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

Practical Law Legal Update w-023-2795 (Approx. 11 pages)

IRS Issues Proposed Rules 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 publicly held corporations from deducting more than $1 million per year in compensation paid to each of certain 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 (grandfathered arrangements).
It broadens the individuals who are covered employees.
It expands the companies that are subject to Section 162(m).

In many cases the application of the Section 162(m) amendments was unclear, particularly with respect to the transition rule. In August 2018, the Treasury Department and the IRS issued Notice 2018-68 (the Notice) to clarify certain aspects of the amendments (see Legal Update, IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform). The Notice provided clarification on both:

The amended rules for determining covered employees.
The operation of the transition rule that applies to certain outstanding arrangements.

The Notice stated that the Treasury and the IRS anticipated issuing further guidance in the form of these Proposed Regulations, which incorporate the guidance provided in the Notice.

For more information on Section 162(m), see Practice Note, Section 162(m): Limit on Compensation. For information on the implications of the TCJA on employee benefits and executive compensation generally, see Legal Update, Tax Reform is Enacted With Significant Implications for Executive Compensation and Employee Benefits.

The Expanded Definition of Publicly Held Corporation

Before the TCJA was enacted, Section 162(m) defined publicly held corporation as any corporation issuing any class of common securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act). The TCJA broadened Section 162(m)'s definition of publicly held corporation to include corporations:

Issuing any class of securities under Section 12 of the Exchange Act.
That are required to file reports under Section 15(d) of the Exchange Act.

The Proposed Regulations clarify that:

An S corporation is a publicly held corporation if it issues securities required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act.
A publicly held corporation includes an affiliated group of corporations, as defined in Code Section 1504 (26 U.S.C. § 1504). Additionally:
- in the case of an affiliated group that includes two or more publicly held corporations, each member of the affiliated group that is a publicly held corporation is separately subject to Section 162(m), and the affiliated group as a whole is subject to Section 162(m); and
- if a publicly held corporation is a wholly-owned subsidiary of a privately held parent corporation, the privately held parent is a member of an affiliated group subject to Section 162(m).
The Proposed Regulations also include rules for prorating the deduction disallowance among the payor corporations in an affiliated group.
A foreign private issuer (FPI) is a publicly held corporation if it issues securities required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act, regardless of whether it is required to file a summary compensation table.
A publicly traded partnership treated as a corporation under Code Section 7704(a) is a publicly held corporation if it issues securities required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act (26 U.S.C. § 7704(a)).
If a privately held corporation owns a disregarded entity that is an issuer of securities required to be registered under Section 12(b) of the Exchange Act or that is required to file reports under Section 15(d) of the Exchange Act, the privately held parent corporation is treated as a publicly held corporation for purposes of Section 162(m).
If an S corporation owns a qualified subchapter S subsidiary (as defined in Code Section 1361(b)(2) (26 U.S.C. § 1361(b)(2))) that issues securities required to be registered under Section 12(b) of the Exchange Act or that is required to file reports under Section 15(d) of the Exchange Act, the S corporation parent is treated as a publicly held corporation.

The Proposed Regulations reiterate that whether a corporation is publicly held is determined based solely on the last day of its taxable year. If a corporation was a publicly held corporation because it was required to file reports under Section 15(d) of the Exchange Act but then its reporting obligations under Section 15(d) are suspended as of the last day of its taxable year, then the corporation is not a publicly held corporation for that taxable year.

The Definition of Covered Employee

The TCJA amended the definition of covered employee to mean any employee of the taxpayer who:

Is the principal executive officer (PEO) or principal financial officer (PFO) of the taxpayer at any time during the taxable year (or was an individual acting in such a capacity).
Is among the three highest compensated officers for the taxable year (excluding the PEO and the PFO).
Was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016.

The three highest compensated officers for the taxable year are determined by looking to the company's proxy statement for the taxable year or, for a company that is not required to file a proxy statement, the three highest compensated officers who would otherwise be listed if a proxy statement were to be filed.

The Proposed Regulations adopt the Notice's clarifications that:

The term covered employee for a taxable year includes any employee who is among the three highest compensated executive officers for the taxable year (other than the PEO and PFO, or an individual acting in that capacity) regardless of whether:
- the executive officer is serving at the end of the corporation's taxable year; or
- the executive officer's compensation is subject to disclosure for the last completed fiscal year under the SEC's executive compensation disclosure rules.
The term covered employee includes any individual who was a covered employee of the corporation (or any predecessor) for any taxable year beginning after December 31, 2016. However, for taxable years beginning before January 1, 2018, covered employees are determined under the pre-amendment rules. This means that individuals who are determined to be covered employees for the taxable year beginning in 2017 under the pre-amendment rules will continue to be covered employees in future taxable years.
A corporation's status as a smaller reporting company or an emerging growth company is not relevant for purposes of determining a corporation's covered employees.

In the Notice, the IRS and the Treasury Department requested comments on determining the three most highly compensated executive officers under the SEC disclosure rules for a taxable year that does not end on the same date as the last completed fiscal year (including, for example, due to a short taxable year as a result of a corporate transaction that does not result in a short fiscal year). The Proposed Regulations provide that the amount of compensation used to identify the three most highly compensated executive officers is determined pursuant to the executive compensation disclosure rules under the Exchange Act using the taxable year as the fiscal year for purposes of making the determination.

For example, if a publicly held corporation uses a calendar year fiscal year but has a taxable year that runs from July 1 to June 30, then the three most highly compensated executive officers are determined for the taxable year ending June 30, 2020, by applying the executive compensation disclosure rules under the Exchange Act as if the fiscal year ran from July 1, 2019 to June 30, 2019.

The Proposed Regulations also clarify that:

Because the SEC's executive compensation disclosure rules apply only to executive officers, only an executive officer (as defined by the SEC in 17 C.F.R. § 240.3b-7) may qualify as a covered employee under Section 162(m).
A corporation's covered employees also include any employee who was a covered employee of any predecessor of the corporation for any preceding taxable year beginning after December 31, 2016. Predecessors may include:
- the publicly held corporation itself if it was a publicly held corporation for a prior taxable year and then again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation's U.S. federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held;
- a publicly held corporation that is acquired, or the assets of which are acquired, by another publicly held corporation in certain transactions;
- a publicly held corporation that becomes a member of an affiliated group; or
- a publicly held corporation that spins-off the stock of a subsidiary that is a publicly held corporation after the spin-off (any covered employee of the publicly held parent corporation that becomes an employee of the spun-off subsidiary within 12 months before or after the spin-off is a covered employee of the spun-off subsidiary and also remains a covered employee of the parent corporation).
The rules for determining predecessors are applied cumulatively, meaning that a predecessor of a corporation includes each predecessor of the predecessor. For example, assume:
- a private target corporation was previously a publicly held corporation;
- the private target corporation is acquired by a private parent corporation; and
- the previously private parent corporation becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the target corporation's US federal income tax return for the last taxable year for which the target corporation was publicly held.
Under these facts, the target corporation is a predecessor of the publicly held parent corporation. The Proposed Regulations include more specific rules and examples that illustrate the rules regarding predecessor corporations, particularly with respect to corporate transactions.
Employees of a disregarded entity or qualified subchapter S subsidiary owned by a publicly held corporation are generally not covered employees of the publicly held parent unless those employees perform policy making functions for the publicly held parent.

Applicable Employee Remuneration

Before the TCJA, applicable employee remuneration (referred to as compensation in the Proposed Regulations) did not include remuneration payable on a commission basis or performance-based compensation. The TCJA amended Section 162(m) to eliminate those exclusions and to provide that remuneration does not fail to be applicable employee remuneration solely because it is includible in the income of, or paid to, a person other than the covered employee, including a beneficiary after the death of the covered employee.

The Proposed Regulations further 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 IRS and Department of Treasury note in the preamble to the Proposed Regulations that they understand that taxpayers may have taken positions contrary to those set forth in the Proposed Regulations based on four private letter rulings issued between 2006 and 2008. Therefore, the Proposed Regulations provide transition relief for compensation paid pursuant to a written binding contract that is:
- in effect on the date the Proposed Regulations are published in the Federal Register (the Initial Publication Date, which is expected to be December 20, 2019); and
- not materially modified after that date.

The Proposed Regulations also clarify that applicable employee remuneration includes compensation provided to a covered employee in a capacity other than as an executive officer (for example, if the covered employee separates from service as an executive officer and subsequently performs services as a director and receives non-employee director fees).

Elimination of the Transition Period for Newly Public Companies

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 (generally referred to in practice as the IPO transition period), which ended on the earliest of:

The expiration of the plan or agreement.
The date the plan or agreement is materially modified.
The issuance of all employer stock and other compensation that is available under the plan.
The first meeting of shareholders at which directors are to be elected that occurs after the end of the third calendar year following the year the corporation becomes publicly held.

The Proposed Regulations eliminate the IPO transition period, instead providing that Section 162(m) applies to any compensation that is otherwise deductible for the taxable year ending on or after the date that the corporation becomes a publicly held corporation.

The TCJA's Transition Rule for Grandfathered Arrangements

Under the TCJA's transition rule, the Section 162(m) amendments do not apply to compensation which is provided pursuant to a written binding contract which was in effect on November 2, 2017, and which was not materially modified on or after that date.

Written Binding Contract

While there must be a written binding contract in order for the transition rule to apply, the existence of a written binding contract on November 2, 2017, is not by itself sufficient to qualify the arrangement for the transition rule.

The Notice clarified that:

Compensation is payable under a written binding contract that was in effect on November 2, 2017, only if the corporation is obligated under applicable law (for example, state contract law) to pay the compensation under the contract if the employee performs services or satisfies vesting conditions. Therefore, if the employer has the right to reduce or eliminate an employee's compensation using negative discretion, the binding contract standard may not be met with respect to amounts that may be reduced or eliminated in the employer's discretion.
If a contract is binding, the amounts required to be paid on November 2, 2017, to an employee under the arrangement are not subject to the Section 162(m) amendments even if the employee was not eligible to participate in the arrangement as of November 2, 2017, provided that the employee either:
- was employed by the corporation on November 2, 2017; or
- had the right to participate in the arrangement pursuant to a written binding contract.
If a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017 to an employee under the arrangement is not subject to the Section 162(m) amendments. However, the Section 162(m) amendments apply to amounts that exceed the amount of compensation that applicable law obligates the corporation to pay under the written binding contract.
The Section 162(m) amendments apply to a written binding contract that is renewed after November 2, 2017, defining renewal broadly.

The Proposed Regulations adopt the Notice's clarifications on the definition of written binding contract for purposes of applying the TCJA's transition rule. For clarity, the Proposed Regulations replace some of the Notice's examples illustrating the definition of written binding contract, but in the preamble to the Proposed Regulations, the IRS and Department of Treasury note that the replacement of examples does not reflect a substantive change.

Compensation Subject to Discretion

The Proposed Regulations provide additional guidance on compensation arrangements that provide the corporation with the ability to exercise negative discretion. In the preamble to the Proposed Regulations, the IRS and Department of Treasury acknowledge that compensation arrangements may purport to provide a corporation with a wider scope of negative discretion than applicable law actually permits the corporation to exercise. They state that in those cases, the negative discretion is taken into account for purposes of determining the grandfathered amount only to the extent the corporation may exercise the negative discretion under applicable law.

The Proposed Regulations also provide guidance on the application of the transition rule to grandfathered 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.

For example, assume that:

An employer is obligated under a grandfathered arrangement to pay $500,000 of compensation if the employee satisfies a vesting condition.
The employer has discretion to recover $300,000 from the employee if the employee is convicted of a felony within three calendar years from the date of payment.

If the employee is not convicted of a felony within three calendar years after the payment, the entire $500,000 is grandfathered. However, if the employee is convicted of a felony within three calendar years after the payment, only $200,000 of the payment is grandfathered, regardless of whether the employer exercises its discretion to recover the $300,000.

Material Modification

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 Notice clarified that:

A material modification occurs when the contract is amended to increase the amount of compensation payable to the employee.
A modification that accelerates the payment of compensation is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money.
If a contract is modified to defer the payment of compensation, any compensation paid or to be paid that exceeds the amount that was originally payable to the employee under the contract will not result in a material modification if the additional amount is based on:
- a reasonable rate of interest; or
- a predetermined actual investment such that the amount payable by the employer at the later date will be based on the actual rate of return on the predetermined actual investment.
The adoption of a supplemental agreement that provides for increased compensation, or the payment of additional compensation, is a material modification if the facts and circumstances demonstrate that the additional compensation is paid based on substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract, subject to an exception for supplemental payments that are equal to or less than a reasonable cost-of-living increase over the payment made in the previous year under the written binding contract.
The failure to exercise negative discretion under a contract does not result in a material modification of that contract.

As with the definition of written binding contract, the Proposed Regulations:

Adopt the Notice's clarifications on the definition of material modification.
For clarity, replace some of the Notice's examples illustrating the definition of material modification, with the IRS and Department of Treasury noting in the preamble to the Proposed Regulations that the replacement of examples does not reflect a substantive change.

The Proposed Regulations also provide that:

For all forms of compensation, a modification of a grandfathered arrangement that provides for acceleration of vesting of compensation or that results in the lapse of a substantial risk of forfeiture is not considered a material modification.
Severance payable under a written binding contract in effect on November 2, 2017, even if the employee remains employed as of that day, may be grandfathered, but only if the amount of severance is based on compensation elements the employer is obligated to pay under the contract. Each element of compensation is analyzed separately for purposes of determining the extent to which the severance payments are grandfathered.
For example, assume:
- Corporation X and Employee A are parties to an employment agreement that was in effect on November 2, 2017, and not materially modified after that date;
- the employment agreement provides for a severance payment if Corporation X terminates Employee A's employment, with the amount of severance equal to two times Employee A's base salary (which is $2,000,000 per year under the employment agreement) plus two times any discretionary bonuses paid to Employee A in the 12 months before termination;
- Corporation X paid a $600,000 discretionary bonus to Employee A on May 14, 2018; and
- Corporation X terminated Employee A's employment on April 30, 2019.
Under these facts, Corporation X is obligated to pay $5,200,000 in severance to Employee A. $4,000,000 of the severance is grandfathered because Corporation X is obligated to pay both the severance payment and the base salary on which the $4,000,000 in severance is based. However, the remaining $1,200,000 is not grandfathered even though Corporation X is obligated to pay it as severance, because the underlying element of compensation was discretionary.
If amounts are paid to an employee from more than one written binding contract, then a material modification of one written binding contract does not automatically result in a material modification of the other contracts unless the material modification affects the amounts payable under those contracts.

The Proposed Regulations also:

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.
Include new examples illustrating the application of the transition rule to additional types of compensation (for example, nonaccount balance plans, linked plans, and earnings on grandfathered amounts in account and nonaccount balance plans). In the preamble and the examples, the IRS and Treasury state that the amount of compensation grandfathered under these types of compensation is the amount the corporation is obligated to pay under applicable law as of November 2, 2017.

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.

Based on requests from commenters, the Proposed Regulations 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. The delay of the grandfathered amounts will not be treated as a subsequent deferral election (previously, the delay in payments of amounts was treated as a subsequent deferral election unless all scheduled payments to that service provider that could be delayed in accordance with the special rules under Section 409A were also delayed).

Additionally, under the Proposed Regulations, if an employer amends a nonqualified deferred compensation arrangement 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), then the amendment will not:

Result in an impermissible acceleration of payment under Section 409A.
Be considered a material modification for purposes of the TCJA's transition rule for Section 162(m).

The amendment must be made no later than December 31, 2020.

Effective Dates

The Proposed Regulations are subject to comment and revision and generally will apply for taxable years beginning on or after the date of publication of the final regulations in the Federal Register (the Final Rule Publication Date).

Because the Proposed Regulations incorporate the guidance provided in the Notice, taxpayers may no longer rely on the Notice for taxable years ending on or after the Initial Publication Date, but taxpayers may instead rely on the Proposed Regulations (until the Final Rule Publication Date) as long as they rely on the Proposed Regulations consistently and in their entirety.

Additionally, the Proposed Regulations include some special effective dates for certain rules:

The definition of covered employee applies for taxable years ending on or after September 10, 2018 (the date the Notice was published), except with respect to the rules related to a corporation whose fiscal year and taxable year do not end on the same date, which apply for taxable years beginning on or after the Initial Publication Date.
The definitions of written binding contract and material modification apply with respect to taxable years ending on or after September 10, 2018.
The provisions defining a predecessor corporation of a publicly held corporation apply:
- with respect to corporate transactions, to transactions for which all events necessary for the transaction occur on or after the Final Rule Publication Date; and
- with respect to corporations that change from publicly held to privately held or vice-versa, to a publicly held corporation that becomes a privately held corporation for a taxable year beginning after December 31, 2017, and subsequently again becomes a publicly held corporation on or after the Final Rule Publication Date.
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 attributable to the compensation paid by the partnership applies to any compensation deduction that is otherwise allowable for a taxable year ending on or after the Initial Publication Date (with a grandfather rule applicable to compensation paid pursuant to a written binding contract that is in effect as of the Initial Publication Date and not materially modified after that date).
The elimination of the IPO transition period applies to corporations that become publicly held on or after the Initial Publication Date.

The comment period for raising additional Section 162(m) issues before the Proposed Regulations are adopted as final regulations runs through the date that is 60 days after the Initial Publication Date.

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