Alert September 11, 2018

IRS Guidance on Application of Code Section 162(m)

Summary

On August 21, 2018, the IRS issued Notice 2018-68 containing initial guidance on the application of amended Section 162(m) of the Internal Revenue Code of 1986 (Code). The notice describes how to identify “covered employees” and the operation of the grandfather rule. 

As noted in our alert on February 1, 2018, the Tax Cuts and Jobs Act of 2017 (the Act) made significant changes to Code Section 162(m), which limits to $1 million the deduction that public companies may take for compensation paid to any “covered employee,” including expanding the scope of Code Section 162(m) and eliminating the exception to the $1 million deduction limitation for “qualified performance-based compensation” and commission-based compensation. While the Act’s amendments to Code Section 162(m) apply to compensation payable after December 31, 2017, a grandfather rule exempts certain compensation payable pursuant to a written binding contract in effect on November 2, 2017, that is not materially modified after such date.

Covered Employee

As a result of the Act, Code Section 162(m), as amended, expands the definition of a “covered employee” to include any employee of a publicly held company (i.e., a company that files reports with the Securities and Exchange Commission (SEC), including any company required to file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934) if such employee (1) is or was the principal executive officer (i.e., CEO) or principal financial officer (i.e., CFO) of the company at any time during the taxable year; (2) is one of the three most highly compensated executive officers during the taxable year other than the principal executive officer and principal financial officer; or (3) was a covered employee of the company (or any predecessor) in any taxable year after 2016 (including years in which the company was not publicly held). 

Guidance on Identifying Covered Employees

Notice 2018-68 specifies that a “covered employee” for a taxable year is any employee (or former employee) who has met the above definition at any time during such year (or any year after 2016), regardless of whether the employee’s compensation is required to be disclosed for the company’s last completed fiscal year pursuant to SEC rules. In this regard, the Notice clarifies that there is no so-called “end-of-year employment” requirement in order for an executive officer of a publicly held corporation to be a “covered employee.” All companies that file reports with the SEC, including any companies required to file reports pursuant to Section 15(d) of the Securities Exchange Act of 1934, as well as companies that do not file proxy statements for a year because they delist their securities in that year, will therefore be subject to Code Section 162(m). 

Planning Considerations

As a result of Notice 2018-68, we recommend that our public company clients review the “covered employee” definition and identify individuals who will be included in their “covered employee” group going forward. The group of covered employees will include, for example, executive officers who are covered due to their position or compensation in periods before the company was publicly held, employees whose compensation is no longer required to be disclosed under SEC rules, and former executive officers who are no longer employed by the company but continue to receive compensation from the company. Companies should expect to have a greater number of “covered employees” than before the effectiveness of the Act and be prepared for the group to expand over time. Some particular items to note include:

  • “Covered employee” group does not always match group of executive officers for SEC disclosure.  Since the amendments to Code Section 162(m) do not impose an end-of-year employment requirement, “covered employees” will include a company’s CEO(s), CFO(s) and three other highest compensated executive officers for a taxable year (or any year after 2016), regardless of whether such executive officers serve as executive officers at the end of the company’s most recently completed fiscal year (which differs from SEC rules).
  • No reduced number of “covered employees” for smaller reporting companies (SRCs) or emerging growth companies (EGCs).  For purposes of identifying a company’s “covered employees,” it is not relevant whether the SEC rules for SRCs or EGCs apply to the company.SRCs and EGCs will be required to have at least five “covered employees” for a taxable year, which will include the company’s CEO(s), CFO(s) and three other highest compensated executive officers for the taxable year. Notice 2018-68 does not address how to determine “covered employees” for a company that does not have at least five executive officers, which is common for SRCs and EGCs.
  • If the last completed fiscal year and taxable year do not end on the same date, “covered employees” are determined based on taxable year.  If a company’s last completed fiscal year and taxable year do not end on the same date (e.g., due to a short taxable year resulting from a corporate transaction), “covered employees” are determined based on the shortened taxable year as well as each taxable year thereafter. In the event a company undergoes a corporate transaction that shortens its taxable year, any “covered employees” identified for such shortened taxable year will generally continue to be “covered employees” for each taxable year thereafter.

Grandfather Rule

While amendments to Code Section 162(m) apply to compensation payable after December 31, 2017, the amendments will not apply to certain compensation payable pursuant to a written binding contract in effect on November 2, 2017, provided that such contract is not materially modified after November 2, 2017.

Guidance on Meaning of Written Binding Contract

  • Legal obligation on the company under applicable law to pay compensation.  Notice 2018-68 clarifies that a written binding contract is one where the company is obligated under applicable law (e.g., state contract law) to pay compensation under such contract if the employee performs services or satisfies applicable vesting conditions as required by such contract.
  • Participation on November 2, 2017, not required.  As long as a written binding contract existed on November 2, 2017, compensation payable to an employee under an arrangement specified in the contract can be subject to the grandfather rule, even if the employee was not eligible to participate in the arrangement until after November 2, 2017.

Guidance on Meaning of Material Modification

  • Increasing, accelerating or deferring payments.  Notice 2018-68 describes that a material modification occurs when a contract is amended to (1) increase the amount of compensation payable to an employee; (2) accelerate the payment of compensation (unless the accelerated amount is discounted to reasonably reflect the time value of money); or (3) defer the payment of compensation (except any amount that was originally payable to the employee under the contract or any excess amount that is based on either a reasonable rate of interest or a predetermined actual investment).
  • Adoption of new arrangements providing supplemental payments.  The adoption of a supplemental contract or agreement providing increased compensation, or the payment of additional compensation, is a material modification of a written binding contract if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract (other than a supplemental payment equal to or less than a reasonable cost-of-living increase over the payment made in the preceding year).
  • Exercise of negative discretion.  Failure, in whole or in part, to exercise negative discretion under a contract does not result in a material modification of a contract for any amount not subject to the $1 million deduction limitation pursuant to the grandfather rule.
  • Renewals to contract terms.  Compensation payable pursuant to a written binding contract that is renewed after November 2, 2017, including automatic renewals, will not be subject to the grandfather rule, unless such contracts have a perpetual term (i.e., are nonrenewable only by the employee).

Planning Considerations

As a result of Notice 2018-68, we recommend that our public company clients use caution when considering changes to potentially grandfathered arrangements. We encourage companies subject to Code Section 162(m) to consult with legal counsel before making any modifications to compensation arrangements that were in place on or prior to November 2, 2017.  Some particular items to note include:

  • Contracts with automatic renewals are likely not grandfathered.  A written binding contract that is terminable by a company without the employee’s consent after November 2, 2017, is treated as renewed as of the date that any such termination, if made, would be effective (e.g., if the term of a contract will be automatically renewed as of a certain date unless either the company or the employee provides notice of termination of the contract at least 30 days before that date, the contract is treated as renewed as of the date that termination would be effective if that notice were given, without regard to whether it was actually given). Similarly, if the term of a contract will be terminated as of a certain date unless either the company or the employee elects to renew within 30 days of that date, the contract is treated as renewed by the company as of that date (or an earlier date if renewed on such earlier date).
  • Contracts with perpetual terms may be grandfathered.  If a company remains legally obligated by the terms of a contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed as of that date if the employee exercises the discretion to keep the company bound to the contract. A contract is not treated as terminable if it can be terminated only by terminating the employment relationship of the employee (e.g., an employment contract without a term).
  • Contracts with lapsed terms but continued employment cannot be grandfathered.  If, following a termination or cancellation of a contract prior to November 2, 2017, an executive’s employment relationship continues, compensatory payments made following termination or cancellation of the contract will not be grandfathered, as they are not made pursuant to a contract that existed on November 2, 2017. However, such contract is not treated as renewed upon such termination or cancellation, even if the employee’s employment relationship continues following the termination or cancellation.
  • No grandfathering if the $1 million deduction limitation would have applied prior to November 2, 2017.  Even if a written binding contract exists on November 2, 2017, if the $1 million deduction limitation applied to compensation payable under such contract, then the grandfather rule does not exempt such compensation from the $1 million deduction limitation. For example, if a covered employee has a grant of time-based restricted stock that was outstanding on November 2, 2017, compensation received from the vesting of such restricted stock would still be subject to the $1 million deduction limitation, since such compensation was not performance-based compensation (assuming no other Code Section 162(m) exemption applies). However, compensation payable pursuant to a written binding contract in effect on November 2, 2017, that was exempt from the $1 million deduction limitation will generally continue to be exempt (e.g., any future compensation payable to CFOs pursuant to a grandfathered arrangement, since CFOs were not subject to the $1 million deduction limitation prior to amendment of Code Section 162(m)).
  • No grandfathering for performance-based bonus subject to complete negative discretion.  If the company has the negative discretion to reduce a performance-based bonus to $0, a common feature in most “umbrella plans” or “plan within a plan” arrangements, then any amount of such bonus payable after December 31, 2017, will be subject to the $1 million deduction limitation, even if the amounts are paid based on the achievement of performance-based metrics, because the company is not legally obligated to pay any amount.
  • Qualifying performance-based compensation with capped negative discretion may be grandfathered.  If a written binding contract in effect on November 2, 2017, permits the exercise of negative discretion, subject to a cap, the amount up to the cap will not be subject to the $1 million deduction limitation assuming achievement of the applicable performance metrics; however, any performance-based compensation in excess of the cap that is paid after December 31, 2017, will be subject to the $1 million deduction limitation.
  • Accrued deferred compensation amounts may be grandfathered.  The grandfather rule applies to deferred arrangements where the company has a legal obligation to pay any amounts accrued as of November 2, 2017. In addition, it is not necessary for an employee to be participating in the deferred compensation arrangement as of November 2, 2017, in order for the grandfather rule to apply, so long as there is a written binding arrangement in place as of November 2, 2017, that entitles the employee to participate with respect to amounts accrued as of such date.
  • Only equity awards granted before November 2, 2017, can be grandfathered.  Promised but not yet granted equity awards do not constitute written binding contracts. Equity awards granted prior to November 2, 2017, constitute written binding contracts but will only be grandfathered to the extent such amounts would not have been subject to the deduction limitations under Section 162(m) prior to amendment (e.g., because such equity awards qualify as performance-based compensation or were granted to the company’s CFO).
  • Supplemental pay cannot be grandfathered.  If a company had a written binding contract in effect on November 2, 2017, to pay only cash compensation to a covered employee and subsequently provides such covered employee with the grant of an equity award, the equity award does not constitute a material modification of the written binding contract, since it is not paid on the basis of substantially the same elements and conditions as the cash compensation. Compensation attributable to an equity award granted after November 2, 2017, will be subject to the $1 million deduction limitation since there was no written binding contract for such equity award in effect on November 2, 2017. If, rather than the equity award, the company provides such covered employee with a supplemental cash amount, the cash amount would not constitute a material modification of the written binding contract only if such amount is less than or equal to a reasonable cost-of-living increase. However, the increased cash amount would be subject to the $1 million deduction limitation because there was no written binding contract for such amount in effect on November 2, 2017. Importantly, a supplemental cash amount that exceeds a reasonable cost-of-living increase will result in the entire arrangement losing grandfather status and being subject to the $1 million deduction limitation under Section 162(m).
  • Equity plan amendments generally should not cause loss of grandfather status.  Based on Notice 2018-68’s definition of what constitutes a material modification to a contract, amendments to equity plans and equity awards in effect on November 2, 2017, that do not (1) increase the amount of compensation payable to the employee; (2) accelerate the payment of compensation; or (3) defer the payment of compensation will generally not result in the loss of grandfather status.

Effective Date

The amendments to Code Section 162(m) apply to taxable years beginning on or after January 1, 2018 and Notice 2018-68 applies to any taxable year ending on or after September 10, 2018 (i.e., it applies to 2018 compensation for companies with a December 31, 2018, tax year-end). The IRS plans to issue further guidance in the form of proposed regulations, which will incorporate the guidance in Notice 2018-68. Any future guidance, including any regulations addressing the issues under Notice 2018-68 that would broaden the definition of “covered employee” or restrict the application of the definition of “written binding contract,” will, according to Notice 2018-68, apply prospectively only. The IRS has asked for comments on additional aspects of Section 162(m), including grandfathering applicable to newly public companies.

The Goodwin ERISA & Executive Compensation team continues to monitor the situation for additional guidance on Code Section 162(m), particularly with respect to the grandfather provisions, and we look forward to assisting our clients in assessing the impact of the changes discussed in this alert on their compensation programs.