United States: IRS Issues Long-Awaited Initial Guidance Under Section 162(m)

On August 21, 2018, the IRS issued guidance regarding recent statutory changes made to Section 162(m) of the Internal Revenue Code. Overall, Notice 2018-68 strictly interprets the Section 162(m) grandfathering rule under the Tax Cuts and Jobs Act. 

Public companies and other issuers subject to these deduction limitations will want to closely consider this guidance in connection with filing upcoming periodic reports with securities regulators. Further action to support existing tax positions or adjustments to deferred tax asset reporting in financial statements may be warranted in light of this guidance.

In Depth

On August 21, 2018, the Internal Revenue Service (IRS) issued Notice 2018-68, which provides limited initial guidance regarding changes recently made to Section 162(m) of the Internal Revenue Code by the 2017 tax reform act, commonly referred to as the Tax Cuts and Jobs Act (TCJA). 

One of the more important immediate aspects of these changes is the application of the transition (or "grandfather") rule to certain outstanding compensatory arrangements. Specifically, the TCJA changes to Section 162(m) do not apply to compensation paid under a "written binding contract" in effect on November 2, 2017, provided the contract is not "materially modified" after such date. 

Notice 2018-68 strictly interprets what is a written binding contract and when compensation is treated as paid under it. Just because a plan or agreement is in place as of November 2, 2017, does not mean that it will be eligible for transition relief. If an arrangement qualifies as a written binding contract, Notice 2018-68 explicitly exempts certain actions from being treated as a material modification. The extent to which other actions will not be treated as a material modification remains to be seen.

Not surprisingly, Notice 2018-68 clarifies that anyone who serves as the principal executive officer, the principal financial officer or one of the three most highly paid executive officers will be a covered employee subject to the tighter Section 162(m) deduction rules, whether or not employed at year end, for tax years beginning on or after January 1, 2018. It also provides that executive officers of a publicly held corporation can be covered employees, even if disclosure of their compensation is not required under US Securities and Exchange Commission (SEC) rules.

The IRS anticipates that further guidance regarding the changes to Section 162(m) made by TCJA will be issued in the form of proposed regulations. Notice 2018-68 specifically requests comments regarding other matters, including the application of Section 162(m) to foreign private issuers, the extent to which the initial public offering (IPO) transition rule will continue to apply under Section 162(m), how covered employees should be treated in a corporate transaction and how to apply SEC disclosure rules for determining the three most highly compensated executive officers when the tax year and the fiscal year are not the same.

The IRS also anticipates that the guidance set forth in Notice 2018-68 will be incorporated into future guidance that will apply to taxable years ending on or after September 10, 2018. Any future guidance addressing matters covered by Notice 2018-68 that either restrict what is a written binding contract or broaden who is a covered employee subject to the new tighter deduction limits under Section 162(m) will be prospective only.

What Qualifies as Compensation Paid under a Written Binding Contract?

In general, compensation is treated as paid under a written binding contract only to the extent that the covered entity is "obligated under applicable law" (including state law) to pay such compensation if the employee performs service or satisfies applicable vesting conditions. Any amount that exceeds what must be paid under applicable law will be subject to the new Section 162(m) rules.

How Does the Written Binding Contract Rule Apply to Performance-Based Compensation Subject to Negative Discretion?

Unfortunately, the Notice does not address how applicable law might apply to arrangements in effect on November 2, 2017, that are intended to comply with the performance-based compensation exemption under pre-TCJA law and permit (but do not require) the exercise of "negative discretion" (i.e., discretion by a compensation committee to reduce payments otherwise payable due to meeting a performance goal). An example in Notice 2018-68 can be read to suggest that the IRS generally believes that broad-based negative discretion clauses are inconsistent with the existence of an "obligation" to pay unless there is a stated minimum amount in the contract. Employers seeking to deduct performance-based compensation under a pre-November 2, 2017 plan or arrangement subject to a negative discretion clause by relying upon the grandfather rule will need to be able to demonstrate that those payments were legally required, such as may be the case where there are explicit limitations on the exercise of discretion due to either explicit contract terms (e.g., adjustments on to fairly reflect certain events) or applicable state laws (e.g., interpretation of contract terms consistent with the implied covenant of good faith and fair dealing).

Will Amounts Payable under Qualifying Stock Options and Stock Appreciation Rights (SARs) Granted Before November 2, 2017, be treated as Payable under a Written Binding Contract?

Generally, yes, so long as (1) all approvals for the grant of stock options and SARs as required under applicable law were secured not later than November 2, 2017, and (2) no material changes are made to the option or SAR. Whether that is the case requires a review of the documentation for the grants. On the other hand, a stock option or SAR grant that is promised to an employee as of November 2, 2017, but is subject to approval by the board of directors at a later date, is not a written binding contract for purposes of Section 162(m). In addition, a restricted stock award that qualifies as a written binding contract will nevertheless be subject to the $1 million deduction limitation if it does not meet the requirements for the performance-based compensation exception under pre-TCJA law.

Will Amounts Accrued under Nonqualified Deferred Compensation Plans Be Treated as Payable under a Written Binding Contract?

It depends on when the deferred amounts accrue under the plan and the specific terms of the plan and any related contact. A deferred amount that is earned during a taxable year ending before November 2, 2017, and that cannot be reduced retroactively by the employer should be considered an amount payable under a written binding contract. On the other hand, amounts that would be eligible to be accrued under a nonqualified deferred compensation plan in existence on November 2, 2017, for taxable years beginning on or after January 1, 2018, will not be treated as compensation paid under a written binding contract if the employer could unilaterally amend the plan to reduce or eliminate those accruals as of November 2, 2017, regardless of whether the employer actually does so. That is often the case under a nonqualified deferred compensation plan unless there is a separate agreement guaranteeing accruals for future years of service.

How Does the Written Binding Contract Requirement Apply to Employment Agreements?

Amounts paid under an employment agreement in effect as of November 2, 2017, during the remainder of its term will be treated as payable under a written binding contact. However, the TCJA changes to Section 162(m) will apply to an employment agreement that is renewed after November 2, 2017, due to action or non-action by the covered entity. On the other hand, an employment agreement will not be treated as renewed due to the action or non-action of the employee to keep the covered entity bound to the contract beyond a certain date at the employee's sole discretion. Amounts payable under a grandfathered employment agreement to an executive officer who was not a covered employee under pre-TCJA law (such as a Principal Financial Officer) will not be subject to the new Section 162(m) deduction rules.

When Will a Written Binding Contract Be Treated as Materially Modified?

The Notice provides that a material modification occurs when a contract is amended to increase the amount of compensation payable to the employee. This rule follows the approach used under the existing Section 162(m) regulations issued shortly following the enactment of Section 162(m) in 1993. The exact contours of what will be considered an increase to the amount of compensation are not addressed by the Notice. Instead, it identifies certain actions that will not be treated as an increase in compensation, including:

  1. An accelerated payment that is discounted for the time value of money,
  2. A deferred payment that includes earnings due to a reasonable rate of interest or a predetermined actual investment (similar to concepts under Section 3121(v) of the Internal Revenue Code) or
  3. The payment of increased compensation or additional compensation that is equal to or less than a reasonable cost of living increase.

It remains to be seen whether acceleration of vesting or certain changes to equity awards (such as transfers for estate planning or adjustments for corporate transactions) will be also be exempt from being treated as material modifications.

The Notice also provides that the failure, in whole or in part, to exercise negative discretion under a contract does not result in the material modification, which implies that certain arrangements subject to a negative discretion clause can constitute a written binding contract.

If a Written Binding Contract Is Materially Modified, What Happens to Amounts Paid before the Date of that Modification?

Amounts received by an employee under a written binding contract before a material modification do not lose protection under the grandfather rule. However, amounts received after the material modification will be subject to the new requirements under Section 162(m).

IRS Issues Long-Awaited Initial Guidance Under Section 162(m)

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