Overview of Proposed Regulations Under Code Section 162(m) — Grandfather Rules

Our last installment of our overview of the Proposed Regulations under Code Section 162(m) focuses on the transition or grandfather rules (“Grandfather Rules”) under the Proposed Regulations.  Our prior installments have focused on the amendments to Code Section 162(m) enacted by the Tax Cuts and Jobs Act of 2017 (“TCJA”) and their effective date.  This installment highlights the extent to which the pre-TCJA provisions of Code Section 162(m) still apply.

General

While the amendments to Code Section 162(m) under TCJA generally ‎apply to taxable years beginning after December 31, 2017, there is an exception for compensation paid ‎under a written binding contract in effect on November 2, 2017, unless the contract is ‎modified in any material respect.‎

The Proposed Regulations clarify that compensation is subject to the Grandfather Rules, only to the extent that the publicly held corporation is obligated under ‎applicable law (generally, state contract law) to pay the compensation under the contract, subject to the covered employee meeting the performance and vesting conditions under the contract. Subject to the limited exceptions described below, the ‎amendments to Code Section 162(m) apply to compensation in excess of the amount of ‎compensation that the publicly held corporation is obligated to pay under the terms and conditions of a written binding ‎contract in effect on November 2, 2017.

Compensation Subject to Negative Discretion

It has been common practice for a public company, typically through its compensation committee, to have discretion to reduce the amount of performance-based compensation otherwise payable to a covered employee (“negative discretion”).  The Proposed Regulations provide that in instances in which a compensation arrangement provides the publicly held corporation with negative discretion, then the grandfathered amount is the minimum amount the publicly held corporation is obligated to pay.  However, if the level of ‎negative discretion given to the publicly held corporation under the contract exceeds what applicable law permits, ‎negative discretion is taken into account only to the extent the publicly held corporation may exercise the ‎negative discretion under applicable law.‎

In addition, the Proposed Regulations provide that failure, in whole or in part, to exercise negative discretion under a contract by the publicly held corporation will ‎not result in a material modification of such contract for purposes of the Grandfather Rule.

Negative discretion can also come into play with claw-back provisions.  For example, if a publicly held corporation pays a bonus based on its audited financial ‎statements but the financial statements are subsequently restated and demonstrate that the conditions to receive such bonus were not, in fact, satisfied, then the corporation is often required to recover all or a portion ‎of the bonus from the employee. If, under applicable law, the employee is entitled to retain the unrecovered ‎portion of the bonus, then the retained portion of the bonus is grandfathered compensation. Similarly, if the corporation has discretion to recover ‎compensation (in whole or in part), only the amount of compensation under applicable law that is not subject to potential recovery is grandfathered.

Severance Agreements

Severance payable under a written binding contract in effect on November 2, ‎‎2017 is grandfathered only if the amount of severance is ‎based on compensation elements the publicly held corporation is obligated to pay under the contract. For example, if the amount of severance is based on final base salary, the severance is ‎grandfathered only if the corporation is obligated to pay both the base salary and the ‎severance under applicable law pursuant to a written binding contract in effect on November 2, ‎‎2017.‎

It is not uncommon for a portion of the severance amount to be based on a variable component, such as a discretionary or performance ‎bonus. ‎ The Proposed Regulations provide that each component of a severance formula must be analyzed separately to determine the amount of ‎severance that is grandfathered. For example, the amount of severance may be equal to two times ‎the sum of: (1) final base salary and (2) any bonus paid within 12 months prior to separation ‎from service. Since the amount of severance is based on two components, the entire amount of severance (based on both components) is ‎grandfathered only if, under applicable law, the corporation is obligated to pay both ‎portions, the base salary and the bonus pursuant to a written binding contract in effect on ‎November 2, 2017.‎

Material Modifications

General Rule

As previously explained, compensation provided ‎under a written binding contract in effect on November 2, 2017 is grandfathered, unless the contract is ‎modified in any material respect on or after November 2, 2017.‎ Under the Proposed Regulations, a material modification occurs when a contract is amended to increase ‎the amount of compensation payable to the employee. If a written binding contract ‎is materially modified, it is treated as a new contract entered into as of the date of the material ‎modification. Accordingly, amounts received by an employee under the contract before a ‎material modification are not affected, but amounts received on or after the material ‎modification are treated as paid pursuant to a new contract and therefore subject to Code Section 162(m) as amended by the TCJA.

Supplemental Agreements

If the publicly held corporation and covered employee enter into a supplemental contract that provides for additional compensation, it will be treated as a material modification of an otherwise grandfathered written binding contract, if based on the facts and circumstances, the additional compensation is paid on substantially the same elements or conditions as the compensation that is otherwise paid ‎pursuant to the written binding contract in effect on November 2, 2017.  However, a ‎ supplemental payment that is equal to or less than a reasonable cost-of-living increase over the ‎payment made in the preceding year under that written binding contract‎ will not be treated as a material modification.

Deferrals of Payments

If a written binding contract in effect on November 2, 2017, is subsequently modified to defer ‎the payment of compensation‎, ‎ any compensation paid or to be paid that is in excess of the amount originally payable ‎to the employee under the contract will not be treated as resulting in a material modification if ‎the additional amount is based on either a reasonable rate of interest or a predetermined actual ‎investment‎.  However, any earnings on the deferred amount are not grandfathered if, as of November 2, 2017, the ‎publicly held corporation was not obligated under the terms of the contract to provide the deferral ‎election and to pay the earnings on the deferred amount.‎

‎Acceleration of Payment or Vesting

A modification of a written binding contract 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. For example, if a publicly held corporation is obligated under applicable ‎law to pay compensation on December 31, 2020, pursuant to a written binding contract in effect ‎on November 2, 2017, then the compensation is grandfathered. However, if the corporation accelerates payment to December 31, 2019, any portion of the compensation otherwise due on December 31, 2020 without a discount to reasonably ‎reflect the time of value of money, then the entire amount of compensation is treated as paid ‎pursuant to a new contract and is no longer grandfathered. Furthermore, any subsequent payment ‎made pursuant to such contract is not grandfathered because the contract itself was materially ‎modified when the prior payment was accelerated without a discount to reasonably reflect the ‎time value of money.‎

However, for all forms of compensation, a modification to a written binding contract in effect on November 2, 2017 ‎that accelerates vesting will not be considered a material modification. The Proposed ‎Regulations provide that this applies to a lapse of the ‎substantial risk of forfeiture with respect to restricted property, the exercise of a stock option or stock appreciation right or an amount of compensation ‎payable under a written binding contract in effect on November 2, 2017.

Ordering Rules for Payments of Grandfathered and Non-Grandfathered Amounts

In some instances, only a portion of the amounts payable under a contract may be grandfathered, depending ‎on the terms of the arrangement and applicable law. ‎In the case of a series of payments, the Proposed Regulations ‎provide that the grandfathered amount is allocated to the first otherwise deductible payment ‎paid.  If the grandfathered amount exceeds the payment, then the remaining grandfathered amount is ‎allocated to the next otherwise deductible payment. This process is ‎repeated until the entire grandfathered amount has been paid. ‎ 

Coordination with Code Section 409A

Code Section 409A addresses non-qualified deferred compensation (“NQDC”) arrangements and the requirements to avoid current income inclusion and additional adverse tax consequences.  Among other requirements, NQDC arrangements ‎must designate a time and form of payment of deferred compensation. However, the regulations under Code Section 409A (the “409A regulations”) permit a payment to be delayed past the designated payment ‎date to the extent that a publicly held corporation reasonably anticipates that such payment would not be deductible due to the application of Code Section 162(m).  Generally, a payment may be delayed no later than the service provider’s first taxable ‎year in which the deduction of such payment will not be barred by Code Section ‎‎162(m).‎

As explained in our January 15th installment, prior to the amendments to Code Section 162(m) by TCJA, an individual who was a covered employee ceased to ‎be a covered ‎employee after separation from service. Accordingly, parties to NQDC arrangements anticipated ‎that in these cases, a ‎publicly held corporation would be able to make the deferred payment when the individual separated from ‎service, since the individual would no longer be a covered employee and the ‎deduction for the payment would no longer be restricted by Code Section ‎‎162(m).

The Proposed Regulations provide that in circumstances in which a publicly held corporation has ‎discretion to delay the payment under the 409A regulations, it may delay the scheduled payment of ‎grandfathered amounts, without ‎delaying the payment of non-grandfathered amounts, and the delay of the grandfathered ‎amounts will not be treated as a subsequent deferral election. The deduction for grandfathered amounts ‎is not subject to Code Section 162(m) when paid to a former covered employee who separated from ‎service. The Treasury Department and the IRS, in the preamble to the Proposed Regulations, indicated their intent to ‎incorporate these modifications into the 409A regulations, and that taxpayers may rely ‎on the guidance in the preamble to the Proposed Regulations for any taxable year beginning after December ‎‎31, 2017, until the issuance of proposed regulations under Code Section 409A incorporating these ‎modifications.

Non-‎grandfathered amounts may require the passage of a significant period of time before a payment ‎of the entire amount would be deductible, and may possibly never become deductible if the ‎ covered employee dies and the payment (or remaining amount due) is payable at death. ‎ The Proposed Regulations provide that if a NQDC arrangement is ‎amended to remove the provision requiring the publicly held corporation to delay a payment if it reasonably anticipates at the time of the scheduled payment that the ‎deduction would not be permitted under Code Section 162(m), then the amendment will not result in ‎an impermissible acceleration of payment under the 409A regulations.  Additionally, it will not be considered a ‎material modification for purposes of the Grandfather Rule. ‎Such an amendment must be made no later than December 31, 2020. If, pursuant to the NQDC arrangement, the publicly held corporation would have been required to make a payment (or ‎payments) prior to December 31, 2020, then the payment (or payments) must be made no later ‎than December 31, 2020. The Treasury Department and the IRS intend to incorporate these ‎modifications into the regulations under Code Section 409A, and the preamble to the Proposed Regulations provide that taxpayers may rely on the guidance in the preamble for any taxable year beginning after December 31, 2017, until the ‎issuance of Proposed Regulations under Code Section 409A incorporating these modifications.

Amounts payable under NQDC arrangements may consist of both grandfathered amounts and ‎non-grandfathered amounts. A NQDC arrangement may be ‎amended to remove the provision requiring a publicly held corporation to delay the payment of ‎non-grandfathered amounts if it is anticipated that the publicly held corporation’s deduction with ‎respect to the payments will not be permitted under Code Section 162(m); notwithstanding such an ‎amendment, the publicly held corporation may continue to delay payment of the grandfathered ‎amounts in accordance with the 409A regulations.‎

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