At long last, the Department of the Treasury and Internal Revenue Service published final regulations to explain how changes to Internal Revenue Code Section 162(m) under the Tax Cuts and Jobs Act of 2017 (TCJA) affect the deductibility (or lack thereof) of compensation in excess of $1 million paid to covered employees. We have blogged about these changes and made recommendations to public companies in the past about how to manage these changes. For the most part, the final regulations did not change any prior guidance. We will not repeat these prior summaries here. Instead, we will highlight the items that we expect will result in the biggest changes or challenges to public companies and the administration of their executive compensation plans.
Keeping track of covered employees
Under IRC Section 162(m), a public company may not claim a deduction with respect to compensation paid to “covered employees” in excess of $1 million. Identifying covered employees in a given year is fairly straightforward under the final regulations. Such individuals currently include any of the three highest-paid executives of the corporation that year, as well as the CEO and CFO, regardless of whether that person is an officer at the end of the year or if that person’s pay must be disclosed under SEC rules.
Interestingly, a commenter suggested that the IRS simplify this process by limiting covered employees only to those officers whose pay must be disclosed under SEC executive pay rules. The IRS and the treasury rejected this suggestion, arguing that the text of the statute did not support doing so. This exchange highlights one potential practical difficulty with the new 162(m) provisions. That is because identifying the three highest paid officers (other than the CEO and CFO) presents a challenge because they may be different people from those reported in the proxy statement. Making such determinations after a merger or acquisition could involve even deeper analysis.
Another potential administrative burden is the requirement that once an officer is a covered employee in one year (for any tax year beginning after Dec. 31, 2016), he or she remains a covered employee subject to the deduction limitation in future years, regardless of compensation.
Finally, the recently-enacted American Rescue Plan Act (ARPA) expanded the class of covered employees more, although this expansion is not effective until tax years beginning after Dec. 31, 2026. For tax years beginning after Dec. 31, 2026, the five highest paid employees, other than any covered employee as defined under the TCJA, also will be covered employees subject to the $1 million deduction limit. These five employees, however, will not be subject to the “once a covered employee, always a covered employee” rule. This group can change from year to year. In other words, the CEO, CFO and the three other highest paid executives represent a permanent group of covered employees. For plan years beginning after Dec. 31, 2026, an additional five employees will represent a current-year group of employees that changes from year-to-year.
The bottom line is that over time, the number of covered employees could grow into a large number, and that number may include many people who no longer work at the company and potentially could include deceased employees (for example, if payments are being made to beneficiaries under a deferred compensation arrangement). The ARPA changes also will require additional covered employee determinations to be made each year. Employers will need to implement systems that can identify and track covered employees.
Transition relief and grandfathered arrangements
The changes to IRC Section 162(m) generally are effective beginning in tax years starting on or after Jan. 1, 2018. A grandfather rule applies, however, that provides that amounts payable under written binding contracts in effect on Nov. 2, 2017, and that have not been materially modified since then, may still take advantage of the former qualified performance-based compensation exception to the deduction limit. The grandfathering guidance has caused a lot of confusion and concern with respect to whether an arrangement could be considered “binding” if it provides for negative discretion or clawbacks. The final regulations addressed some of these concerns.
One source of good news came with respect to clawbacks, which typically require forfeiture and repayment of compensation if the participant engaged in fraud or if the company must restate its accounting statements. The proposed rules provided that if a clawback were triggered, and the company recovered payment, the arrangement would lose grandfathered status. The final regulations change that, stating that neither the right to clawback, nor the clawback itself, makes a contract lose its grandfather status.
With respect to negative discretion—the ability of the company to reduce or eliminate the amount payable to a participant—the final regulations remain consistent with prior guidance. If a pay plan allows for negative discretion (and nearly every plan does), the amount paid under that arrangement is not grandfathered to the extent a company is not obligated to pay it under applicable law. As a result, companies and their legal counsel will need to analyze state contract law, including such principles as illusory promises and promissory estoppel, to determine whether their particular arrangements provide a right to payment of some minimum amount of compensation, or no amount at all.
Such an analysis can be difficult and often involves a highly specific facts-and-circumstances test. One of the comments requested that the final regulations disregard negative discretion for purposes of determining if pay is grandfathered. The IRS and the treasury rejected this plea, this time making more of a “dog that didn’t bark” type of statutory construction argument. The IRS and the treasury explained that Congress was very well aware of the fact that most plans contain negative discretion. If Congress wanted to carve out a specific exception to its Nov. 2, 2017, effective grandfather date, it could have done so. The fact that it did not carve out such an exception shows that Congress did not intend for negative discretion to be disregarded.
IPO transition relief
Historically, if a private company became publicly traded, compensation it paid to covered employees was exempt from the $1 million tax deduction limit and thus the need to satisfy the qualified performance-based exception for a period of time (generally about three years). This provision applied so long as the plan was approved by shareholders before an initial public offering and the pay arrangements were not materially altered thereafter. In other words, newly public companies had a transition period to comply with IRC Section 162(m).
When the treasury and the IRS published proposed regulations under the new IRC Section 162(m), it eliminated the transition relief for any private company that became public after Dec. 20, 2019. Because there was no longer a performance-based compensation exception to the deduction limit, the idea was that there was no need to take extra time to adjust pay arrangements. The final regulations preserve the elimination of the prior transition relief.
By itself, that denial is not surprising. We point it out, however, because companies that become public may still have grandfathered arrangements. While the IPO transition relief may no longer apply, newly public companies may still qualify for relief from the deduction limit to the extent that they have grandfathered arrangements.
Related IRC Section 409A issues
We also blogged previously about how the changes to IRC Section 162(m) may require some companies to have to amend their deferred compensation arrangements to avoid an inadvertent violation of IRC Section 409A. In general, IRC Section 409A contains strict rules regarding when elections to defer compensation may be made when such deferred amounts can be paid. IRC Section 409A also generally prohibits acceleration or delays of payment. One exception, however is that the IRC Section 409A regulations allow payment to be delayed if a publicly-held company reasonably anticipates that a payment would result in a disallowed deduction under IRC Section 162(m). In such a case, payment must be made as soon as it is reasonably anticipated the payment could be made without loss of a deduction. Historically, that often would be when the participant retired or terminated service because such person would no longer be a covered employee. Under the new IRC Section 162(m), however, it is theoretically possible that such a payment may never be deductible.
In the proposed regulations, the IRS explained that if a plan required a delay in these circumstances, it could be amended before Dec. 31, 2020, to accelerate payment and avoid this indefinite delay in payment. It also explained that it intended to amend the IRC Section 409A regulations to permit such an amendment. We note that the proposed regulations do not appear to require amendments to plans that simply permitted deferrals but did not require deferrals. Under the final regulations, however, the IRS did not amend the IRC Section 409A regulations and did not provide an extension of the time permitted to amend deferred compensation plans that had this mandatory deferral requirement. The IRS did acknowledge in the preamble it was aware of the coordination issue.
The final regulations under IRC Section 162(m) are here, and we expect additional guidance to come under the ARPA. Public companies should review their compensation arrangements to determine what extent, if any, they can take advantage of grandfathering or other transition relief. They also should review their deferred compensation plans to determine if there are any coordination issues. Most importantly, they will need to put systems in place to track their covered employees.