On December 16, 2019, the IRS issued proposed regulations under Section 162(m) of the Internal Revenue Code (the "Proposed Regulations"). The Proposed Regulations respond to comments made on Notice 2018-68 (the "Notice"), which provided initial guidance on the application of Section 162(m) in light of amendments made by the Tax Cuts and Jobs Act (the "Act").1 In general, the Proposed Regulations clarify: (1) the revised definitions of "covered employee," "publicly held corporation" and "applicable employee compensation"; and (2) the application of the amendment's transition rule (commonly referred to as the grandfathering rule).
The IRS is scheduled to publish the Proposed Regulations in the Federal Register on December 20, 2019, upon which date a 60-day comment period will commence. The public hearing to discuss the Proposed Regulations is scheduled for March 9, 2020 at 10 a.m.
Section 162(m) disallows a deduction by any "publicly held corporation" for "applicable employee remuneration" paid to any "covered employee" in excess of $1 million. The Act made the following significant changes to Section 162(m):
- Removed the "qualified performance based compensation" exception;
- Expanded the definition of "publicly held corporation" to include any issuers of securities (including debt) required to be registered under Section 12 of the Exchange Act, or any corporation that is required to file reports under Section 15(d) of the Exchange Act; and
- Expanded the definition of "covered employee" to include any employee serving or acting as the corporation's CFO during the tax year and any individual who was a covered employee of the corporation (or any predecessor) for any tax year that begins on or after January 1, 2017.
Although the Proposed Regulations apply to tax years beginning after December 31, 2017, the Act includes a grandfathering rule whereby compensation provided pursuant to a written binding contract in effect on November 2, 2017 will not be subject to the amendments, provided the contract is not modified in any material respect after that date.
Certain Defined Terms
Definition of Publicly Held Corporation. The Proposed Regulations confirm that a publicly held corporation means any corporation that issues securities (including debt) that are required to be registered under Section 12 of the Exchange Act and any corporation that is required to file reports under Section 15(d) of the Exchange Act. This determination is to be made as of the last day of the corporation's taxable year and, if a corporation's obligation to file reports under Section 15(d) of the Exchange Act is suspended, its status as a publicly held corporation under 162(m) is suspended, as well. In addition, the Proposed Regulations eliminate any transition relief previously afforded to privately held corporations that become publicly held.
The definition of "publicly held corporation" is expansive and includes: (i) foreign private issuers, (ii) partnerships that are treated as corporations under Section 7704 of the Code, (iii) publicly held subsidiaries (even if wholly owned by a publicly held parent) and (iv) the parents of qualified subchapter S subsidiaries, in each case to the extent the entity meets the new definition of a "publicly held corporation." As foreign private issuers are not required to disclose their executives' compensation under the SEC's disclosure rules, the IRS is requesting comments on whether it should design a safe harbor for determining the three most highly compensated executive officers of a foreign private issuer.
Definition of Covered Employee. The Proposed Regulations confirm that if an individual was a covered employee of the publicly held corporation or its predecessor for any preceding taxable year beginning after December 31, 2016, that individual will remain a covered employee for all subsequent tax years. As a result, compensation paid to covered employees following a separation from service (including, for example, any non-qualified deferred compensation payments or fees for services as a director) will remain subject to the deduction limitation.
Definition of Applicable Employee Remuneration. The Proposed Regulations clarify that compensation paid to a beneficiary on behalf of a deceased covered employee is subject to the deduction limitation of Section 162(m).
What Constitutes a Written Binding Contract?
The Proposed Regulations provide that compensation is considered payable under a written binding contract that was in effect on November 2, 2017 only to the extent that the corporation was obligated as of that date under applicable law (such as state contract law) to pay the compensation if the employee satisfied the conditions for receipt of the compensation. As a result, a written binding contract does not exist to the extent amounts payable may be reduced in the discretion of the company, even if the employees satisfies the conditions for receipt of the compensation. In practical terms, an arrangement, such as a discretionary annual bonus plan that provides the company with the ability to not make any payment, would fail to qualify as a written binding contract that was in effect on November 2, 2017, even if the plan were in place on that date. With respect to discretion that is triggered upon an event (such as a restatement permitting recoupment of bonus amounts), grandfathering of amounts subject to forfeiture or recoupment will be lost upon the occurrence of the triggering event (regardless of whether the corporation actually exercises its discretion).2
We note that, notwithstanding contract language providing for negative discretion, one could still argue that bonus amounts are grandfathered to the extent that equitable principles support a claim by the employee for the bonus. Such might be the case, for example, if there is a known practice of an employer over multiple years of never having exercised their theoretical negative discretion and it can be shown that employees relied on that practice to their detriment.
The IRS recognizes the burden of applying the written binding contract standard and welcomes comments on possible simplification. Specifically, the IRS seeks comments on whether it should apply a safe harbor such that an arrangement in effect on or before November 2, 2017 will be grandfathered if an amount payable under it was accrued (or could have been accrued) under GAAP, regardless of whether the corporation is obligated to pay the amount under applicable law.
What Constitutes a Material Modification?
The Proposed Regulations provide that a material modification to a contract will occur when the contract is amended to increase the amount of compensation payable to the employee. In that instance, the contract will be deemed a new contract entered into as of the date of the modification and the amounts received after the date of the modification will not be grandfathered. A material modification will also occur if a payment under a contract is accelerated or deferred unless, if accelerated, the compensation paid is discounted to reasonably reflect the time value of money or if deferred, any additional amount paid is based on either a reasonable rate of interest or a predetermined actual investment. Note, however, that although there is no material modification, the additional earnings will not be grandfathered and will therefore be subject to the deduction limitation of Section 162(m).
The Proposed Regulations also clarify that the adoption of a supplemental contract providing for 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. A supplemental payment, however, that is equal to or less than a reasonable cost-of-living adjustment over the payment made in the preceding year will not be considered a material modification.
Finally, the IRS adopted commentators' suggestion that accelerating the vesting (as opposed to payment) of any form of compensation will not result in a material modification of the contract.
The Proposed Regulations highlight the additional administrative burdens facing publicly held companies in light of the amendments to Section 162(m). Notably, corporations will now need to track the compensation of an individual categorized as a covered employee until all payments from the company have been made to that individual or his or her beneficiaries. It remains to be seen whether, in its final regulations, the IRS will adopt any of its proposed safe harbors, which may ease some of the compliance burdens.
Special thanks to associate Teri Tillman for her contributions to this client publication.
1 For a discussion of the Tax Cuts and Jobs Act, please see our client publication "Tax Cuts and Jobs Act: House and Senate Pass Tax Reform Bill," available at: https://www.shearman.com/perspectives/2017/12/tax-cuts-and-jobs-act-passed.
2 As noted by the IRS, the language regarding written binding contracts is almost identical to language that addressed the initial application of Section 162(m) and grandfathered compensation provided pursuant to a written binding contract in effect as of February 17, 1993. Section 1.162-27(h) of the Income Tax Regulations provides guidance on the definition of "written binding contract" and "material modification" for purposes of applying the original grandfathering provision.
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