IRS Issues Final Regulations Addressing Changes Made to Section 162(m) by the Tax Cuts and Jobs Act

Practical Law Legal Update w-028-9325 (Approx. 7 pages)

IRS Issues Final Regulations Addressing Changes Made to Section 162(m) by the Tax Cuts and Jobs Act

by Practical Law Employee Benefits & Executive Compensation

Background

Section 162(m) prohibits a publicly held corporation from deducting more than $1 million per year in compensation paid to each of its covered employees (26 U.S.C. § 162(m)). The TCJA made the following significant changes to Section 162(m), effective for taxable years beginning after December 31, 2017:

It eliminates the performance-based compensation exception to Section 162(m)'s $1 million deduction limit for compensation paid to covered employees in any tax year, subject to a transition rule for written binding contracts that were in effect on November 2, 2017, and that are not materially modified on or after that date (grandfather rule).
It broadens the individuals who are covered employees.
It expands the companies that are subject to Section 162(m).

In August 2018, the Treasury Department and the IRS issued Notice 2018-68 (the Notice) to clarify certain aspects of the changes (see Legal Update, IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform). In December 2019, the Treasury Department and IRS issued the Proposed Regulations, incorporating the guidance from the Notice and providing further guidance on the changes made to Section 162(m) by the TCJA.

The Final Regulations retain the basic structure and approach of the Proposed Regulations, with a few clarifications and changes. The Final Regulations make clarifications to the Proposed Regulations regarding:

Affiliated groups (see Affiliated Groups).
Corporate transactions (see Corporate Transactions).
Payments by partnerships (see Partnerships).
Account and nonaccount balance plans (see Account and Nonaccount Balance Plans).
Coordination with Section 409A (see Coordination with Section 409A).

The Final Regulations make changes to the Proposed Regulations regarding:

Compensation subject to a clawback right (see Compensation Subject to a Clawback Right).
An ordering rule for payments consisting of both grandfathered and non-grandfathered amounts (see Ordering Rule).
Material modification with respect to an extension of a stock option's exercise period (see Material Modification and Stock Options).

Like the Proposed Regulations, the Final Regulations include numerous examples illustrating the application of the rules.

For more information on Section 162(m), see Practice Note, Section 162(m): Limit on Compensation.

Clarifications Provided in the Final Regulations

Affiliated Groups

Payments by Members of Affiliated Groups

The Proposed Regulations provide that:

If a covered employee of a publicly held corporation that is a member of an affiliated group performs services for one or more other members of the affiliated group:
- compensation paid by all members of the affiliated group is aggregated; and
- any amount disallowed as a deduction by Section 162(m) is prorated among the payor corporations in proportion to the amount of compensation paid to the covered employee by each corporation in the taxable year.
If a covered employee is paid compensation during a taxable year by more than one publicly held corporation that are members of the same affiliated group, the amount of the deduction that is disallowed for compensation paid to the covered employee is determined separately with respect to each payor corporation that is a publicly held corporation.

The Final Regulations clarify that compensation paid by an affiliated group member that is not a publicly held corporation to an employee who is a covered employee of two or more other members of the affiliated group is prorated for purposes of determining the deduction disallowance among the members that are publicly held corporations of which the employee is a covered employee.

Transition Relief for Subsidiaries of Affiliated Groups

Prior to enactment of the TCJA, compensation paid under a compensation plan or agreement existing during a period that a corporation was not publicly held was not subject to Section 162(m) after the corporation became publicly held until the end of a transition period (IPO transition relief).

The Proposed Regulations:

Provide that a privately held corporation that became a publicly held corporation on or before December 20, 2019, generally may rely on the IPO transition relief.
Eliminate the IPO transition relief for any privately held corporation that becomes a publicly held corporation after December 20, 2019.

The Final Regulations clarify that a subsidiary that is a member of an affiliated group may generally rely on the IPO transition relief if it became a separate publicly held corporation (for example, in a spin-off transaction) on or before December 20, 2019.

Corporate Transactions

The TCJA amended the definition of covered employee so that, among other changes, it includes any employee who was a covered employee of any predecessor of the publicly held corporation for any preceding taxable year beginning after December 31, 2017. The Proposed Regulations provide rules for determining the predecessor of a publicly held corporation for various corporate transactions. Under the Proposed Regulations, if an acquiror corporation in an asset acquisition acquires at least 80% of the operating assets of a publicly held corporation, then the target corporation is a predecessor of the acquiror corporation.

The Final Regulations clarify that the operating assets refer to gross operating assets and not net operating assets.

Partnerships

The Proposed Regulations provide that if a publicly held corporation is a partner in a partnership, then Section 162(m) applies to the corporation's distributive share of the partnership's deduction for compensation paid by the partnership for services performed for it by a covered employee.

The Final Regulations clarify that:

The publicly held corporation's distributive share of the partnership's deduction for compensation paid by the partnership for services performed for it by a covered employee includes the partnership's deduction for payment to the covered employee for services under Code Section 707(a) or 707(b) (26 U.S.C. § 707(a) and 707(b)).
Section 162(m) would generally not apply with respect to compensation paid to a publicly held corporation's covered employee by a corporate subsidiary of a partnership for services performed as an employee of the subsidiary because the corporate subsidiary would not be a member of the publicly held corporation's affiliated group.

Due to prior lack of clarity on this issue, the Final Regulations include a special applicability date relating to compensation paid by a partnership. Under the Final Regulations, Section 162(m) applies to a corporation's distributive share of a partnership's deduction for compensation paid by the partnership after December 18, 2020.

Account and Nonaccount Balance Plans

The Proposed Regulations include several examples illustrating the application of the grandfather rule to account and nonaccount balance nonqualified deferred compensation plans.

The Final Regulations clarify the application of the grandfather rule to account balance plans, thereby eliminating the need to retain certain examples. Specifically, the Final Regulations clarify that the grandfathered amount under an account or nonaccount balance plan is the amount that the corporation is obligated to pay pursuant to the terms of the plan as of November 2, 2017. The Final Regulations further clarify the application of the grandfather rule to account and nonaccount balance plans with various specified plan terms.

Coordination with Section 409A

Before the TCJA, an employee who was a covered employee for one taxable year did not necessarily remain a covered employee for subsequent taxable years and was not a covered employee after separation from service. As a result, parties to nonqualified deferred compensation arrangements often delayed payments, in accordance with special rules under Section 409A, until the employee was no longer a covered employee.

The preamble to the Proposed Regulations provided that certain modifications would be made to regulations under Section 409A to allow an employer:

That has discretion to delay payment of grandfathered amounts to delay the scheduled payment of those amounts in accordance with Section 409A without also delaying the payment of non-grandfathered amounts.
To amend a nonqualified deferred compensation arrangement, no later than December 31, 2020, to remove a provision requiring the delay of payment if the employer reasonably anticipates at the time of the scheduled payment that the deduction would not be permitted under Section 162(m).

The Final Regulations clarify that taxpayers may continue to rely on the preamble to the Proposed Regulations and state that the Treasury Department and IRS will consider whether additional guidance under Section 409A is appropriate.

Changes Provided in the Final Regulations

Compensation Subject to a Clawback Right

The Proposed Regulations provide the following guidance on the application of the grandfather rule to compensation that is subject to a clawback:

If the employer is obligated to or has discretion to recover compensation paid in a taxable year only upon the future occurrence of an event that is objectively outside of the employer's control, then the employer's right to recovery is disregarded for purposes of determining the grandfathered amount for the taxable year.
If the condition occurs, only the amount the employer is obligated to pay under applicable law (the amount that is not recoverable) remains grandfathered.

In the preamble to the Final Regulations, the Treasury Department and IRS indicate that they further considered clawback rights and recognize that a clawback right is a contractual right that is separate from a binding obligation to make a payment. As a result, the Final Regulations provide that the corporation's right to recover compensation does not affect the determination of the amount of compensation that is covered by the grandfather rule, whether or not the corporation exercises its clawback right.

Ordering Rule

The Proposed Regulations contain an ordering rule for payments if only a portion of the amounts payable is grandfathered, with the grandfathered amount allocated to the first payment or payments until the entire grandfathered amount has been paid. The Final Regulations:

Retain the ordering rule from the Proposed Regulations for taxable years ending on or after December 20, 2019.
Permit the grandfathered amount to be allocated to the last otherwise deductible payment or to each payment on a pro rata basis for taxable years ending before December 20, 2019.

Material Modification and Stock Options

The Section 162(m) amendments apply to any contract that is materially modified after November 2, 2017. A materially modified contract is treated as a new contract entered into as of the date of the material modification.

The Final Regulations provide that, if compensation attributable to the exercise of a non-qualified stock option or stock appreciation right (SAR) is grandfathered and the exercise period of the stock option or SAR is extended, then all compensation attributable to the exercise of the stock option or SAR remains grandfathered if the extension complies with Treasury Regulation Section 1.409A-1(b)(5)(v)(C)(1), which allows the extension of a stock option exercise period if either:

The stock option exercise price exceeds the fair market value of an underlying share of stock at the time the exercise period is extended.
The exercise period is not extended beyond the shorter of:
- the original expiration date; and
- ten years from the grant date.

Effective Dates

The Final Regulations generally apply for taxable years beginning on or after December 30, 2020 (the Publication Date) but taxpayers may choose to apply them to a taxable year beginning after December 31, 2017, provided that the taxpayer applies the final regulations in their entirety and in a consistent manner to that taxable year and all subsequent taxable years.

Additionally, the Final Regulations incorporate the special applicability dates from the Proposed Regulations with the following changes:

The definition of predecessor of a publicly held corporation applies to corporate transactions that occur on or after the Publication Date. For corporate transactions occurring before the Publication Date, taxpayers may apply either the definition of predecessor of a publicly held corporation in the Final Regulations or a reasonable good faith interpretation of the term "predecessor" in Section 162(m)(3)(C). However, excluding target corporations from the definition of the term "predecessor" is not a reasonable good faith interpretation of the statute for the following corporate transactions occurring after December 20, 2019, and before the Publication Date:
- a publicly held corporation acquires the stock or assets of a publicly held target corporation in a transaction to which Code Section 381(a) applies; or
- a publicly held corporation acquires at least 80% of the total voting power, and at least 80% of the total value, of the stock of a publicly held target corporation.
The rule that the definition of compensation includes an amount equal to the publicly held corporation's distributive share of a partnership's deduction for compensation expense applies to deductions attributable to compensation paid by the partnership after December 18, 2020.

IRS Issues Final Regulations Addressing Changes Made to Section 162(m) by the Tax Cuts and Jobs Act | Practical Law