Section 162(m) guidance: IRS interpretation of grandfathering rule may require adjustment to deferred assets

IRS guidance (Notice 2018-68) on new rules tightening the restrictions on public company deductions for executive compensation under Section 162(m) narrowly interprets the transition rule for written binding contracts in effect on Nov. 2, 2017. The guidance was issued Aug. 21 as a notice that the IRS intends to incorporate in future proposed regulations. The notice also provides guidance on the new definition of a covered employee, but does not address changes to the definition of a public corporation, which will be covered in the proposed regulations.

Section 162(m) was amended by the Tax Cuts and Jobs Act (TCJA) to expand the definitions of covered employees and public companies subject to the rules, and to repeal an exception from the $1 million limit for performance-based compensation and commissions. A grandfathering rule exempts compensation payable pursuant to a written binding contract in effect on Nov. 2, 2017, from the changes made by the TCJA. The guidance provides that whether compensation is subject to a written binding contract is a matter of state or other applicable law, taking into account the term of the compensation plan or arrangement. In effect, this means that compensation that can be eliminated through discretion afforded in the written terms of the plan document is not payable pursuant to a binding contract unless under the applicable law the employer is legally obligated to pay the compensation.

The notice provides critical information for public corporations to assess whether their plans qualify for the grandfathering rules. Companies should reevaluate their deferred tax assets for compensation items to determine whether adjustments should be made. For calendar year companies this should be done for the third quarter statement.

More detailed information on the rules is provided below.

Background Section 162(m) caps a public company’s annual compensation deduction at $1 million per covered employee. Prior to the enactment of the TCJA, a covered employee was defined as the CEO, or an individual serving such a role, and a 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 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 Securities and Exchange Commission (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.
  • It contains a provision that grandfathers compensation as long as it is made pursuant to a written binding contract that was effective on Nov. 2, 2017, and 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 exemption and the definition of covered employee, applies to this grandfathered compensation.

The new guidance specifically focuses on the latter two changes, answering taxpayer questions regarding the amended definition of a covered employee and addressing the written binding contract and material modification aspects of the grandfather rule.

Definition of a covered employee The guidance clarifies that an employee need not have served as an executive officer at the end of the taxable year to be a covered employee under Section 162(m)(3)(B). So 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 and not disclosed on the proxy statement. When determining whether the executive is among the top three paid 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.

Under the pre-TCJA Section 162(m) rules, the $1 million limit often did not apply to a public company’s short taxable year because the public company often did not file a proxy statement for that short taxable year 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. Under the amendment made to Section 162(m) and the guidance provided in the notice, if a company has a short taxable year for which a proxy statement is not filed, the company will have covered employees and will be required to calculate compensation under the SEC rules for executive compensation disclosure when identifying the top three paid other than the CEO and CFO.

Section 162(m) grandfather rule In determining whether a contract is binding under the Section 162(m) 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 effective 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 in 2018 and future taxable years.

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. According to the notice, compensation payable pursuant to a written contract in effect on Nov. 2, 2017, is generally not binding, and thus not grandfathered, to the extent the compensation is subject to negative discretion, even if that discretion is not exercised. However, 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 a binding contract.

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. So too will compensation paid under a written binding contract that is renewed after Nov. 2, 2017. This applies to contracts that automatically renew thereafter or are slated to terminate after that date but are ultimately renewed, provided that 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, where a contract is set to automatically terminate at a certain date unless the corporation or employee opts to renew, it is deemed renewed when either party elects to renew. In cases where the employee has sole discretion over the term of the contract, the guidance states that the contract will not be treated as renewed as of the date the employee chooses to keep the corporation bound.

The notice further specifies that where employment continues after the termination of a valid contract under Section 162(m), subsequent payments for employment are not made pursuant to it and are thus unprotected by the statute’s grandfather rules.

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 modification occurs, the contract is treated as new, effective as of the date of the modification. The notice defines a material modification as one that increases the compensation payable to the employee. This includes accelerated compensation, unless it is discounted to reflect the time value of money, and deferred compensation, provided the excess amount ultimately paid to the employee exceeds a reasonable rate of interest or predetermined return on investment adjusted for actual gains or losses.

Supplemental contracts providing for increased compensation 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, the IRS exempts supplemental payments equal to or less than a reasonable cost of living increase over payment made the year prior pursuant to the written binding contract.

Next steps Section 162(m), as amended, applies to tax years beginning on or after Jan. 1, 2018. The guidance provided in the notice will be incorporated in future regulations and will apply to any taxable year ending on or after Sept. 10, 2018. Companies should reevaluate their deferred tax assets for compensation items to determine whether adjustments should be made. For calendar year companies this should be done for the third quarter statement.

Treasury and the IRS are seeking comment on issues addressed in this guidance as well as others related to Section 162(m). Written comments may be submitted through Nov. 9, 2018.

For more information contact: Jeffrey Martin
Washington National Tax Office, Grant Thornton LLP
T +1 202 521 1526

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein.
Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.