On August 21, 2018, the Internal Revenue Service (“IRS”) issued Notice 2018-68 (“Notice”) which provides initial guidance on amendments made by the Tax Cuts and Jobs Act of 2017 (“Tax Act”) under Section 162(m) of the Internal Revenue Code (“Code”). Section 162(m) of the Code limits the amount of compensation public companies can deduct for “covered employees” to $1 million. Primarily, the Notice provides guidance on the revised definition of a “covered employee” and the compensation excluded under written, binding contracts in effect on Nov. 2, 2017 for purposes of the $1 million deduction limit. While the Notice does not eliminate all uncertainty surrounding the new rules, it does provide some clarity on certain outstanding questions.
Before the Tax Act amendments, a “covered employee” included an individual who on the last day of the tax year was a CEO or among the four highest-paid officers, as determined based on the executive compensation SEC disclosure rules. Under the old rules, the deduction limitation of $1 million did not apply to performance-based compensation or commissions. The Tax Act changes Code Section 162(m) of the Code to repeal the exclusion on performance-based pay and commissions, expand who qualifies as an applicable employer for Code Section 162(m) purposes and revise the definition of a “covered employee.”
Covered Employee
Under the Tax Act, a covered employee in any given tax year includes the CEO or the CFO (or individual acting in that capacity) at any time during the tax year, one of the three highest paid officers for the tax year other than the CEO or the CFO, or any individual who was a “covered employee” starting with the 2017 tax year. In the Notice, the IRS noted that these rules do not perfectly correlate with SEC’s disclosure rules. Accordingly, even if the individual’s compensation is not subject to SEC disclosures, the individual still may need to be considered a covered employee for purposes of Code Section 162(m).
The new definition of a “covered employee” takes effect beginning with the 2018 tax year. However, under the Tax Act, any employee who becomes a “covered employee” in 2017 or later tax years will remain a “covered employee” in any future tax year, even if the employee is no longer employed or living. Accordingly, any employees who were classified as “covered employees” in 2017 under the rule’s old definition (CEO or among four highest-paid officers), will need to be included in the list of covered employees for the 2018 tax year.
Grandfathered Compensation
Under the Tax Act’s transition rule, any compensation paid pursuant to a written binding contract in effect on Nov. 2, 2017, that has not been materially modified after Nov. 2, 2017, can be excluded from the $1 million deduction limit. The application of the transition rule raised a number of questions, so practitioners asked for clarification from the IRS on the definition of a material modification and a binding contract. Specifically, practitioners asked if changes in the amount payable affect eligibility for the transitional relief and would certain stipulations (such as the ability to terminate the contract at any time) make a contract ineligible for the relief.
In the Notice, the IRS addresses some of the concerns by employing similar concepts it used when it developed transitional relief guidelines when Code Section 162(m) was first enacted in 1993. Described below are the key takeaways provided in the Notice with respect to compensation that can be excluded from the deduction limit calculation for binding contracts in effect on Nov. 2, 2017:
-
All compensation received prior to the material modification is grandfathered, while compensation received after a material modification would be taken into account for purposes of the deduction limit.
-
A binding contract exists if it was in effect on Nov. 2, 2017 and a company is legally bound to pay compensation under the contract, subject to service and vesting conditions.
-
For compensation to be excluded, an employee need not participate in the plan on Nov. 2, 2017, as long as the employee was employed by the company on Nov. 2, 2017.
-
A contract that can be terminated or cancelled by the company without the employee’s consent is considered a new contract on the effective date of the termination or cancellation.
-
A material modification occurs if a contract is amended to increase the amount of compensation payable to the employee (other than a reasonable cost-of-living increase).
-
Acceleration of payment under a contract is considered a material modification, unless the accelerated payment is discounted to reflect the time value of money.
-
If a payment is deferred under a contract, amounts in excess of the original amount are treated as material modifications unless the additional amounts are based on either a reasonable rate of interest or a predetermined actual investment.
Absent a material modification, compensation payable pursuant to a binding contract in existence as of Nov. 2, 2017 is excluded from the deduction limit. The application of the transition rule is noteworthy, giving companies an opportunity to exclude compensation paid under arrangements in existence on Nov. 2, 2017 while they develop new compensation strategies that take into account the revised rule.
Additional Guidance
The IRS intends to issue additional guidance on the revised Code Section 162(m) in the form of proposed regulations. These proposed regulations will incorporate the guidance in the Notice to the extent applicable and answer some of the other outstanding questions (application of the revised definition of a publicly held corporation, the definition of a “covered employee” who was a covered employee of a predecessor employer, application of Code Section 162(m) immediately after a company becomes publicly held and how the SEC compensation disclosure rules apply to determine the three (3) highest paid employees for any taxable year, when the taxable year does not end on the same date as the company’s last completed fiscal year). The proposed regulations are scheduled to be issued sometime after Nov. 9, 2018.
