The Internal Revenue Service ("IRS") recently proposed Regulation 122180-18 (the "Proposed Regulations") to implement the amendments found in the Tax Cuts and Jobs Act of 2017 (the "Act")1 to Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code"). The Proposed Regulations supersede the IRS guidance previously released in IRS Notice 2018-682 and remain open for comment until February 18, 2020; however, many aspects of the Proposed Regulations take immediate effect. This alert summarizes key aspects the Proposed Regulations on executive compensation arrangements.
- Private companies may delay going public. Recently IPO'ed companies are no longer eligible for transition relief under Code Section 162(m). Some companies may therefore choose to delay going public. However, given the relatively low corporate tax rate currently in effect, the advantage of delaying Code Section 162(m) applicability is not as important as it would be if tax rates were higher.
- Tax Deductibility Not a Consideration in Whether to Accelerate Awards. Under the Proposed Regulations, acceleration of the vesting of awards will not in and of itself cause the award to lose any grandfathered status. This fact provides companies more flexibility in administering their outstanding awards.
- New Items to Diligence in M&A Transactions. Companies subject to Code Section 162(m) that engage in M&A transactions should now consider which, if any, target employees gained in the transaction will be Covered Employees, taking special care to diligence any previous transactions of the target in which Covered Employees may have been gained. Likewise, companies engaging in such transactions may consider adding representations from the target to acquisition documents regarding the identity of Covered Employees.
- Recordkeeping Critical. Companies will need to annually identify current Covered Employees. Given that once an employee becomes a Covered Employee he or she will always remain a Covered Employee (even if he or she terminates employment or there is a break in his or her employment), companies will need to establish good recordkeeping systems to maintain lists of Covered Employees and ensure that the proper contacts in HR, Legal and Accounting are all aware of the identity of Covered Employees.
Code Section 162(m) and the Tax Cuts and Jobs Act
Prior to the Act, Code Section 162(m) capped the tax deductible compensation paid to a public company's CEO and three other most highly compensated executive officers (excluding the CFO) ("Covered Employees") at $1,000,000, with an exemption for qualifying performance-based compensation. Covered Employees were determined based upon employment on the last day of a company's taxable year.
The Act performed a major overhaul to Code Section 162(m). Its amendments included:
- Removal of the performance-based compensation exemption
- Expansion of the list of Covered Employees to include a company's CFO, in addition to its CEO and three other most highly compensated executive officers
- Implementation of a "once covered, always covered" standard, such that once an executive becomes a Covered Employee (effective for years beginning January 1, 2017), he or she will be subject to Code Section 162(m)'s $1M deduction limitation in all future years – including after termination
- Inclusion of interim CEOs and CFOs as Covered Employees
- Expansion of Code Section 162(m) applicability to include all companies required to file reports under Exchange Section 15(d), picking up companies with public debt
Highlights of the Proposed Regulations
The Proposed Regulations largely confirm the preliminary guidance issued by the IRS in Notice 2018-68 and also address several new points:
- New "Publicly Held Corporation" Definition. The Proposed Regulations redefine "publicly held corporation" in light of the Act by expanding the definition to include, among others, large private corporations with registered debt securities, foreign private issuers with ADRs listed on a national securities exchange, company affiliates to companies with securities registered under Section 12 or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and private company parents of disregarded entities with securities registered under Exchange Act Section 12 or 15(d). The "publicly held" determination is dependent upon a corporation's status on the last day of its taxable year. Note that if a parent and subsidiary both have securities registered under Exchange Act Section 12 or 15(d), they must each independently determine their list of covered employees.
Compensation. The Proposed Regulations generally affirm
the guidance previously issued in Notice 2018-68. The Proposed
Regulations provide in part that:
- Acceleration of vesting of equity and cash awards will not be considered a material modification causing compensation to lose its grandfathered status.
- Negative discretion is considered in determining whether a contract has been modified (and grandfathered status lost) only to the extent the company is eligible to exercise negative discretion under applicable law.
- Each component of severance arrangements will be analyzed independently; such that one component may be eligible for grandfather status while another is not.
- Severance under a contract in effect on November 2, 2017 that is based on compensation elements will receive grandfather status to the extent that the company was obligated to pay on November 2, 2017 (e.g., if severance is based on bonus amounts, the structure of the bonus was likely unknown as of November 2, 2017 and therefore would not be grandfathered).
- Deferred compensation arrangements under Code Section 409A may be modified until December 31, 2020 to delete provisions delaying payment until a time when such payment is deductible under Code Section 162(m) without losing grandfather status.
- If a nonqualified deferred compensation arrangement is grandfathered only in part, the grandfathered portion is generally treated as being paid first.
- Predecessor Corporation
Guidance. The Proposed Regulations clarify that any
Covered Employee of a predecessor company will be a Covered
Employee of the new company for taxable years beginning January 1,
2017. Further, Covered Employee status is cumulative, such that a
Covered Employee from a previous transaction is not absolved of
covered employee status merely because a new transaction occurs.
The following are examples of Covered Employees who remain Covered
Employees following the corporate transaction:
- Employees acquired in an acquisition of another public company, whether via stock purchase, asset purchase or corporate reorganization. For applicable asset purchases, target Covered Employees who become purchaser employees within 12 months prior or following the consummation of 80% of the target's operating assets will be counted as Covered Employees of the purchaser.
- In a subsidiary spin-off, Covered Employees of the parent who become employees of the public company subsidiary within 12 months prior to or following the spin-off will remain Covered Employees of the parent in addition to becoming Covered Employees of the company that was spun-off.
- Where a public company becomes a private entity and then regains its public status all within 36 months after a tax due date, Covered Employees of the original public company will remain Covered Employees of the new public company.
- Covered Employees Include CEO, CFO and Three Most Highly Compensated Employees. The individuals covered by Code Section 162(m) now include the CEO, CFO and the three other most highly compensated individuals at a company. Interim CEOs and CFOs who serve during any part of a company's fiscal year will qualify as Covered Employees. The Proposed Regulations clarify that an individual must meet the definition of an "executive" under SEC rules to be a Covered Employee and that his or her compensation should also be calculated pursuant to SEC rules in determining Covered Employee status. But note that, as previously indicated in Notice 2018-68, whether or not executives qualify as named executive officers (NEOs) requiring SEC proxy disclosure is irrelevant to the Covered Employee determination. For companies with different fiscal and tax years, the Proposed Regulations indicate that a company should use its taxable year as the fiscal year for purposes of the Code Section 162(m) Covered Employee calculations.
- Covered Employees - Once Covered, Always Covered. Once an executive becomes a Covered Employee (effective for taxable years beginning January 1, 2017), he or she will be subject to the Code Section 162(m) $1,000,000 deduction limitation in all future years – including after termination and death. If a Covered Employee leaves a company and later returns, he or she remains a Covered Employee notwithstanding that his or her role or title may have changed upon return.
- IPO Transition Period Rule Repealed. Prior to the Act, new public companies received transition relief under Code Section 162(m). This relief has been eliminated in the Proposed Regulations beginning December 20, 2019. Going forward, companies undertaking IPOs or other going-public events will be subject to the Code Section 162(m) compensation limitations beginning in the taxable year in which the company is considered a public entity.
1 For a discussion of how the Act amended Code Section 162(m), see our prior alerts at: https://www.womblebonddickinson.com/us/insights/alerts/what-tax-cuts-and-jobs-act-means-executive-compensation and https://www.womblebonddickinson.com/us/insights/alerts/time-revisit-executive-compensation-arrangements-light-recent-tax-reform.
2 Our prior alert addressing Notice 2018-68 is available at https://www.womblebonddickinson.com/us/insights/alerts/time-review-executive-compensation-arrangements-light-irs-guidance-section-162m.
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.