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.
After working to reconcile differences between the two Tax Cuts and Jobs Act bills, the Senate and House Conference Committee reached a tentative agreement on Wednesday, December 13. Although there is not yet a published version of the Conference Committee’s bill, both the Senate and House had proposed adding a new Section 4960 to the Internal Revenue Code (Code) which would, effective for taxable years beginning after December 31, 2017, impose an excise tax of 20% on certain compensation paid to a covered employee by a tax-exempt organization in excess of $1,000,000 and for certain excess parachute payments. The excise tax would be payable by the tax-exempt organization. This post summarizes key provisions of the proposed excise tax provision.
General Rule: Tax-exempt organizations will be required to pay a 20% excise tax equal to 20% of the sum of (i) remuneration paid in excess of $1,000,000 during a taxable year to a covered employee and (ii) any excess parachute payment paid to the employee by such organization during such year. The proposed statutory text notes, though, in relevant part that any such amounts shall be considered “paid” for this purpose when there is no substantial risk of forfeiture. Continue Reading The Tax Cuts and Jobs Act-Understanding the Proposed Excise Tax On Tax-Exempt Organizations
On November 16, 2017, Institutional Shareholder Services (ISS) published its updated proxy voting guidelines for the US, Canada, and Brazil effective for shareholder meetings that occur on or after February 1, 2018. In addition to many other changes, ISS addressed two issues that relate to compensation programs that should be considered by public company clients.
First, ISS added a problematic compensation practice related to non-employee director compensation. ISS notes that it will generally vote against the members of the board committee responsible for non-employee director compensation if there is a pattern of awarding excessive compensation to non-employee directors. Although excessive is not defined, ISS notes that it has identified cases of “extreme outliers” of non-employee director compensation relative to peers and the broader market so it appears that peer data will be used as a justification for identifying excessive compensation. Additionally, because a pattern of excessive compensation is the trigger for a negative vote (as opposed to a single instance), ISS will not consider non-employee director compensation for vote recommendations in 2018, but may take current compensation into account in the future if a pattern of excessive compensation is identified in consecutive years.
Second, ISS updated guidance regarding the responsiveness of the company’s board of directors to an advisory vote of less than 70% in favor of executive compensation. ISS will consider a failure to adequately respond to investors following a previous say-on-pay vote that received less than 70% support on a case-by-case basis when evaluating ballot items related to executive compensation. Factors considered when evaluating the company’s response include:
- Disclosure of engagement efforts with institutional investors (including the timing and frequency of engagements and whether independent directors participated);
- Disclosure of specific concerns voiced by such investors that led to voting against the say-on-pay proposal;
- Disclosure of specific actions taken by the company in response to such concerns; and
- Disclosure of any other recent changes in the compensation program made by the company.
ISS notes that independent director participation in any engagement with shareholders is preferred as being more conducive to receiving candid shareholder feedback. ISS also notes that it wants a summary of the concerns raised to more effectively evaluate whether changes are responsive to the feedback and to evaluate not just whether changes were made but whether quality changes were made.
During the two years following the SEC’s publication of final rules that require that companies satisfy the pay ratio disclosure requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act beginning in 2018 proxy statements, many public companies, hoping for a repeal or delay in the implementation of the rules, have waited to take the significant preparatory steps necessary for compliance. As there has been no reprieve in the deadline — the pay ratio is still required to be disclosed in 2018 proxy statements — the time for procrastination has ended, and public company clients need to take immediate steps to ensure compliance in 2018.
Briefly, the pay ratio disclosure contained in Item 402(u) of Regulation S-K requires public companies to disclose:
- The median of the annual total compensation of all employees of such public company other than the CEO;
- The annual total compensation of the CEO; and
- The ratio of those two amounts.
With all of the press about the new tax reform legislation and the proposed changes to the corporate tax rates, many companies might be considering strategies for accelerating deductions into earlier years to take advantage of those deductions in a year when the tax rates may be higher than in future years. One strategy to consider is whether it is possible to accelerate from 2018 to 2017 deductions for bonus payments (even though, at this stage, it is not entirely clear when or whether tax rate changes will actually go into effect). This strategy may work for other types of incentive compensation as well.
Generally, deductions must be taken in the year that is “proper” based on the taxpayer’s accounting method. Most corporations are accrual basis taxpayers and deductions by accrual basis taxpayers generally are to be taken when the liability is incurred—that is when all events establishing liability have occurred (commonly known as the “all events test”). In order for the all events test to be met, three things have to happen: (1) all events have occurred that establish the fact of liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred.
The first prong of the all events test is met when the event fixing liability occurs or the payment is unconditionally due. In the case of bonus compensation, that might mean that the employee remains employed through a specified date (e.g., the end of the bonus year or the bonus payment date). Sometimes that means that performance targets have to be satisfied at certain levels. In any case, the relevant “event” is not likely to occur earlier than the end of the year and possibly later into the next year. Revenue Ruling 2011-29, however, provides that the first prong of the all events test can be met if, at the end of the year in which the services are performed, the company is obligated to pay a minimum bonus amount. This is usually accomplished by the company’s board, compensation committee or other committee or person with the requisite authority adopting resolutions obligating the company to pay the minimum amounts. The adopting resolutions do not have to be a minimum amount PER INDIVIDUAL but rather an aggregate amount. If this can be established, then the first prong would be met in year one (and eligible for deduction in year one if the other prongs of the all events test are met for year one).
It is possible that your board (or applicable committee) would have sufficient information to determine at least a minimum aggregate amount that would be paid in bonuses and could establish that prior to year end. Assuming other requirements are met, this could accelerate the deduction for the group of employees covered by the minimum, at least as to the extent of the minimum amount. That minimum would actually have to be paid though—in other words, you could not decide to pay less for whatever reason.
The foregoing approach would most likely not work for covered employees within the meaning of section 162(m) of the Internal Revenue Code (assuming 162(m) remains in effect after tax reform) because it is highly unlikely that the company would have the requisite information to certify the performance targets prior to year end so as to establish the minimum amount. In addition, if the company did indicate that the covered employees would get a minimum amount (or any bonus amount) without regard to certification of the targets, the 162(m) treatment would be blown. Accordingly, in drafting resolutions establishing the minimum bonus amount, the company may wish to expressly exclude its 162(m) covered employees.
The Revenue Ruling also indicates that if the foregoing approach is taken, it will be treated as a change in accounting method and the appropriate rules for such change would need to be observed and taken into account going forward.
If this approach is of interest to your company, talk to your internal and external tax advisors to determine whether establishing the facts early can help you.
Although not quite as entertaining as the intrigue in Game of Thrones or Hamilton, the House and Senate have continued their dueling ways with respect to tax reform. The most recent salvo came from the Senate in the form of a Joint Committee on Taxation, Description of the Chairman’s Modification to the Chairman’s mark of the “Tax Cuts and Jobs Act” (JCX-56-17), November 14, 2017.
Unlike the original Senate version of proposed changes to the House version of the Tax Cuts and Jobs Act (both of which are summarized in our Client Alert dated November 14, 2017), which provided for drastic changes to the nonqualified deferred compensation rules, the new description appears to leave the deferred compensation rules in place. It also adds a transition rule for the modifications to section 162(m) of the Code that would provide that the expansion of section 162(m) would not apply to any remuneration under a written binding contract that was in effect on November 2, 2017 and that was vested as of December 31, 2016. In addition, the proposal eliminates the limitations on 401(k) catch-up contributions for high wage earners.
We are looking forward to the next episode…..
On November 2, 2017, H.R.1 or the Tax Cuts and Jobs Act (the “House Bill”) was introduced in the House of Representatives. The House Bill initially proposed to make sweeping changes to executive compensation provisions in the Internal Revenue Code of 1986, as amended (the “Code”). Among other changes, as initially proposed, the House Bill proposed to:
- Repeal Sections 409A and 457A of the Code and replace such Sections with Section 409B of the Code. While the repeal of Sections 409A and 457A would have been welcome news for many companies over the last ten or fifteen years, Section 409B would effectively prohibit the deferral of all compensation past the point in time when such compensation is no longer subject to a substantial risk of forfeiture related to the performance of services. Section 409B would apply to stock options as well (which were generally excluded from Sections 409A and 457A). The only exception to this rule would be the taxation of the transfer of property pursuant to Section 83 of the Code (other than stock options). While onerous, Section 409A at least permitted the deferral of compensation if certain requirements were met. Section 457A prohibited the deferral of compensation for service providers of nonqualified entities, which were limited and did not apply to most domestic entities. However, Section 409B effectively takes the requirements of Section 457A and makes them applicable to all companies.
- Repeal the performance-based compensation exception of Section 162(m) of the Code. All compensation paid to covered employees would only be deductible up to $1,000,000 regardless of whether the compensation was structured as performance-based compensation or not. The House Bill also expands the definition of the companies subject to Section 162(m), expands the definition of covered employee and makes the designation of any person as a covered employee permanent rather than a year by year determination for years after 2017.
- Add an excise tax of 20% for compensation paid by a tax-exempt organization in excess of $1,000,000. The excise tax is payable by the tax-exempt organization.
If your company is transferring employees to the U.S., be sure to review any outstanding equity grants and other awards of compensation (such as deferred bonuses) that they previously received under home country compensation plans that vest and are payable after they arrive in the U.S. In many cases, a company must amend the terms of such awards to comply with the Internal Revenue Code’s deferred compensation rules (Internal Revenue Code Section 409A) no later than the last day of the first year in which the transferred employees become U.S. tax residents. Failing to do so could result in a big tax bill for these employees down the road, which companies often end up paying, as well as a tax gross-up.