10 Things to Know About Tax Reform Changes to Deductibility of Executive Compensation
On August 21, the IRS issued Notice 2018-68 to provide further guidance on certain changes made to the $1 million deduction limit under Section 162(m), which applies to executive compensation.
Prior to amendments made by Tax Reform (also known as the Tax Cuts and Jobs Act (TCJA)), Section 162(m) applied to companies with publicly traded equity (Iisted corporations); generally only covered the principal executive officer (PEO) and the three highest paid officers of such companies (other than the principal financial officer (PFO), whose compensation was fully deductible); and excused properly structured and approved performance-based compensation and commissions from the $1 million limit.
Effective for tax years after December 31, 2017:
- The definition of “publicly held corporation” was expanded to include listed corporations as well as certain non-listed corporations with publicly traded debt and foreign companies publicly traded through American depositary receipts.
- The group of covered employees was enlarged to include the PEO, PFO, and three highest paid officers without regard to whether their compensation is required to be reported in the proxy statement under SEC rules who satisfied the covered employee definition during any tax year beginning after December 31, 2016.
- The performance-based and commissioned-based compensation exceptions to the $1 million deduction limit were eliminated.
Under transition relief, however, the TCJA’s changes to Section 162(m) do not apply to compensation payable under a written binding contract that was in effect on November 2, 2017, which hasn’t been materially modified thereafter (“grandfathered” contracts).
Transition Relief Guidance
Notice 2018-68 clarifies the transition relief with numerous examples illustrating the grandfathering principles. Here are our top 10 observations from the Notice.
1. If grandfathered pay was fully deductible under prior Section 162(m), it will continue to be under the new Section 162(m).
Under the new guidance the PFO and the entities that were not previously covered under Section 162(m) have the greatest protection. Similarly, performance pay arrangements that were designed to be 100-percent deductible via a written binding contract executed by November 2, 2017, will continue to be fully deductible on account of the law change as long as the agreement is not materially modified.
2. Applicable state law determines if a “written binding contract” exists on November 2, 2017.
The new Section 162(m) rules do not apply to compensation that is payable under a written binding contract that was in effect on November 2, 2017, where the corporation is obligated under applicable state law to pay a specified or determinable amount after the employee performs the required services or satisfies the applicable vesting conditions. Accordingly, the new Section 162(m) rules will apply to compensation that exceeds the amount that a corporation is obligated to pay under such written binding contract. Further, written binding contracts are not limited exclusively to performance-based arrangements, but apply more broadly to various types of compensation plans and arrangements: base salary, incentive compensation plans, stock rights, nonqualified deferred compensation, and severance arrangements.
3. Grandfathering applies to those employed on November 2, 2017, but not yet eligible for plan benefits.
Any amount paid to a person employed on November 2, 2017, by a plan with grandfathered status will be deductible under the pre-TCJA rules even if the employee was not a plan participant on that date. For example, a plan intended for management-level employees will be able to apply the grandfather rules when determining the deductible amount for employees hired on or before November 2, 2017, or had a legally binding right to participate in the plan as of that date, as long as the plan continues to have its grandfathered status.
4. Plans with negative discretion generally are not grandfathered.
Plans that allow employers to unilaterally reduce the payment (exercise negative discretion) are contrary to the principles of a “written binding contract” since the company is not bound to make the payment. If, however, the payment is subject to reduction, but not below a specified amount, then the amount of the award that exceeds the threshold does not qualify for grandfathered status and its deduction is limited under the new Section 162(m) rules. Only the amount up to the threshold would be treated as a written binding contract that is grandfathered and deductible under the more favorable Section 162(m) rules of the past.
5. The types of material modifications to a grandfathered contract that can nullify the transition relief.
A material modification includes an amendment to (1) increase the amount of compensation payable to the employee; (2) accelerate payment, unless the amount is discounted to reflect the time value of money; or (3) defer payment, unless any increase to the amount originally payable is based on either a reasonable rate of interest or a predetermined investment. A supplemental contract or agreement that increases compensation payable on substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the grandfathered contract can also be a material modification.
6. Renewals and extensions under “evergreen provisions” are problematic.
Grandfathered contracts that contain a provision that automatically renews or extends its terms (an “evergreen provision”) will be treated as new contracts subject to the new Section 162(m) rules on the date of such renewal or extension, thereby voiding the transition protection for payments made after the renewal.
7. Grandfathered arrangements are not automatically 100-percent deductible.
The prior Section 162(m) rules must be applied in its entirety to determine deductibility. Once the payments under a grandfathered contract are identified, the next step is to determine whether the prior Section 162(m) rules would limit the deduction or exclude the payment from the $1 million limit.
For instance, a distribution from a grandfathered, nonqualified deferred compensation payable upon a PEO’s separation from service would not be subject to the $1 million limit under prior Section 162(m), since the PEO would cease to be a covered employee upon separating from service before the last day of the year; whereas, an in-service distribution made to such plan while the PEO is still a covered employee would be counted toward the $1 million limit.
The award of stock options, stock appreciation rights and time-vested restricted stock to a PEO prior to November 2, 2017, are all grandfathered.The options and stock appreciation rights satisfy the performance-based compensation exception under the prior Section 162(m) rules, such that the compensation attributable to the exercise and vesting is excluded from the $1 million limit under prior Section 162(m) rules; whereas, the vesting of time-based restricted stock would be counted toward the $1 million limit.
8. A single payment under one contract can be governed by both the post-TCJA provisions and the pre-TCJA Section 162(m) provisions, because only the amount required to be paid as of November 2, 2017, is grandfathered.
If a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017, to an employee pursuant to the plan or arrangement will not be subject to the new Section 162(m) rules. For example, amounts deferred under a nonqualified deferred compensation plan (plus credited earnings) on or before November 2, 2017, may qualify for grandfathered status. However, later accruals that were not required to be made under the provisions of the plan as of November 2, 2017, would be governed by the new rules.
9. A significant pay increase can materially modify a grandfathered agreement, making the entire payment subject to the new rules.
For severance plans with payouts based on a multiple of base salary, a significant increase in base salary (beyond a reasonable, annual cost-of-living increase) may be treated as a material modification of the written binding contract. The material modification causes the entire severance payment to be subject to the new Section 162(m) rules.
10. Cost of living adjustments to grandfathered severance agreements are not material modifications, but the increased amount is limited under the new rules.
A severance amount that is based on a multiple of base salary that has increased after November 2, 2017, by virtue of a reasonable, annual cost of living adjustment to the base salary, would not be treated as having a material modification. However, the severance amount related to the increase would be included in the $1 million limit while the remainder, based on the rate of salary in effect on November 2, 2017, would be excluded from the limit since the terminated executive would no longer be a covered employee at the time of payment under the prior.
The new Section 162(m) rules and transition relief provide numerous planning opportunities for affected employers that can help to maximize the deductibility of compensation plans for covered employees, thereby minimizing the cost of these plans. However, without careful due diligence, those benefits could be lost forever.Management and compensation committees should be apprised on the benefits of preserving grandfather status and the types of modifications that will jeopardize the grandfathered status of compensation arrangements and cause the compensation deduction to be limited to $1 million under the new rules and lose the exemptions under pre-TCJA law.
For more information, please reach out to a member of MFA’s Tax Team.
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