On August 21, 2018, the IRS issued Notice 2018-68 providing initial guidance on the amendments made to Section 162(m) of the Internal Revenue Code of 1986 (the “Code”) by the 2017 tax reform bill, which has been renamed “To provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018” (the “Tax Bill”). As background, Code Section 162(m) disallows the deduction by any publicly held corporation for remuneration paid to any covered employee to the extent such remuneration for the taxable year exceeds $1,000,000. Performance-based compensation was exempted from this limitation. The Tax Bill made several changes to Code Section 162(m), notably eliminating the exemption for performance-based compensation, amending the definition of “covered employee” and including a transition rule. Below is a high-level summary of the guidance provided in Notice 2018-68.
The Tax Bill expanded the group of employees classified as “covered employees” to include the principal executive officer, the principal financial officer of the publicly held corporation and any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than the PEO and PFO).
Commentators asked whether the employee must serve as an executive officer at the end of the taxable year to be a covered employee under Code Section 162(m), asserting that the Securities and Exchange Commission (SEC) rules relating to executive compensation disclosure under the Securities Exchange Act of 1934 require disclosure of the three most highly compensated executives other than the PEO and PFO who were serving as executive officers at the end of the last completed fiscal year. The Notice concludes that the statutory language of Code Section 163(m)(3)(B) and the legislative history do not impose an end-of-year requirement to determine which employees are covered employees.The Tax Bill also expanded the definition of “covered employee” to include any individual who was a covered employee of a publicly held corporation for any taxable year beginning after December 31, 2016. The Notice clarified that an individual classified as a covered employee for the tax year beginning prior to January 1, 2018, as determined under the pre Tax Bill rules in effect for that year, will continue to be treated as a covered employee for taxable years beginning in 2018 and beyond.
The Tax Bill includes a transition rule whereby the amendments made to Code Section 162(m) do not apply to remuneration that is payable pursuant to a written binding contract which was in effect on November 2, 2017 and which is not modified in any material respect on or after that date.
According to the Notice, a written binding contract in effect on November 2, 2017 is grandfathered only to the extent it created a legal obligation on the corporation under applicable law (such as state contract law) to pay the remuneration if the employee performs services or satisfies any vesting conditions. Any amount of remuneration that exceeds the amount of remuneration that applicable law obligates the corporation to pay under such written binding contract will be subject to the Code Section 162(m) limitations. As an example, if an individual received an award of stock options that qualify as performance-based compensation on March 1, 2016 and have a three year vesting schedule; the compensation deduction for those options upon exercise would be determined based on the pre-Tax Act rules.
Importantly, the Notice takes an unfavorably narrow position with respect to the common practice of retaining negative discretion with respect to performance-based compensation. Under the Notice, a compensation award is not eligible for the transition rule if the employer has retained the right to reduce or terminate the award prior to its payment date. An example in the Notice demonstrates how this rule will be applied:
|On February 1, 2017, a corporation established a cash bonus plan under which an employee will receive a cash bonus of $1,500,000 if a specified performance goal is satisfied. The Compensation Committee retained the right, if the performance goal is met, to reduce such payment to no less than $400,000. On March 1, 2018, the Compensation Committee certified the goal was met and then exercised its negative discretion to reduce the bonus amount to $500,000.
The Notice states that the retention of “negative discretion” causes the bonus to be treated as a written binding contract to pay $400,000 with a discretionary right to pay compensation above that amount. As a result, the performance-based compensation exception under Code Section 162(m) would apply to $400,000 of the $500,000 payment to the employee. The remaining $100,000 is subject to the Code Section 162(m) deduction limitation regardless of whether the amount qualified as performance-based compensation.
This interpretation raises a significant issue for companies that have designed their performance-based compensation plans to utilize negative discretion but which did not establish a minimum guaranteed payment. In such case, it appears the full amount paid would be subject to the Code Section 162(m) limitations. In addition, there may be a financial accounting impact due to the loss of deferred tax assets that were accrued when the compensation agreements were originally established.
A separate set of examples in the Notice will be of interest to corporations that previously entered into a written binding contract in effect on November 2, 2017 with a PFO that may result in future payments in excess of the Code Section 162(m) limitation. To the extent the PFO is classified as a “covered employee” under the rules adopted by the Tax Bill but would not have been classified as a covered employee under the prior rules, then the transition rule will allow the PFO to not be treated as a covered employee on the date the payment is received and, as a result, the Code Section 162(m) limitation will not apply to that payment.
The Notice also discusses when a written binding contract is considered to be renewed after November 2, 2017. A contract that is terminable or cancelable by a corporation without the employee’s consent after November 2, 2017 is treated as “renewed” (and therefore not grandfathered) as of the date that the termination/cancelation could be effective. This does not apply if the agreement can only be terminated/canceled by terminating the employment of the employee.
The Notice also addresses when the operation of a traditional nonqualified deferred compensation will provide for a written binding contract. In an example, the Notice makes clear that amounts must be credited as of November 2, 2017 to be covered by the grandfather rule.
Finally, the Notice provides guidance as to what type of actions will be considered material modifications, voiding grandfather status.
- 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.
- A modification to defer the payment of compensation is not a material modification if the additional compensation paid as a result of the deferral is based on either a reasonable rate of interest or a pre-determined actual investment.
- The adoption of a supplemental contract or agreement may, in certain circumstances, result in a material modification of the original written binding contract.
- The failure to exercise negative discretion is not a material modification
The guidance provided in Notice 2018-68 is intended to be incorporated in future regulations that will be applicable to taxable years ending on or after September 10, 2018; provided, however, that if the regulations expand the definition of “covered employee” or restrict the definition of “written binding contract”, such changes will be prospective only.