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.
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.