United States: IRS Provides Guidance On Application Of Code Section 162(m) As Amended By The Tax Cuts And Jobs Act Of 2017

On August 21, 2018, the IRS issued initial guidance (Notice 2018-68) to assist companies in determining how the changes made to Internal Revenue Code Section 162(m) ("Section 162(m)") by the Tax Cuts and Jobs Act of 2017 (the "Act") affects the deductibility of their compensation arrangements. The guidance focused on two aspects: (1) determining who is a "covered employee" under the new Section 162(m) rules and (2) defining when an arrangement is considered "grandfathered," such that the arrangement may continue to be governed by the old (pre-tax reform) Section 162(m) rules. This article focuses on the guidance related to determining when a compensation arrangement is grandfathered. We previously addressed the guidance about determining "covered employees" in a separate article.

Background

Section 162(m) limits the tax deduction a publicly held company can take with respect to compensation paid to its "covered employees" to no more than $1 million per year.

The Act made the following notable changes to the Section 162(m) rules for tax years beginning on or after January 1, 2018:

  • The definition of "covered employee" was expanded to include anyone acting as CEO or CFO at any time during the year and the three other most highly compensated executive officers (determined with reference to Securities and Exchange Commission rules)
  • Once an individual becomes a "covered employee" under the new Section 162(m) rules, he or she always remains a "covered employee" (even following termination of employment)
  • "Performance-based compensation" paid to covered employees is now subject to the $1 million deduction limitation

The Act included significant transition relief (referred to as the "grandfathering rules"), under which none of the changes to Section 162(m) apply to compensation provided pursuant to a written binding contract that was in effect on November 2, 2017, and not modified in any material respect on or after such date. This means that "grandfathered" compensation will be deductible under the more expansive older Section 162(m) rules, including that qualified performance-based compensation will not count toward the $1 million limit and grandfathered compensation paid to the CFO is generally going to be fully deductible.

What Constitutes a "Written Binding Contract?"

For compensation to be grandfathered, it must be provided pursuant to a "written binding contract" in effect on November 2, 2017.

"Binding" Means Obligated Under Law

The IRS guidance clarifies that compensation is payable under a written binding contract in effect on November 2, 2017, only to the extent the company is obligated under "applicable law" to pay that compensation, as long as the employee performs any required future services or satisfies applicable vesting conditions. In many cases, "applicable law" will be state contract law.

The grandfathered compensation is therefore limited to the amount of the company's obligation as of November 2, 2017; additional amounts will not be grandfathered.

Discretion

Under the IRS guidance, if a contract gives the company the discretion to reduce the amount of compensation payable, and applicable law takes that negative discretion into account, then any amount that could be reduced will not be treated as grandfathered (even if the company does not exercise that negative discretion).

Practice Note: Many companies reserved negative discretion under their annual bonus plans and performance-based equity arrangements as part of their Section 162(m) compliance strategy or to maintain flexibility to take into account unexpected events. Unfortunately, this discretion could, under the IRS guidance, cause awards that were in effect prior to November 2, 2017, to be ineligible for grandfathering. We recommend reviewing all award documentation and participant communications in light of state law to determine whether there is negative discretion that will result in a determination that the arrangement is not a "written binding contract" and is therefore not grandfathered.

Renewals

Any grandfathered employment agreement or other written binding contract will lose its grandfathered status if the agreement is renewed. If a contract is terminable or cancelable by the company without the employee's consent, then it is treated as renewed as of the date that any termination or cancellation could be effective if the company had taken action.

The IRS guidance includes the following examples of when a contract will be treated as "renewed":

  • An "evergreen" contract that automatically renews on a specified date unless either the company or the employee provides notice of termination at least 30 days in advance of that date. The contract is treated as renewed (and therefore no longer subject to the grandfathering rules) as of the date that the contract would terminate if the notice were given.
  • An "opt-in" contract providing that it will be terminated or canceled as of a certain date unless either the company or the employee elects to renew within 30 days is treated as renewed if and when it is actually renewed.
  • A contract that gives the employee discretion over whether to keep the company legally obligated is not treated as renewed if the employee exercises discretion to keep the company bound.

Some exceptions are:

  • A contract is not treated as terminable or cancelable if it can be terminated or canceled only by terminating the employee's employment
  • A contract is not treated as renewed if it provides that, upon its termination or cancelation, the employment relationship continues (but not under the contract)

What Constitutes a "Material Modification?"

A grandfathered compensation arrangement will lose its grandfathered status (and become subject to the new Section 162(m) rules) if the arrangement is "materially modified" after November 2, 2017. Amounts paid before the modification will remain grandfathered (and subject to the old Section 162(m) rules), but all amounts paid after the modification date are subject to the new Section 162(m) rules to determine deductibility.

Basic Definition of Material Modification: Amendment that Increases the Amount of Compensation

In general, any amendment to increase the amount of compensation payable to the employee will be treated as a material modification. There is a limited exception for supplemental payments that are no more than a reasonable cost-of-living increase over a payment made in the preceding year under the contract.

Acceleration is a Material Modification Unless Discounted

If a grandfathered arrangement is modified to accelerate the payment of compensation, then it is treated as materially modified unless the amount paid is discounted to reasonably reflect the time value of money.

Deferrals are Not Material Modifications Unless Amount Increased Beyond Reasonable Interest or Investment Return

If a grandfathered arrangement is modified to defer when the compensation is payable , then the arrangement will be treated as materially modified unless the amount paid is increased only by a reasonable rate of interest or the return on a predetermined actual investment (which must reflect decreases as well as increases in the investment).

Substitutions

If the company and the employee enter into a separate agreement that provides for increased or additional compensation related to the compensation payable under a grandfathered arrangement, then the IRS will evaluate whether the new arrangement should be treated as materially modifying a grandfathered arrangement on a facts and circumstances basis. The IRS will look at the facts and circumstances to determine whether the additional compensation is paid on the basis of substantially the same elements or conditions as the grandfathered compensation.

You Have a Grandfathered Arrangement That Has Not Been Materially Modified – What Does That Mean?

The IRS guidance confirmed that, if compensation is grandfathered for Section 162(m) purposes, it is not subject to any of the changes made to Section 162(m) under the Act.

Some practical implications of this are:

  • Grandfathered compensation paid to someone who is a "covered employee" under the new Section 162(m) rules solely because of his or her CFO status does not count toward the $1 million limit on deductibility
  • Grandfathered compensation that is payable after termination of employment (such as severance or nonqualified deferred compensation paid after termination) generally does not count toward the $1 million limit on deductibility. Note that the amount considered grandfathered under nonqualified deferred compensation arrangements will generally be limited to the amount accrued as of November 2, 2017.
  • Grandfathered compensation that otherwise qualifies as "performance-based compensation" under the old Section 162(m) rules will not count toward the $1 million limit on deductibility if the requirements of the old Section 162(m) rules, including certification of achievement of the performance goals by a committee consisting solely of "outside directors," are met. As noted above, the grandfathering of performance-based compensation arrangements may be severely limited by any negative discretion provisions within the arrangement.
  • Stock options and stock appreciation rights (SARs) granted before November 2, 2017, should be considered grandfathered.

Further Guidance and Open Items

The IRS guidance indicated that the IRS intends to issue proposed regulations to cover the items discussed in the Notice. The IRS also requested public comment on some issues not addressed in its guidance, including the application of the definition of "covered employee" to an employee who was a covered employee of a predecessor company and the application of Section 162(m) to newly public companies. As a result, we expect additional guidance related to these issues to be forthcoming following the public comment period.

Companies should start or further review compensation arrangements that were in effect on November 2, 2017, to determine what arrangements may be "grandfathered" under the new Section 162(m) rules. In addition, companies should develop processes and procedures to (i) avoid any unintentional modifications of grandfathered arrangements and (ii) track all covered employees.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions