United States: New 162(m) Guidance: IRS Notice 2018-68 Clarifies Scope Of Tax Reform And Transition Rules

Section 162(m) of the Internal Revenue Code denies a tax deduction to a public company for compensation paid to certain individuals—called "covered employees"—to the extent that the compensation paid to such individual exceeds $1,000,000 for the taxable year.

In 2017, Section 162(m) was amended to, among other things:

  • Expand the definition of a "covered employee",
  • Expand the definition of a "public company" subject to Section 162(m), and
  • Apply the 162(m) deduction limitation to commission pay and performance-based compensation, which had been previously exempted from the 162(m) deduction limitation.

These 2017 amendments apply to all taxable years beginning on or after January 1, 2018. However, an exception to this rule provides that compensation payable pursuant to written binding contracts in force as of November 2, 2017, will remain subject to the 162(m) deduction limitations that were in effect prior to the 2017 amendments, until such contracts are materially modified (referred to in this client alert as the "grandfathering rule" and "grandfathered compensation"). Please see our prior client alert for additional details, Congress Approves Tax Reform Bill Impacting Equity Compensation."

On August 21, 2018, the IRS issued Notice 2018-68 which clarified the scope of the 2017 amendments. These clarifications are effective for taxable years ending on or after September 10, 2018. A summary of key points follows:

  • Covered Employees Interpreted Broadly. The 2017 amendments expanded the definition of a "covered employee" to include an employee of a public company who:
    1. Served as the principal executive officer or the principal financial officer of the company (or acted in such capacity) at any time during the taxable year,
    2. Is the among the three highest compensated executive officers for the taxable year (other than an individual described in (1)), or
    3. Was a covered employee of the company or a predecessor at any time after December 31, 2016 (this includes an individual who was a covered employee for 2017 as determined under the pre-amended rules).
    An individual is a covered employee regardless of whether the individual is employed at the end of the taxable year, and regardless of whether disclosure of his or her compensation is required under SEC rules.
  • Grandfathering Rule Interpreted Narrowly. The relief provided by the grandfathering rule is narrow. Specifically, compensation will not be treated as payable pursuant to a "written binding contract," and as such will not be grandfathered, to the extent that the amount of the compensation can be decreased in the company's discretion after November 2, 2017. Compensation will also not be grandfathered if the grant of the compensation remained subject to a condition as of November 2, 2017, such as a grant that is subject to board approval. Examples of the narrow relief are provided below.

    As described above, the 2017 amendments provided that compensation payable pursuant to a grandfathered contract becomes subject to the new Section 162(m) deduction limitation rules once the contract is "materially modified." The new IRS guidance defines a "material modification" to mean an amendment to increase the compensation payable to the employee under the contract. However, the new IRS guidance provides limited exceptions to this rule for reasonable cost of living increases and additional compensation paid on the basis of elements or conditions that are not substantially the same as the elements or conditions that are the basis for grandfathered compensation.

Practical Tips

  • Grandfathering. When applying the grandfathering rule, the first consideration should be whether the covered employee would have been a covered employee for the taxable year if the pre-amended rules had continued to apply.

    We expect the grandfathering rule to have the greatest impact when the covered employee would not have been a covered employee for the taxable year under the pre-amended rules.1 In this case, all compensation under a grandfathered contract (even non-performance based) will remain deductible until the contract is materially modified.

    The grandfathering rule will also apply in the case of a covered employee who would have been a covered employee for the taxable year under the pre-amended rules. However, in this case, grandfathered compensation will remain deductible only if such compensation would have qualified as deductible performance-based compensation under the pre-amended rules, and only until the grandfathered contract is materially modified.
  • Negative Discretion. Under the pre-amended rules, many performance-based arrangements provided for shareholder approval of a reach target and allowed the compensation committee to use negative discretion to arrive at a lower actual payout. As described above, Notice 2018-68 provides that performance-based compensation under this type of plan will be grandfathered only to the extent that the compensation was not subject to the company's negative discretion as of November 2, 2017. For example, if a plan established in early 2017 allowed the company's compensation committee to apply negative discretion to reduce a payout to a covered employee to $0, then none of the compensation payable pursuant to this plan will be grandfathered.
  • Recordkeeping. Public companies will now need to implement robust compensation recordkeeping protocols for a greater number of employees. This is because public companies will be required to identify their three highest compensated executive officers (other than their principal executive officer and principal financial officer) in accordance with the SEC's compensation disclosure framework, even if those persons are not subject to SEC disclosure rules. This includes smaller reporting companies and emerging growth companies, despite the scaled-down SEC compensation disclosure requirements that apply to these companies.
  • Incentive Stock Options. When an employee exercises an incentive stock option, he or she has no ordinary taxable income upon exercise, and if the shares are held for requisite holding periods, the sale proceeds are capital gains. As a result of the 2017 amendments, many public companies may no longer receive a deduction when their executive officers exercise their stock options. Since the company would stand to lose the deduction under Section 162(m) anyway, this may make incentive stock options more attractive.
  • Alternative Forms of Compensation. A grandfathered contract will be considered "materially modified" if it is amended in order to increase the compensation payable under it. However, it is not a material modification to provide a covered employee with additional compensation in another form—even if that new compensation is subject to the 162(m) deduction limitation under the new rules—so long as the new compensation is paid on the basis of elements or conditions that are not substantially the same as the elements or conditions for grandfathered compensation.2
  • More to Come Regarding IPO and M&A Considerations. The recent IRS guidance does not address the application of Section 162(m) to corporations immediately after they become public through an initial public offering or a similar business transaction, or to an employee who was a covered employee of a predecessor of the public company.

Fenwick & West will continue to closely monitor any developments and encourages clients to reach out with questions.


1 For instance, a principal financial officer will qualify as a covered employee for all taxable years beginning after January 1, 2018, but generally was excluded from the 162(m) deduction limitation rules in prior tax years. However, we note that in a Chief Counsel Advice (CCA) legal memorandum issued on August 24, 2015, the IRS concluded that a principal financial officer of a smaller reporting company can be a covered employee for a taxable year if he or she is one of the two highest compensated executive officers of the company. The CCA left open the question of whether the same analysis would apply in the case of a principal financial officer of an emerging growth company.

2 For example, assume that an employee who is not a covered employee receives a written binding commitment on August 1, 2017 to receive $500,000 on June 1, 2018. On January 1, 2018, the employee becomes a "covered employee" due to the tax reform. If the company increases the total payout to $800,000, the entire amount will be subject to the 162(m) deduction limitation. However, if the payment remains $500,000, but the company grants new awards of restricted stock worth $300,000, only the new stock awards will be subject to the 162(m) deduction limitation, and the payout under the original contract will remain grandfathered.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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