On August 21, 2018, the Internal Revenue Service (the "IRS") issued Notice 2018-68 (the "Notice"), offering initial guidance on changes made to Section 162(m) of the Internal Revenue Code (the "Code") by the Tax Cuts and Jobs Act (the "Act"). The Notice provides guidance relating to the Act's expansion of the definition of "covered employee" and the operation of the grandfather rule under the Act.
- Companies can no longer simply look to the summary compensation table to identify covered employees.
- Smaller reporting companies and emerging growth companies are treated the same as larger reporting companies.
- Clauses in plans that allow a company to reduce or eliminate payments (commonly referred to as "negative discretion" clauses) will likely take the plans outside the scope of the grandfather rule to the extent of the company's discretion to reduce or eliminate such payments.
- In corporate transactions, compensation paid under non-grandfathered arrangements to target company executives will be subject to Code Section 162(m) for the pre-closing short tax year, regardless of whether compensation for the short tax year is required to be disclosed under the rules of the Securities and Exchange Commission (the "SEC").
- Companies should be careful to avoid inadvertent material modifications that could limit the deductibility of otherwise grandfathered compensation.
Code Section 162(m) disallows a deduction by publicly held corporations for compensation paid to a "covered employee" to the extent the compensation for the taxable year exceeds $1,000,000. As discussed in a previous Morrison & Foerster alert, the Act significantly expanded the reach of Code Section 162(m) by, among other things, amending the definition of "covered employee" and eliminating the exemptions for commission- and performance-based compensation. The Act contained a transition rule making the Act's changes to Code Section 162(m) inapplicable to written binding contracts that were in effect on November 2, 2017, provided they are not materially modified after that date (commonly referred to as the "grandfather rule"). Other than with respect to grandfathered amounts, the Act's changes to Code Section 162(m) apply to taxable years beginning on or after January 1, 2018.
Definition of Covered Employee
Before the Act, the definition of "covered employee" was limited to the chief executive officer ("CEO") and the corporation's four other most highly compensated executive officers whose compensation was required to be reported in the corporation's summary compensation table. Notably, before the Act, the definition of "covered employee" did not pick up chief financial officers ("CFOs") or anyone who was not serving as an executive officer on the last day of the tax year.
The Act significantly expanded the coverage of Code Section 162(m) by amending the definition of covered employee to include individuals who, at any time during the year, serve as the CEO or CFO, and to provide that any officer who was a "covered employee" of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016 will remain a covered employee in future tax years. The Act also added flush language to the covered employee definition that provides that the term "covered employee" includes an employee who would have been one of the three most highly compensated employees whose compensation is required to be reported under SEC rules if such reporting were required. Many practitioners believed this flush language was added simply to address the expansion of the coverage of Code Section 162(m) to include certain issuers that are not required to disclose compensation of their top executive officers in a summary compensation table, such as companies required to file reports under Section 15(d) of the Securities Exchange Act of 1934, or publicly traded corporations that delist.
The IRS has interpreted this flush language more broadly, applying it to companies that are required to disclose compensation of their top executive officers in a summary compensation table. The Notice provides that the term "covered employee" includes any employee who is among the three highest-compensated executive officers for the taxable year (other than the CEO and CFO), regardless of whether the employee's compensation is required to be disclosed under SEC rules even when the company is required to disclose the compensation of other executive officers. For example, if a corporation's three most highly compensated executive officers other than the CEO and CFO were to terminate employment during the year, although only two of the three would be reported in the proxy statement, all three would be covered employees, and the three other next most highly compensated executive officers (other than the CEO and CFO) who were serving on the last day of the year and whose compensation is disclosed in the proxy would not be covered employees (unless they were covered employees with respect to a prior taxable year beginning after December 31, 2016). Consequently, companies will no longer simply be able to look to the summary compensation table to identify covered employees.
By decoupling the covered employee determination from the SEC disclosure rules, the IRS's expansive interpretation of the flush language added by the Act will also have less obvious, but still important, implications for smaller reporting and emerging growth companies and companies involved in mergers and acquisitions.
Impact on Smaller Reporting Companies and Emerging Growth Companies
Under the SEC's rules for executive compensation disclosure, smaller reporting companies and emerging growth companies are only required to disclose compensation with respect to individuals serving as the CEO, the two most highly compensated executive officers other than the CEO who were serving as executive officers at the end of the last completed fiscal year, and up to two additional individuals for whom disclosure would have been provided based on compensation level but for the fact that the individual was not serving as an executive officer at the end of the last completed fiscal year. Thus, it was generally thought that smaller reporting and emerging growth companies that did not have any executive officers leave during the year would only have three covered employees: the CEO and two most highly compensated officers who were serving as executive officers at the end of the last completed fiscal year.
The Notice clarifies that this is not the case, stating that it is not relevant whether the SEC rules for smaller reporting companies and emerging growth companies apply to the corporation, nor is it relevant whether a specific executive officer's compensation must be disclosed under the SEC rules applicable to the corporation. In other words, smaller reporting companies and emerging growth companies are treated on par with larger reporting companies under Code Section 162(m). As with larger reporting companies, smaller reporting companies and emerging growth companies will have to look beyond their summary compensation tables to determine who their covered employees are, picking up anyone acting as CFO during the year (regardless of compensation level), the three most highly compensated executive officers other than the CEO and CFO, regardless of whether their compensation has to be reported under the SEC's disclosure rules, and any covered employees from prior taxable years beginning after December 31, 2016.
Before the Act, the IRS had concluded in a number of private letter rulings that target company executives in certain mergers and acquisitions were not covered employees with respect to the short tax year resulting from the transaction since the SEC rules do not require disclosure of their compensation for the short tax year in a summary compensation table.1 In a break from the position reflected in these past private letter rulings, the Notice clarifies that executive officers of a target corporation will now be covered employees for the short tax year, even though their compensation is not reported under SEC rules for that year. The Department of Treasury and the IRS deferred guidance as to how the three most highly compensated executive officers for the taxable year should be determined when the taxable year does not end on the same date as the last completed fiscal year, and requested comments as to how the SEC executive compensation disclosure rules should be applied in that circumstance. Until further guidance is issued, taxpayers should base their determination upon a reasonable good faith interpretation of Code Section 162(m), taking into account the guidance provided under the Notice.
This new position, together with the guidance on material modifications of grandfathered arrangements (discussed below), will create a number of interpretive issues, such as whether the deduction attributable to accelerated vesting of restricted stock upon a change in control pursuant to a grandfathered plan or employment or severance agreement will be subject to Code Section 162(m) or, instead, will be grandfathered based on the reasoning reflected in private letter rulings noted above.
Companies should begin now, if they haven't already, to consider how the changes to the covered employee definition might impact determination of their covered employees and develop a game plan for identifying and tracking covered employees.
The Grandfather Rule
The Act contained a grandfather rule providing that the amendments to Code Section 162(m) do not apply to compensation provided under a written binding contract which was in effect on November 2, 2017, and that is not thereafter modified in any material respect or renewed (e.g., pursuant to an evergreen clause). The Notice addresses questions relating to what constitutes a "written binding contract" and a "material modification" of a written binding contract.
Written Binding Contract
Compensation is considered payable under a written binding contract that was in effect on November 2, 2017, only to the extent the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration if the employee performs services or satisfies applicable vesting conditions. Accordingly, the amendments to Code Section 162(m) made by the Act apply to any amount of compensation that exceeds the amount that applicable law obligates the corporation to pay under a written binding contract that was in effect on November 2, 2017, if the employee performs services or satisfies the applicable vesting conditions.
Since the Act's passage, practitioners and taxpayers have been struggling with the question of whether a negative discretion clause in a plan or agreement would be enough to take the plan or agreement outside of the scope of the grandfather rule. The Notice generally confirms practitioners' and taxpayers' fears, indicating, by way of an example, that the grandfathered amounts under such a plan or agreement are limited to the amounts the corporation is legally obligated to pay, taking into account the corporation's unilateral authority to reduce or eliminate payments pursuant to a negative discretion clause. Thus, unless applicable law would override the corporation's authority to effect such a reduction or elimination, it appears a negative discretion clause will cause payments under the plan or agreement to fall outside the scope of the grandfather rule.
The Notice states that a material modification occurs when a contract is amended to increase the amount of compensation payable to the employee. Also, a modification of a contract that accelerates the payment of compensation is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Finally, if a contract is modified to defer the payment of compensation, any compensation paid or to be paid that exceeds the amount originally payable to the employee under the contract will not be treated as resulting in a material modification if the additional amount is based on either a reasonable rate of interest or a predetermined actual investment. If a written binding contract is materially modified, it is treated as a new contract entered into as of the date of the material modification.
Supplemental Contracts and Agreements
The Notice provides that the adoption of a supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, will constitute 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, and the supplemental payment exceeds a reasonable cost-of-living increase over the payment made in the preceding year under that written binding contract. This guidance, while helpful in understanding the potential scope of the material modification rule, creates a potential trap for the unwary and raises some difficult interpretive questions.
By way of example, the Notice clarifies that granting time-vesting restricted stock to an executive with a grandfathered employment contract that stipulated a base salary would not result in loss of grandfathering of the salary payments, since compensation from the restricted stock is based on both stock price and continued services (whereas salary compensation is based solely on continued services). The implication from the example is that if, instead of receiving a restricted stock grant, the executive received additional compensation tied solely to continued services (such as a cash-based retention bonus), it could be enough to lose grandfathering protection for the salary component. While not addressed in the Notice, presumably the addition of a performance-based vesting condition to a new entitlement would, like the restricted stock example, be an additional element that would cause the bonus not to be treated as an increase in the executive's base salary.
An additional question not squarely addressed in the Notice is how severance payments under an otherwise grandfathered agreement that are paid to a CFO or other executive officer who is a covered employee solely due to the Act's amendment to the definition of "covered employee" should be analyzed if the severance agreement is not modified, but the amount of severance payable under the agreement has increased due to salary or target bonus increases occurring after November 2, 2017.
Corporations need to consider carefully the potential loss of grandfathering before approving new or increased compensation for a CFO or other executive officer who is a covered employee solely due to the changes made by the Act and who is paid pursuant to a grandfathered plan or agreement, as the new or increased compensation could result in a loss of grandfathering. For example, the Notice suggests that if a company's CFO is party to a grandfathered employment agreement with a specified salary amount, providing the CFO with a retention bonus that is earned based solely on continued services may be considered a payment of additional salary, potentially causing all future salary payments (and not just the retention bonus) to become subject to Code Section 162(m).
The changes to Code Section 162(m) implemented by the Act became effective on January 1, 2018. The Treasury Department and the IRS anticipate that the guidance in the Notice will be incorporated in future regulations that, with respect to the issues addressed in the Notice, will apply to taxable years ending on or after September 10, 2018. The IRS states in the Notice that any future guidance, including regulations, addressing the issues covered by the Notice in a manner that would broaden the definition of "covered employee" as described in the Notice, or restrict the application of the definition of "written binding contract" as described in the Notice, will apply prospectively only.
The Treasury Department and the IRS anticipate issuing further guidance on other aspects of Code Section 162(m) and they have requested comments on additional issues under Code Section 162(m) that future guidance, including regulations, should address, specifically noting the following issues: (1) the application of the definition of "publicly held corporation" to foreign private issuers, including the reference to issuers that are required to file reports under Section 15(d) of the Securities Exchange Act of 1934, (2) the application of the definition of "covered employee" to an employee who was a covered employee of a predecessor of the publicly held corporation, (3) the application of Code Section 162(m) to corporations immediately after they become publicly held either through an initial public offering or a similar business transaction, and (4) the application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year.
1 Although private letter rulings may not be relied upon by a taxpayer other than the taxpayer requesting the ruling, and may not be used or cited as precedent, based on the IRS position as expressed in the rulings, taxpayers have consistently followed these rulings in mergers and acquisitions.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
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