We previously blogged about how the Tax Cuts and Jobs Act (the Act) amended Internal Revenue Code Section 162(m). In general, the amended Code Section 162(m) restricts the ability of publicly traded companies to recognize a tax deduction for amounts paid to “covered employees” in excess of $1 million. It does this primarily by expanding the groups of individuals who are classified as covered employees and restricting the scope of the arrangements that are exempt from the $1 million deduction limit. The Act left many questions unanswered, and the IRS recently answered some of those questions by publishing transition guidance in Notice 2018-68 (the Notice). The most notable takeaway from the Notice is that the ability of arrangements to be grandfathered under prior Code Section 162(m) is more limited than many practitioners had hoped for.

The guidance from the Notice will require public companies to evaluate both the design and administration of their executive compensation plans. Doing so is important both to preserve the tax deductibility of grandfathered amounts and to consider the best way to align executive compensation with increasing shareholder value in the new tax environment. Companies also will need to be able to explain these issues as part of their compensation discussion and analysis in their proxy statements. To manage these issues, public companies should consider taking the following actions with respect to their executive compensation plans:

Determine whether there was a written binding contract in effect as of Nov. 2, 2017 that created a legally binding obligation on the company under any applicable law to pay the compensation under the contract, assuming that applicable service or performance-based requirements were met. Doing so helps determine whether payment under the contract could be deductible under the grandfathered rules or not.
Implement measures to track covered employees. Once an executive is a covered employee under Code Section 162(m), that person remains a covered employee forever (including after termination of service and even after he or she is deceased) and thus subject to the $1 million deduction limit. Covered employees are not necessarily the same as named executive officers under the proxy rules, and additional analysis may be needed with respect to mergers and acquisitions.
Analyze agreements with Chief Financial Officers. Previously, CFOs were exempt from covered employee status. Now that CFOs are considered covered employees, companies should evaluate their agreements to determine whether any payments are grandfathered under the prior rules or whether they will be subject to the deduction limits.
Reevaluate the design and administration of their plans, but consult with counsel before amending any arrangements. In this new tax environment, companies may consider amending their plans to align compensation with pure business goals more closely, without having to worry about what tax law considers “performance-based” compensation. Before making any changes, however, companies should be careful that any amendment will not cause a payment to lose its grandfathered status (and thus its exemption from the $1 million deduction limit).
Encourage covered employees to consider deferring larger amounts of compensation until termination of employment or later, when total compensation may be less than $1 million.
Review their proxy statement disclosures and make any appropriate updates to reflect the changes that the Act and Notice made to Code Section 162(m).
Watch for additional IRS guidance (and consider submitting comments to the IRS). The Notice states that the IRS and Treasury will issue additional regulations in the future, and the IRS is requesting comment by November 9, 2018, including issues related to Code Section 162(m) and initial public offerings and mergers and acquisitions.

Background on Code Section 162(m) and the Changes Made by the Act

Previously under Code Section 162(m), if a publicly traded company paid more than $1 million in compensation to a “covered employee,” that company generally was not able to recognize a tax deduction with respect to the amount that exceeded $1 million. A notable exception, however, was that amounts that qualified as “performance-based” compensation were not subject to the $1 million deduction limit and therefore were deductible. The regulations under Code Section 162(m) contained extensive guidance as to what qualified as performance-based. Further, “covered employees” generally included anyone employed on the last day of the taxable year as the chief executive officer and any of the three highest compensated executive officers (other than the CEO and CFO) whose compensation was reported in the proxy statement. In other words, CFOs generally were not considered covered employees, and the requirement to be employed on the last day of the taxable year also excluded some key executives who held such titles during the year.

The Act made significant amendments to Code Section 162(m). Amended Code Section 162(m) no longer contains a performance-based compensation exception for amounts paid in tax years beginning on or after January 1, 2018, unless the grandfather rule explained below applies. In other words, public companies no longer will be able to deduct any amount paid to a covered employee in excess of $1 million, regardless of whether or not it is performance-based. However, amounts paid under agreements that were effective on or before Nov. 2, 2017, may still be able to be deductible because of being grandfathered under the prior Code Section 162(m) rules (assuming that the agreements are not materially modified). The Act also expanded the group of “covered employees” to include CFOs and eliminated the end of the year employment requirement. The Internal Revenue Service recently published proposed regulations to clarify some questions that the Act had raised. The Notice provides further guidance and clarification surrounding these changes that the Act made to Code Section 162(m).

Scope of Grandfathered Relief

The biggest concern of practitioners was how narrowly or broadly the IRS would interpret the scope of the Act’s transition relief. In particular, would the presence of a negative discretion provision — the ability to reduce a performance award — in an executive compensation arrangement disqualify it as a written, binding contract in effect on Nov. 2, 2017? The answer appears to be “yes”. Under the Notice, the IRS explains that companies must be able to demonstrate under state or other applicable law (e.g., state contract law) the amount that, as of Nov. 2, 2017, the company would have to pay if the employee performed the services or satisfied the vesting conditions under the arrangement. If a compensation plan or arrangement is binding, the amount that is required to be paid as of Nov. 2, 2017, is grandfathered and may still qualify for the performance-based compensation exception. Anything in excess of the amount bound to be paid would not be grandfathered and thus would be subject to the amended Code Section 162(m). As illustrated in an example in the Notice, the ability of a company to exercise negative discretion to reduce a bonus, perhaps to zero, could mean that the company had no obligation to pay all or a portion of such amount as of Nov. 2, 2017. Therefore, all or a portion of such amount may not be deductible.

Performance-based compensation that previously was deferred under a deferred compensation plan, however, could be considered to be paid under a written, binding contract under the grandfathered relief if the company may not amend or reduce the deferred amounts.

The Notice also explains that renewals of arrangements terminate grandfathered status. For example, suppose a written, binding contract allows a company to terminate the arrangement after Nov. 2, 2017 (e.g., by requiring only that the company provide advanced written notice of termination). The Notice explains that such amount is treated as renewed (and thus, grandfathered status ends), on the date that any such termination would be effective had notice been given.

The Notice also offers some clarifications on material modifications that would cause an agreement to no longer be grandfathered. In general, a material modification is an amendment to increase the employee’s compensation, and it is treated as a new contract as of the modification date. A supplemental contract that provides increased compensation would be a material modification if the additional compensation is based on substantially the same elements as the original written binding contract. The Notice also explains the conditions in which accelerations and delays of payment may be considered material modifications.

Covered Employee Clarifications

Covered employees under Code Section 162(m) include the chief executive officer and the chief financial officer of a publicly held corporation, any individual who served in those capacities during the taxable year, and the three highest-compensated employees apart from the CEO and CFO. Further, any covered employee will remain a covered employee in all future years.

The Notice clarifies that anyone serving as CEO or CFO at any time during the year (rather than only as of the last day of the year) will be covered employees. Additionally, individuals who are covered employees under the three highest-compensated employees standard will be covered employees 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. Further, a covered employee includes any individual who was a covered employee of the corporation (or any predecessor) for any taxable year beginning after Dec. 31, 2016. For taxable years beginning before January 1, 2018, however, covered employees are determined under the prior Code Section 162(m) rules. Thus, individuals who have been determined to be covered employees for the taxable year beginning in 2017 under the prior rules will continue to be covered employees in future taxable years.

Next Steps and a Caution

The changes to Code Section 162(m) apply to amounts paid to covered employees in tax years beginning on or after Jan. 1, 2018. For many publicly traded companies, that means these rules are effective now. Accordingly, public companies should review the 7 action items listed at the beginning of this blog and determine what changes should be made to the design and administration of their executive compensation plans and how they will report these changes in their proxy statements. Further, companies should carefully consider whether an amendment to a prior arrangement could cause the arrangement to lose grandfathered status.