The enactment of last December's Tax Cut and Jobs Act (the "Act") fundamentally changed Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code"), and, in many cases, executive compensation as we know it. However, the Act left important questions unanswered, including:
- When and to what extent are executive compensation arrangements protected by the Act’s so-called grandfather relief?
Tuesday's Notice 2018-68 from the Internal Revenue Service (the "IRS") provides us with the IRS's initial answer to those questions.
This update summarizes the grandfather relief guidance under Notice 2018-68 and its effects on publicly-held corporations that maintain incentive-based compensation programs and other compensation arrangements for their executives who are "covered employees" for purposes of Section 162(m).
It is a well-settled principle under the tax laws that employers generally may deduct the reasonable compensation they pay for personal services as an ordinary and necessary business expense. However, Section 162(m) of the Code provides a $1 million annual limit on the deductibility of compensation expenses with respect to a "covered employee" of a publicly-held corporation. Prior to the enactment of the Act, (1) certain performance-based compensation and compensation paid on a commission basis were exempt from this $1 million deduction limit and (2) "covered employee" status was dependent on whether an individual was serving, as of the close of the taxable year, as chief executive officer ("CEO") or was one of the three most highly compensated officers of the corporation (excluding the CEO and chief financial officer ("CFO")).
The Act amended Section 162(m) effective for tax years beginning on and after January 1, 2018. Under amended Section 162(m):
- The "qualified performance-based compensation" and commission exceptions to the $1 million annual deduction limitation are eliminated (other than with respect to grandfathered arrangements described below).
- The definition of "covered employees" subject to the $1 million deduction limit under Section 162(m) is expanded under the Act to permanently apply to anyone who served as a CEO or CFO at any time during a given taxable year and anyone else (other than such CEO or CFO) who was one of the three most highly compensated officers for such taxable year.
The Act provides "grandfather relief" that preserves the deductibility of certain legacy compensation arrangements that (1) were maintained under "written binding contracts" as of November 2, 2017 and (2) are not "materially modified" thereafter. Amounts that are payable under such grandfathered arrangements after November 2, 2017 may remain exempt from the Act's deduction limitations if certain conditions are satisfied, meaning those grandfathered arrangements may continue to rely on Section 162(m) of the Code as in effect prior to the Act's enactment and the amounts payable over $1 million may be treated as deductible compensation.
Written Binding Contract Considerations. For purposes of the grandfather relief, Notice 2018-68 explains that compensation is maintained under a written binding contract "to the extent the corporation is obligated under applicable law (for example state contract law) to pay" the compensation if the relevant vesting or performance conditions are satisfied (emphasis added in italics). The corporation is not considered to be obligated to pay such compensation as of such time that the relevant contract is terminable or cancellable by the corporation. Thus, the grandfather relief will often cease to apply at the contract's renewal date, if the corporation has any ability to cancel or terminate the contract effective as of such renewal date.
Effect of Negative Discretion. Notice 2018-68 clarifies that a failure to exercise negative discretion (e.g., features that allow the corporation to reduce the compensation payout even when the relevant vesting or performance conditions are satisfied) does not cause a compensation payout to be materially modified for purposes of the grandfather relief. That being said, examples in Notice 2018-68 address the effect that negative discretion features have on the written binding contract component of the grandfather relief. Under such examples, it appears that the grandfather relief is in serious jeopardy for arrangements with negative discretion features. In other words, the examples suggest that negative discretion features, which, under applicable law and the terms of the arrangement, allow a corporation to reduce the compensation payout even when the relevant vesting or performance conditions have been satisfied, create substantial risk that the compensation arrangement is not maintained under a binding contract for purposes of the above "written binding contract" requirement. For instance, if a cash bonus arrangement provides for payment of $1,500,000 that otherwise satisfies the grandfather relief requirements but negative discretion that is reserved in the arrangement (and respected under applicable law) would allow such payment to be reduced to an amount that is no less than $400,000, then only $400,000 will be grandfathered for purposes of the Act.
Grandfather Relief Preconditions. Examples in Notice 2018-68 make it clear that grandfather relief is limited to compensation arrangements that would have been exempt from the version of Section 162(m) of the Code that was in effect prior to the Act's enactment. Thus, the examples address the following scenarios:
- CFO compensation arrangements of all kinds, such as regular salary under employment agreements, that were in effect as of November 2, 2017;
- "Qualified-performance based compensation" arrangements, such as traditional stock options and stock appreciation rights, that were in effect as of November 2, 2017; and
- Compensation arrangements that were in effect as of November 2, 2017 and paid after termination of employment for individuals who were "covered employees" before and after the Act's enactment, such as CEOs.
For instance, an example in the Notice relates to certain deferred compensation paid in 2019 to a CEO who is serving as CEO as of the close of 2019. Under this example, such deferred compensation is payable pursuant to a written binding contract that was in effect as of November 2, 2017. However, the CEO is serving in a CEO capacity as of the close of 2019. Serving as CEO at the end of that taxable year would have triggered Section 162(m)'s deduction limitations under the version of Section 162(m) that was in effect prior to the Act's enactment. Therefore, grandfather relief would not apply to the deferred compensation. In contrast, if the CEO had retired prior to the close of 2019, the grandfather relief would have applied to the deferred compensation.
Material Modification Considerations. Notice 2018-68 provides additional detail on what constitutes a material modification of a written binding contract that would otherwise be subject to the grandfather relief. For instance, material modifications do not arise with respect to:
- Reasonable cost of living increases for compensation payments that are made over time;
- Appropriate adjustments to take into account the time value of money when payments of compensation are accelerated; and
- Reasonable interest amounts being added when payments of compensation are deferred.
In addition, Notice 2018-68 makes it clear that grandfather relief will cease to apply at the time a material modification is made to the relevant contract. Thus, material modifications will not have retroactive effect to compensation received prior to the date the material modification occurs. Accordingly, the grandfather relief that applied to compensation paid prior to the material modification will continue to apply.
It is probably fair to say that many companies and practitioners will be disappointed with the IRS's narrow view of the application of the grandfather relief. Notice 2018-68 also touches on other aspects of the new rules, including the scope of the application of the new rules for determining "covered employee" status, and states that further guidance will be issued in the form of proposed regulations that address the changes made to Section 162(m) by the Act. At this time, it is unclear whether there may be more to come on the grandfather relief from the IRS (although it would not surprise us if some ambiguities in Notice 2018-68 are clarified by the IRS whether formally or informally). In the meantime, corporations will need to review their executive compensation arrangements in effect as of November 2, 2017 and determine whether those arrangements fall within grandfather relief as provided under Notice 2018-68.
If you have any questions or concerns about the guidance or how it may impact your business, please contact any of the authors of this update.
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