IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform

Practical Law Legal Update w-016-3220 (Approx. 7 pages)

IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform

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 Act 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 were not materially modified on or after that date.
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. The Treasury Department and the IRS issued the Notice to clarify certain aspects of the amendments and anticipate issuing further guidance in the form of proposed regulations which will 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 Act on employee benefits and executive compensation generally, see Legal Update, Tax Reform is Enacted With Significant Implications for Executive Compensation and Employee Benefits.

The Definition of Covered Employee

The Act amends 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) whose compensation for the taxable year is required to be reported to shareholders under the Securities and Exchange Commission's (SEC's) executive compensation disclosure rules.
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.

Commenters asked whether:

An employee must have served as an executive officer at the end of the taxable year to be a covered employee.
An employee can be a covered employee even if his or her compensation is not required to be disclosed under the SEC's disclosure rules.

The application of the covered employee definition to smaller reporting companies and emerging growth companies was also unclear.

The Notice clarifies 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.

The Notice also addresses the situation where a corporation's last completed fiscal year and the taxable year do not end on the same date (for example in the case of a short taxable year), providing that the corporation will have three most highly compensated executive officers for the taxable year. The IRS and the Treasury Department request 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.

The Notice includes several examples that illustrate the application of the covered employee rules in various circumstances.

The Transition Rule

Under the Act'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. While the Joint Explanatory Statement that was released by the House-Senate Conference Committee when the Act was enacted included one example of a contract that would be grandfathered under the transition rule, its application to other situations was unclear.

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 clarifies 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.
Example: A bonus plan provides that the employer may, at any time, exercise negative discretion to reduce or eliminate bonus amounts. Employees have no right to payment under applicable state law. The plan does not constitute a written binding contract.
Example: An employee was granted stock options on January 2, 2017, that vest and become exercisable on January 2, 2019. The grants constitute a written binding contract in effect on November 2, 2017, under applicable law.
Example: An executive entered into an employment agreement on January 1, 2017 which provides that the executive will be granted stock options on January 2, 2018, subject to the approval of the board of directors. As of November 2, 2017, the potential grant of stock options does not constitute a written binding contract.
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 was either:
- employed by the corporation on November 2, 2017; or
- had the right to participate in the arrangement pursuant to a written binding contract.
Example: An employee entered into an employment agreement on October 2, 2017, (a written binding contract) which provides that the employee will participate in a nonqualified deferred compensation plan on April 1, 2018, and will have an accrued benefit of $3,000,000 on that date. The Section 162(m) amendments do not apply to the $3,000,000 even though the employee was not eligible to participate in the plan on November 2, 2017.
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.
Example: An employee participates in a nonqualified deferred compensation plan that is an account balance plan and has a legally binding right to his $100,000 account balance on November 2, 2017, but no legally binding right to any future credits to his account because the corporation may stop or reduce the amount of future credits at any time. The Section 162(m) amendments do not apply to the $100,000 but they do apply to any future credits.
The Section 162(m) amendments apply to a written binding contract that is renewed after November 2, 2017, defining renewal broadly. The Notice provides guidance on specific contractual terms that would result in a contract renewal and when the renewal would occur.

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 clarifies 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.
Example: A PEO entered into a five-year employment agreement on January 1, 2017, providing for a salary of $1,800,000 per year (a written binding contract). In 2019 the corporation increases the PEO's salary with a supplemental payment of $40,000. On January 1, 2020, the corporation increases the PEO's salary to $2,400,000. The $40,000 supplemental payment does not constitute a material modification because the $40,000 is less than or equal to a reasonable cost-of-living increase from 2017. The $560,000 salary increase in 2020 is a material modification of the contract.
The failure to exercise negative discretion under a contract does not result in a material modification of that contract.
Example: On February 1, 2017, a corporation establishes a bonus plan under which an employee will receive a $1,500,000 cash bonus if a specified performance goal is achieved. The compensation committee has the discretion to reduce the payment to no less than $400,000 even if the performance goal is met. On March 2, 2018, the compensation committee certifies the achievement of the performance goal and reduces the bonus to $500,000. The payment satisfies the requirements for qualified performance-based compensation. The bonus plan is a written binding contract to pay $400,000. The Section 162(m) amendments do not apply to $400,000 of the $500,000 payment but they do apply to the additional $100,000. The failure of the compensation committee to reduce the payment to $400,000 instead of $500,000 does not result in a material modification of the contract.

Effective Date

The Section 162(m) amendments apply to taxable years beginning on or after January 1, 2018. The Treasury Department and the IRS expect to incorporate the guidance in the Notice into future regulations that, with respect to the issues in the Notice, will apply to any taxable year ending on or after September 10, 2018. The comment period for raising additional Section 162(m) issues that future guidance should address runs through November 9, 2018.

IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform | Practical Law