On December 16, 2019, the Treasury Department released proposed regulations (the “Proposed Regulations”) to address the amendments made to Code Section 162(m) by the Tax Cuts and Jobs Act (the “Amendment”). As background, the Amendment eliminated the exclusion attributable to qualified performance-based compensation from the $1 million cap on the deductibility of compensation paid to certain executives by a publicly held corporation. In its first round of guidance, IRS Notice 2018-68 (the “Notice”), the IRS had delivered mostly unfavorable news to publicly held companies. The Proposed Regulations appear to be another lump of coal in the holiday stocking.
Generally speaking, the Proposed Regulations take a fairly comprehensive approach to the applicability of the Code Section 162(m) limit on deductibility of remuneration in excess of $1,000,000 paid to certain executives by publicly held corporations, including taking a seemingly ever narrowing approach to “grandfathered” amounts and certain transition relief, and a broadening scope of definitional and structural reach.
Some of the more salient topical highlights include:
- Publicly Held Corporations. Consistent with the Amendment and the Notice, the Proposed Regulations broaden the definition of “publicly held corporation” to which Code Section 162(m) applies. Among other things, the Proposed Regulations address subsidiaries that file reports under section 15(d) of the Securities Exchange Act (the “Exchange Act”), foreign private issuers, disregarded entities, publicly traded partnerships, and affiliated groups, all in a manner that will generally increase the scope of the deduction limitation.
- Covered Employees.
- The Proposed Regulations adopt the Notice’s approach that a covered employee for any taxable year means, in addition to the PEO and PFO, any employee who is among the three highest paid executive officers regardless of whether the executive officer is serving in such position at the end of the employer’s taxable year and regardless of whether the executive officer’s compensation is subject to disclosure under applicable SEC rules.
- The Proposed Regulations clarify that, in accordance with the Amendment, a covered employee for a taxable year beginning after December 31, 2016 will continue to be a covered employee for all subsequent tax years.
- The Proposed Regulations make clear that a covered employee also includes any employee who was a covered employee of a “predecessor of the publicly held corporation,” as defined by reference to the type of acquisition, and may include employees of a disregarded entity owned by a publicly held corporation.
- Applicable Remuneration.
- The Proposed Regulations provide certain clarifying rules as to what compensation is covered, including any remuneration for services performed by a covered employee, whether or not the services were performed during the taxable year. The Proposed Regulations also clarify that compensation includes an amount that is includable in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.
- In addition, and beyond the guidance in the Notice, the Proposed Regulations address the issue of compensation paid by a partnership to a covered employee of a publicly held corporation, requiring aggregation of a corporation’s allocable distributive share of the compensation deduction for remuneration paid by the partnership to a covered employee with the corporation’s other deductible compensation.
- The Proposed Regulations also clarify that if, after a separation from service, a covered employee returns to service with the publicly held corporation in any capacity, including common law employee, director, or independent contractor, such compensation is subject to Code Section 162(m).
- Privately Held Corporations that Become Publicly Held. The Proposed Regulations provide that in the case of a of privately held corporation that becomes a publicly held corporation, Code Section 162(m) applies for the tax year ending on or after the date the corporation becomes publicly held. This position resolves, albeit unfavorably, an ambiguity in the Notice as whether the pre-Amendment transition relief would continue to apply. Fortunately, such relief is preserved for any privately held corporation that became publicly held on or prior to December 20, 2019.
- Grandfather Rule
- The Amendment generally provides that the amendments to Code Section 162(m) apply to taxable years beginning after December 31, 2017. However, it further provides that those amendments do not apply to remuneration that is provided pursuant to a written binding contract that was in effect on November 2, 2017 and not materially modified on or after such date.
- The Notice clarified that remuneration is payable under a written binding contract only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under the contract if the employee performs services or satisfies applicable vesting conditions and accordingly, any amount in excess of such amount is not grandfathered. The Proposed Regulations acknowledge the difficulty of determining what qualifies as a written binding contract and, while not adopting a commenter’s proposed GAAP-based safe harbor, welcome comments on that suggested safe harbor.
- With respect to compensation subject to discretion, including “negative” discretion, the Proposed Regulations generally retain the position of the Notice that such discretion causes the remuneration not to be grandfathered. The Proposed Regulations unfortunately provide for additional complexity with respect to contingent discretion to recover amounts that have been paid (i.e. pursuant to a “clawback”), and suggest that a taxpayer must take a “wait and see” approach on the deductibility of the payment.
- Finally, the Proposed Regulations set forth rules for determining grandfathered amounts in account and nonaccount plans, earnings thereon, and severance. Particularly interesting is the treatment of severance, suggesting that the publicly held corporation must be obligated to pay each element of severance in order for payments to be treated as made under a written binding contract.
- Material Modification.
- The Proposed Regulations adopt the definition of material modification in the Notice. Under that definition, a material modification occurs when the contract is amended to increase the amount of compensation payable to the employee.
- In one of the few taxpayer favorable provisions, the Proposed Regulations provide that for compensation received pursuant to substantial vesting of restricted property, or the exercise of a Code Section 409A exempt stock option or stock appreciation right, a modification of a written binding contract in effect on November 2, 2017 that results in a lapse of the substantial risk of forfeiture is not considered a material modification.
- The Proposed Regulations also provide ordering rules for situations when payments may be bifurcated into grandfathered and non-grandfathered amounts, generally allocating grandfathered amounts to the first otherwise deductible payments.
- Compliance with Section 409A.
- Code Section 409A addresses nonqualified deferred compensation arrangements and sets forth certain requirements that must be met to avoid current income inclusion and excise taxes including the establishment of designated payment dates. The 409A regulations generally permitted a delay of payment if the employer’s deduction would not be permitted due to the application of Section 162(m). Under Code Section 409A, if payment is delayed, all scheduled payments must be delayed or else the delay would be treated as a subsequent deferral with its own set of rigorous rules. Because the Amendment changed how long a covered employee remains a covered employee, the Proposed Regulations accommodate a change to Code Section 409A arrangements that allows a delay of grandfathered amounts without delaying the non-grandfathered amounts.
- In addition, plans may be amended to remove a required delay and such removal will not be considered an impermissible acceleration of payment under Code Section 409A. However, the plan amendment must be made no later than December 31, 2020. These rules will be incorporated into the next round of Code Section 409A guidance.
- Proposed Applicability Dates. Except as provided by the special applicability dates below, taxpayers may no longer rely on the Notice for taxable years ending on or after December 20, 2019 (the date the Proposed Regulations were published in the Federal Register), but instead may rely on the Proposed Regulations.
- The definition of covered employee is proposed to apply to taxable years ending on or after September 10, 2018, the publication date of the Notice.
- The provisions defining a predecessor corporation of a publicly held corporation are proposed to apply to corporate transactions for which all events occur on or after the date of publication of the final regulations. Until such date, taxpayers can rely on the Proposed Regulations or a reasonable good faith interpretation of “predecessor.” However, excluding certain target corporations shall not be a reasonable good faith interpretation.
- The special rule for distributive shares of a partnership’s deductions is to apply to any deduction for compensation that is otherwise allowable for a taxable year ending on or after December 20, 2019. However, this would not apply to compensation paid pursuant to written binding contract in effect on December 20, 2019.
- The guidance relating to a privately held corporation that becomes a publicly held corporation is proposed to apply to corporations that become publicly held after December 20, 2019, and a corporation that becomes a publicly held corporation on or before December 20, 2019 may rely on the pre-Amendment transition relief.
- The definition of written binding contract and material modification are proposed to apply to taxable years ending on or after September 10, 2018.
Locke Lord LLP will be providing detailed analyses of the Proposed Regulations over the first quarter of 2020. Please stay tuned.
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