as of the date that the termination or cancellation, if made, would be effective. For example, if a contract provides that it will be automatically renewed as of a certain date unless one party provides notice of termination within a specified period prior to such date, the contract is treated as renewed as of the date that the contract would have terminated had notice been given.
- If the terms of a contract provide that it will terminate as of a certain date unless either party elects to renew the contract, the contract is treated as modified as of the date that it is renewed.
- It appears that a contract that permits the employer to terminate the contract unilaterally will be treated as “renewed” as of the first day that termination could have occurred and been effective. This may significantly impact the status of deferred compensation plans, SERPs and long-term incentive plans.
- Exception: A contract is not treated as terminable or cancelable if it can be terminated or canceled only by terminating an employee’s employment. Similarly, a contract is not treated as renewed if, upon termination of the contract, the employee continues in employment. However, any compensation payable after termination of the contract would not be covered by the Grandfather Rule.
What to Do Now
Companies subject to Section 162(m) should consider several action items in light of the guidance:
- Regularly update (or start keeping) a list of covered employees, which will be needed for future years.
- Inventory and analyze existing contracts (including plan documents and employment agreements) to determine whether and to what extent payments thereunder can come within the Grandfather Rule. This may entail computing the value of benefits under certain plans (such as SERPs) as of November 2, 2017, which may raise recordkeeping complexities.
- Determine whether any plans contain provisions that delay payment until the date on which the compensation would be deductible under Section 162(m), and discuss with your advisors how such provisions should be administered given the changes to Section 162(m).
- Determine whether and to what extent preserving deductions is a priority to the company, and whether it makes sense to preserve any grandfathering that may be available given any associated uncertainty and complexity.