The IRS recently released long-awaited proposed regulations (REG-122180-18) on the new version of Section 162(m) that incorporate most of the initial, interim guidance provided in Notice 2018-68, but also make a number of significant changes. In addition, the proposed regulations provide guidance in areas not covered by the notice, including several provisions in the existing regulations that were not directly changed by the Tax Cuts and Jobs Act (TCJA).
Section 162(m) limits a public company’s annual compensation deduction to $1 million for each covered employee, and was amended by the TCJA. The proposed regulations address the new definitions of “publicly held corporation” and “covered employee” and the grandfather relief for the TCJA changes to Section 162(m). They also make significant changes to the existing regulations, such as eliminating the transition relief for new public companies, expanding the reach of the affiliated group rules to include private parent corporations, and requiring compensation paid by a partnership to a covered employee of a corporate owner in the partnership to be included in the compensation subject to Section 162(m).
The regulations are proposed to apply to compensation that is otherwise deductible for taxable years beginning on or after the date final regulations are published. However, taxpayers can choose to rely on the proposed regulations until then, provided the proposed regulations are applied consistently and in their entirety. Taxpayers generally may no longer rely on Notice 2018-68 for taxable years ending on or after Dec. 20, 2019. In addition to the general proposed effective date, there are special effective dates for specific provisions in the proposed regulations, which are identified below.
Companies should re-evaluate their deferred tax assets for compensation items to determine whether adjustments should be made. For calendar-year companies, this should be done for the fourth quarter statement.
More detailed information on the rules is provided below.
Background Section 162(m) limits a public company’s annual compensation deduction to $1 million per covered employee. Prior to the TCJA’s enactment, a covered employee was defined as the CEO, or an individual serving such a role, and the company’s three highest-paid officers, other than the CEO and CFO, as of the last day of the taxable year (the CFO was thus excluded entirely as a covered employee). More notably, companies could exclude qualified performance-based compensation and commissions from the $1 million annual limit.
The TCJA made three major changes to Section 162(m), which are statutorily effective for taxable years beginning after Dec. 31, 2017:
- It expanded the definition of a public corporation to include both domestic and foreign corporations publicly traded through American depository receipts, and certain large private corporations and S corporations required to make certain filings with the SEC.
- It eliminated the exception from the $1 million annual limit for qualified performance-based compensation and commissions.
- It broadened the definition of a covered employee. The term now encompasses any person who served as CEO or CFO, or acted as such, at any point during the taxable year. The three highest-paid officers other than the CEO and CFO continue to be covered employees. It also includes an employee who was formerly a covered employee of the company (or its predecessor) for any prior tax year beginning after Dec. 31, 2016. This extends to compensation paid to the employee after termination or to a beneficiary after death.
The TCJA also contains a provision which grandfathers certain compensation if the compensation is paid pursuant to a written binding contract which was in effect on Nov. 2, 2017, and is not materially modified on or after that date. This grandfathered compensation is not subject to the amendments made to Section 162(m) by the TCJA. Instead, the prior law, including the qualified performance-based compensation exception and the definition of covered employee, applies to this grandfathered compensation.
Definition of a covered employee Under the proposed regulations, an employee does not have to serve as an executive officer as of the end of a taxable year to be a covered employee. An officer’s compensation also does not have to be disclosed in the Summary Compensation Table of the company’s annual proxy statement. As a result, executives who are among the three highest paid for the taxable year will be covered employees even if they are not employed at year-end or are not disclosed on the proxy statement. In addition, a company’s covered employee group will include former employees after they have stopped providing services.
When determining whether the executive is among the top three paid employees other than the CEO and CFO, the company will be required to calculate the amount of an executive’s compensation pursuant to the applicable SEC rules for executive compensation disclosure. This is typically different from the executive’s Form W-2 compensation or the amount of otherwise deductible compensation. This may mean that officers who have never been reported on the proxy statement are included in the top three paid group because of severance and other payments in the year of termination.
Under the pre-TCJA rules, the $1 million limit often did not apply to a public company’s short taxable year because the public company generally did not file a proxy statement disclosing officer compensation for the short period. Because the definition of a covered employee was directly tied to the executive compensation required to be disclosed on the proxy statement, there were no covered employees for that short taxable year.
In contrast, under the amendments made to Section 162(m) and the proposed regulations, if a company has a short taxable year for which a proxy statement is not filed, the company will have covered employees for that short year. The top three paid officers other than the CEO and CFO are determined based on calculating compensation under the SEC rules for executive compensation disclosure, treating the short-taxable year as a fiscal year. This will require a special calculation of compensation pursuant to the SEC disclosure rules, taking into account payments related to a change in control if the change in control results in a short taxable year.
The proposed regulations also address who is considered an “executive officer” for purposes of identifying covered employees. The proposed rules refer to the SEC rules for the definition of an officer and point out that an officer of a subsidiary may be deemed an officer of the parent public company if the officer performs policy-making functions for the parent. This may include an officer of a partnership in which the public company owns an interest, provided that the partnership officer performs policy-making functions for the corporate owner. Similarly, officers of disregarded entities owned by a public corporation (or part of a public corporation’s affiliated group) are officers of the public corporation if they perform policy-making functions for the public corporation.
Under the proposed new rules, a corporation’s covered employees include covered employees of a “predecessor” public corporation for any preceding taxable year beginning after Dec. 31, 2016. The proposed regulations address the identification of predecessor corporations under various situations, including the types of transactions that result in predecessors. These include corporate reorganizations, corporate divisions (e.g., spin-offs), stock acquisitions and asset acquisitions. The proposed regulations also address situations in which the target company in the transaction was publicly held at one point, but was privately held immediately before the transaction.
The definition of a covered employee is proposed to apply to taxable years ending on or after Sept. 10, 2018. However, for corporations with different taxable and fiscal years (e.g., because of a short taxable year), the rule requiring the determination of the top three paid officers other than the CEO and CFO applies to taxable years beginning on or after Dec. 20, 2019.
The definition of a predecessor of a publicly-held corporation is proposed to apply to corporate transactions that occur on or after the date the final regulations are published. Until the regulations become final, taxpayers may rely on the proposed regulations or a reasonable good-faith interpretation of the term “predecessor.” However, the proposed regulations provide that excluding certain target corporations in a transaction from the definition of a “predecessor” will not be considered a reasonable good-faith interpretation.
Definition of publicly-held corporation The TCJA amended the definition of “publicly-held corporation” to include any corporation that is an issuer of securities which are required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act), or that is required to file reports under Section 15(d) of the Exchange Act. Unlike the existing definition of “publicly-held corporation,” the definition in the proposed regulations does not focus on whether the corporation is subject to the reporting obligations of Section 15(d).
This new definition includes corporations that traditionally have been thought of as publicly held, such as corporations with stock traded on a national securities exchange, but the new definition also includes corporations that traditionally have not been thought of as publicly held. For example, it includes privately-held corporations that have over $10 million of assets with a number of shareholders in excess of certain thresholds, certain foreign private issuers with American Depository Receipts (ADRs) and privately-held corporations with public debt.
The proposed regulations continue to treat all members of an affiliated group (as defined in Section 1504, but without regard to Section 1504(b)) that includes a publicly-held corporation as a single publicly-held corporation. However, if a subsidiary in an affiliated group is also a publicly-held corporation, that subsidiary is not part of the parent’s affiliated group, but is instead a separate publicly-held corporation with its own affiliated group. In a change from the existing regulations, the proposed rules provide that, if a parent corporation in an affiliated group is privately held, but a subsidiary in the affiliated group is publicly held, the parent is treated as publicly held.
The proposed regulations also provide other guidance with respect to the definition of a publicly-held corporation, including the following:
- S corporations, including their qualified subchapter S subsidiaries (QSUBs), can be publicly-held corporations
- Whether a corporation is publicly held is determined on the last day of the taxable year
- Publicly-traded partnerships that are treated as corporations for U.S. federal tax purposes under Section 7704 can be publicly-held corporations for purposes of Section 162(m)
- A public company’s affiliated group can include a private foreign corporation
- If a private company owns a disregarded entity, and that disregarded entity would otherwise be treated as a public corporation, the parent corporation is treated as a publicly-held corporation
TCJA grandfather rule In determining whether a contract is binding under the TCJA grandfather rule, the IRS effectively defers to the law applicable to that specific contract, such as state contract law. To the extent a contract was in effect on Nov. 2, 2017, any amount a corporation would be obligated to pay pursuant to that contract under applicable law is not subject to the amendments made to Section 162(m) by the TCJA. This is especially important when determining whether performance-based compensation is grandfathered and exempt from the $1 million limit and how the definition of “covered employee” is applied.
The proposed regulations do not provide a safe harbor for determining whether compensation is paid pursuant to a written binding contract. They still require the determination to be made under applicable law, which is generally state contract law. This leads to some uncertainty as to how state law applies when a compensation plan or agreement includes negative discretion.
Many performance-based compensation plans allow the company’s compensation committee to exercise discretion to reduce or eliminate the amount payable to the executive, even after the performance goals are met. This “negative discretion” provides the compensation committee flexibility to make downward adjustments to performance awards to take into account factors not specifically included in the performance goal. The IRS did not adopt a suggestion to ignore negative discretion when determining whether there is a written binding contract. Instead, the IRS stated that the negative discretion must be taken into account, but only to the extent the corporation may exercise it under applicable law. Thus, if under applicable law, the negative discretion is disregarded and the company is legally obligated to make a payment, the amount the company is legally obligated to pay is considered payable pursuant to a binding contract.
The proposed regulations also address clawback provisions included in compensation plans. These provisions generally require or permit the corporation to recoup compensation paid to employees if it is later determined that the compensation should not have been paid to the employee. For example, an employee may have been paid a bonus because the original financial statements show that the applicable performance goals were achieved. If it is later determined that the financial statements were incorrect and the performance goal was not achieved, a clawback provision may require an employee to repay all or a portion the bonus.
Under the proposed regulations, if there is a clawback, but the employee is entitled to retain the remaining portion of the compensation under applicable law, the remaining portion is considered paid under a binding contract. In addition, if a company has discretion to recoup compensation, only the amount of compensation that the corporation is obligated to pay under applicable law that is not subject to the discretionary clawback is considered a binding contract.
The proposed regulations provide multiple examples of how to determine the grandfathered amount of compensation. Earnings on grandfathered amounts are not grandfathered if the company may amend or terminate the plan at any time after Nov. 2, 2017, to stop earnings credits. Severance can also be grandfathered, but only if the amount of severance is based on compensation the employer is obligated to pay under the contract. For example, if the amount of severance is based on the employee’s base salary at the time of termination, the severance is grandfathered only if the corporation was obligated to pay both the base salary and the severance under applicable law pursuant to a written binding contract in effect on Nov. 2, 2017. If the amount of severance is based on different elements of compensation (e.g., base salary and bonus), each element of the severance is analyzed separately.
Compensation that exceeds the amount a corporation is required to pay under applicable law, however, will be subject to the amended Section 162(m) rules. This same treatment also applies to compensation paid under a written binding contract that is renewed after Nov. 2, 2017, as well as to contracts that automatically renew thereafter or are slated to terminate after that date, but are ultimately renewed, provided the corporation possessed the power to terminate the contract without the employee’s consent.
Thus, where a contract is automatically renewed because the corporation or employee opted not to exercise their respective right to terminate, the contract is deemed renewed as of the date such termination would have been effective. Conversely, when a contract is set to automatically terminate at a certain date unless the corporation or employee opts to renew, the contract is deemed renewed when either party elects to renew. In cases where the employee has sole discretion over the term of the contract, the proposed regulations provide that the contract will not be treated as renewed if the employee chooses to keep the corporation bound to the contract.
Compensation payable pursuant to a written binding contract that is materially modified on or after Nov. 2, 2017, is not grandfathered. The IRS states that when such a modification occurs, the contract is treated as a new contract, effective as of the date of the modification. All compensation paid after the date of the material modification, regardless of when earned, is no longer grandfathered.
A “material modification” is generally defined as an amendment that increases the compensation payable to the employee. This includes an acceleration of compensation, unless it is discounted to reflect the time value of money, and a deferral of compensation, unless the amount ultimately paid to the employee does not exceed a reasonable rate of interest or predetermined return on investment adjusted for actual gains or losses.
Supplemental contracts providing for increased compensation generally are considered material modifications if the facts and circumstances show the compensation is based on substantially the same elements or conditions as compensation otherwise paid under the written binding contract. However, a material modification does not include supplemental payments equal to or less than a reasonable cost-of-living increase over the payment made in the prior year pursuant to the written binding contract. But the amount of the cost-of-living adjustment is not a grandfathered amount.
The proposed regulations also clarify that the accelerated vesting of grandfathered compensation is not a material modification. For example, stock options granted prior to Nov. 2, 2017, may be grandfathered. If the vesting of those stock options is accelerated after Nov. 2, 2017, the accelerated vesting is not considered a material modification. The proposed regulations provide that this applies to all forms of compensation, and is not limited to stock options and other forms of equity-based compensation.
The definitions of “written binding contract” and “material modification” are proposed to apply to taxable years ending on or after Sept. 10, 2018.
New public company transition relief The proposed regulations would eliminate the current transition relief for private companies that become publicly held. Under the existing regulations, certain compensation paid by new publicly-held corporations, including corporations that become publicly held through an IPO, is exempt from Section 162(m) for a certain period of time after the corporation becomes public. This transition relief was initially intended to provide new publicly-held corporations with a period of time to change their compensation plans and obtain shareholder approval of the plans so the compensation could be excluded from the $1 million limit as qualified performance-based compensation.
According to the IRS, this transition relief is no longer needed because the performance-based compensation exemption no longer applies. As a result, corporations do not need time to change their plans and obtain shareholder approval.
The elimination of this transition relief is proposed to be effective for corporations that become publicly held after Dec. 20, 2019. Companies that became publicly held prior to that date may still rely on the transition relief in the existing regulations through the end of the applicable reliance period, even if the reliance period extends beyond Dec. 20, 2019.
Compensation subject to Section 162(m) The IRS also clarifies the compensation that is subject to Section 162(m). Compensation generally means, for any taxable year, the aggregate amount of compensation allowable as a deduction for the taxable year (determined without regard to Section 162(m)) for remuneration for services performed by the covered employee. The TCJA eliminated the exceptions for performance-based compensation and commissions. However, there are still certain exceptions to the definition of “compensation” in the proposed regulations, such as contributions and distributions from a qualified retirement plan.
The proposed regulations clarify that compensation includes an amount that is includible in the income of, or is paid to a person other than, the covered employee. This includes payments to a beneficiary after the death of an employee. It also likely includes payments that are directed to an alternate payee, such as under a divorce decree.
Compensation paid by a partnership The proposed regulations would change the IRS’s position regarding the application of Section 162(m) to compensation paid by a partnership to covered employees of a corporate owner. In previously issued private letter rulings (PLRs), the IRS addressed situations where a publicly-held corporation owned an interest in a partnership. The covered employees of the corporation provided services to the partnership and were paid for those services. The IRS ruled in the PLRs that the corporation’s distributive share of the deduction for compensation paid by the partnership was not aggregated with the compensation paid by the corporation when applying the Section 162(m) limit.
Under the proposed regulations, the IRS changes its position and provides that the $1 million limit applies to both the compensation paid by the publicly-held corporation as well as any compensation paid by a partnership to the publicly-held corporation’s covered employees, but only to the extent the corporation is allocated a share of the otherwise deductible compensation as a result of its ownership in the partnership.
As a result, if a publicly-held corporation owns an interest in a partnership and that partnership pays the corporation’s covered employees for services, the corporation is required to take into account its distributive share of the partnership’s deduction for compensation paid to the covered employees. This distributive share of the deduction is aggregated with the deduction for compensation paid by the corporation when applying the $1 million limit.
To the extent the $1 million limit is exceeded in this situation, the corporation is the taxpayer that loses the deduction. The partnership still reports the total tax deduction on its U.S. federal income tax return and allocates the full deduction on its Schedule K-1s. The partnership will need to communicate to the corporation the amount of its distributive share of the deduction for compensation paid to covered employees. This may prove challenging in situations where there is limited information flowing between the partnership and the corporation.
This new rule is generally applicable to any deduction for compensation that is otherwise allowable for taxable years ending on or after Dec. 20, 2019. There is special transition relief for this change with respect to compensation paid by partnerships. The new rule does not apply to compensation paid pursuant to a written binding contract in effect on Dec. 20, 2019, that is not materially modified after that date.
Next steps Section 162(m), as amended, generally applies to taxable years beginning on or after Jan. 1, 2018. The regulations are proposed to apply to compensation that is otherwise deductible for taxable years beginning on or after the date the final regulations are published. However, as noted above, several of the provisions in the regulations are proposed to be effective for earlier taxable years. Companies should re-evaluate their deferred tax assets for compensation items to determine whether adjustments should be made. For calendar year companies, this should be done for the 2019 fourth quarter statement. Any written or electronic comments regarding the proposed regulations must be received by the IRS by Feb. 18, 2020.
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