The IRS released final regulations (TD 9932) under Section 162(m) on Dec. 18 that substantially adopt the proposed regulation issued in 2019, but make several changes.
Section 162(m) limits a public company’s annual compensation deduction to $1 million for each covered employee, and was amended significantly by the Tax Cuts and Jobs Act (TCJA) to expand the definition of a public corporation, eliminate the exception for performance-based compensation and broaden the definition of a covered employee. The TCJA also contains a provision which grandfathers certain compensation 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.
The final regulations implement the TCJA changes and make several important changes to the applicability date rules in the proposed regulations (see our prior coverage for a full discussion of the proposed regulations). The final regulations are generally applicable to tax years beginning after the date they are published in the Federal Register, but there are a number of special provisions that are made effective earlier. Companies can also choose to apply the final regulations to any tax year beginning after 2017, when the TCJA changes were made effective, provided the company applies the final regulations in their entirety and in a consistent manner to that tax year and all subsequent years.
Companies should re-evaluate their deferred tax assets for compensation items to determine whether any adjustments should be made. For calendar-year companies, this should be done for the 2020 fourth quarter statement.
Partnership compensation paid to covered employees
The proposed regulations provided that a publicly held corporation that holds a partnership interest must take into account, for Section 162(m) purposes, its distributive share of the partnership’s deduction for any compensation paid to the corporation’s covered employees. The proposed regulations included a special applicability date – the requirement would apply with respect to compensation paid by a partnership for a tax year ending on or after Dec. 20, 2019 (the publication date of the proposed regulations). In recognition of the prior lack of clarity in this area, the final regulations delay the applicability date further so that it now first applies to compensation paid by a partnership for a tax year ending after Dec. 18, 2020. The proposed regulations also included transition relief: the new requirement does not apply to any compensation paid pursuant to a written binding contract in effect on Dec. 20, 2019, that is not materially modified after that date. This date is not extended under the final regulations.
New public corporations
The existing Section 162(m) regulations issued in 1995 included a transition rule for certain privately held corporations that become publicly held. This rule provided that the Section 162(m) deduction limitation does not apply for a limited transition period to any compensation paid pursuant to a plan or agreement that existed during the period in which the corporation was not publicly held if certain conditions are met. The transition period ends upon the earliest date to occur of certain events. The proposed regulations eliminated this “new public company” transition rule, but included a special applicability date for corporations that become new public companies on or before Dec. 20, 2019. These companies can rely on the new public company transition rule under the existing regulations. The final regulations retain this special applicability date, but clarify that a subsidiary that is a member of an affiliated group may rely on the new public company transition rule if it becomes a separate publicly held corporation (for example, in a spin-off transaction) on or before Dec. 20, 2019.
Grandfather rule claw-back provisions
Compensation that is paid pursuant to a written binding contract in effect on Nov. 2, 2017, is not subject the amendments made by the TCJA if the compensation is not materially modified on or after that date. For purposes of the grandfather rule, the proposed regulations provided that, if a corporation has a right to recover (i.e., claw back) compensation if certain conditions occur, then the clawback is disregarded in determining the grandfathered amount, but if a condition occurs, then only the amount the corporation is ultimately obligated to pay remains grandfathered. The IRS modified this rule to provide that a corporation’s clawback right does not affect the determination of the grandfathered amount, regardless of whether the corporation exercises its discretion to clawback any compensation in the future.
Ordering rule for grandfathered and non-grandfathered payments
When a series of payments include both grandfathered and non-grandfathered amounts, the proposed regulations required the grandfathered amount to be allocated to the first otherwise deductible payments until the entire grandfathered amount has been paid. Because companies may have used different ordering methods before the proposed regulations were issued, the final regulations also permit the grandfathered amount to be allocated to the last otherwise deductible payments or to each payment on a pro rata basis for tax years ending before Dec. 20, 2019. However, the final regulations require the grandfathered amount to be allocated under the first payments method for tax years ending on or after Dec. 20, 2019, regardless of the method used for tax years ending prior to that date.
Extension of exercise period for NSOs and SARs
The final regulations confirm that, if certain conditions are satisfied, the extension of the exercise period for non-statutory stock options (NSOs) or stock appreciation rights (SARs) that are otherwise grandfathered would not be treated as a material modification and the stock rights would retain their grandfathered status. The conditions that must be met are the same conditions that apply under the Section 409A regulations for extending stock rights: (1) the exercise price of the stock right must exceed the underlying stock’s fair-market value as of the date of the extension (that is, the stock right must be “underwater”); or (2) the exercise period cannot be extended beyond the earlier of either the latest date upon which the stock right could have expired by its original terms or the 10th anniversary of the original date of grant of the stock right.
Covered employees include employees who were covered employees of a predecessor of the publicly held corporation for any preceding tax year beginning after Dec. 31, 2016. With respect to asset acquisitions, the proposed regulations provided that a publicly held target corporation is a predecessor if the acquiring corporation acquires at least 80% of the target’s operating assets (determined by fair-market value on the date of acquisition). The final regulations clarify that the operating assets refer to gross operating assets instead of net operating assets.
The Section 162(m) changes enacted by the TCJA can have a significant impact on a public company’s deductions, and the final regulations make important changes to the applicability dates of several important rules. Companies should re-evaluate their deferred tax assets for compensation items to determine whether any adjustments should be made. For calendar-year companies, this should be done for the 2020 fourth quarter statement.
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