The IRS recently released Notice 2018-68, providing long-awaited initial guidance on amendments made to Section 162(m) of the Internal Revenue Code by the Tax Cuts and Jobs Act of 2017 (TCJA). While the Notice only addressed certain issues pertaining to the recent 162(m) changes (with further guidance to come), the IRS importantly discussed how it interprets the “grandfathering” transition relief rules that allow certain pre-existing arrangements to continue to be treated as “performance-based compensation” exempt from the revised Section 162(m) limits. The IRS expects to issue further guidance on the TJCA changes to Section 162(m) (and to formally codify the guidance provided in Notice 2018-68) in future proposed Treasury Regulations, although no timetable has been provided.

Scope of Grandfathering Relief

Section 162(m) of the Internal Revenue Code generally disallows the deduction by any publicly held company for applicable employee remuneration paid to covered employees to the extent that such remuneration exceeds $1 million for a tax year. Under the pre-TCJA formulation of Section 162(m), “qualified performance-based compensation” was exempted from the $1 million deductibility limitation. The TCJA eliminated this performance-based exemption going forward, but grandfathered from the harsher post-TCJA Section 162(m) rules any “remuneration which is provided pursuant to a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date.” Neither the text of the TCJA nor the IRS offered an interpretation of this key phrase, creating substantial uncertainty among taxpayers on how to apply the grandfathering relief to existing compensation arrangements.

Notice 2018-68 dispels much of that uncertainty by providing the following key guidance regarding the scope of the grandfathering relief:

• Remuneration is payable under a “written binding contract” that was in effect on Nov. 2, 2017 (and thus eligible for grandfathering) only to the extent that the corporation is obligated under applicable law, such as state contract law, to pay the remuneration under the contract if the employee performs services or satisfies the required vesting conditions. This strict interpretation is not completely unexpected, and means that, simply because a plan or agreement was signed as of November 2, 2017 does not necessarily imply that future grants issued under such plan or agreement will be eligible for grandfathering relief. For example, if a publicly held company adopted an omnibus incentive plan prior to November 2, 2017 providing for grants of qualified performance-based awards, but such awards were granted to employees after November 2, 2017, those awards would not qualify for grandfathered status because the grantees’ contractual rights to such awards arose after November 2, 2017. Similarly, Notice 2018-68 contains an example in which a pre-November 2, 2017 employment agreement provides for the grant of stock options, SARs and restricted stock on January 2, 2018. The IRS states that, because under applicable law, as of November 2, 2017, the potential grants of options, SARs and restricted stock did not constitute a written binding contract, those grants would not be grandfathered from the post-TCJA 162(m) rules.
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• The Notice provides guidance on what constitutes a “material modification” of a written binding contract. A material modification will be treated by the IRS as a new contract entered into as of the date of material modification, which would effectively strip a pre-November 2, 2017 arrangement of grandfathered status with respect to amounts received after the material modification (amounts received prior to the material modification would not lose grandfathering protection). The Notice states that any amendment to a grandfathered contract to increase the amount of compensation payable to the employee will be treated as a material modification. Certain amendments will not constitute an increase in compensation, such as an accelerated payment discounted to reflect the time value of money, a deferred payment that includes earnings based on a reasonable rate of interest, or reasonable adjustments for cost of living increases.
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• The Notice also provides guidance on when a grandfathered contract is “renewed” and thus subject to the harsher post-TCJA 162(m) rules:
  • A contract that is terminable or cancelable by the corporation without the employee’s consent after November 2, 2017 is treated as renewed as of the date that any such termination or cancellation, if made, would be effective.
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  • A contract that is automatically renewed or extended as of a certain date unless either party gives notice to the other before a specified date is treated as renewed as of the date that termination would be effective if that notice were given.
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• The Notice contains an example that throws into doubt the ability for amounts subject to negative discretion (e.g. a feature by which a company may discretionarily pay less than the amount that would otherwise be payable under the contract or award) to qualify for grandfathering relief. This example suggest that negative discretion features may create a risk that the amounts subject to such negative discretion are not maintained under a “written binding contract” as required for grandfathering status, holding that the only portion of a cash bonus arrangement that constitutes a “written binding contract” and therefore may be grandfathered is that part of the arrangement that is not subject to a negative discretion feature. Interestingly, there is no actual discussion of the impact of negative discretion features on grandfathering relief anywhere in the discussion section of the Notice; the topic is only raised in the examples. Thus, it remains to be seen whether the IRS will formally adopt a grandfathering rule addressing negative discretion features in future guidance. However, the Notice did clarify that the failure to exercise negative discretion under a contract that allowed for that discretion does not result in the material modification of that contract and so does not destroy the grandfathered status of that contract.

In addition to considering the above takeaways, we suggest also reviewing the detailed examples contained in the Notice, which are often times more helpful than the textual explanation itself and illustrative of the IRS’ position on grandfathering relief.

Guidance on Covered Employees

The Notice also provided clarification regarding the post-TCJA definition of “covered employees” subject to Section 162(m) limitations:

• The Notice clarified that there is no “end-of-year” requirement, such that an employee doesn’t have to have served as an executive officer at the end of the taxable year to be considered a covered employee under the post-TCJA rules. The Notice states that executive officers of publicly held corporations can be covered employees under Section 162(m) even when disclosure of their compensation is not required under SEC rules. Thus, companies should not automatically assume that their named executive officers who are subject to SEC executive compensation rules purposes will entirely align with the Section 162(m) covered employees.For example, if an employer does not have to file a proxy statement for a year because its securities are delisted, employees who otherwise meet the definition of “covered employee” remain covered employees under the post-TCJA rules.
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• While the new, post-TCJA Section 162(m) rules generally apply beginning in 2018, the Notice clarifies that covered employees identified for the taxable year beginning during 2017 (in accordance with the old pre-TCJA rules for identifying covered employees) will continue to be covered employees for taxable years beginning in 2018 and beyond.

Next Steps

Before Notice 2018-68 was issued, there was significant uncertainty regarding the extent to which the IRS would allow companies to continue taking deductions under Section 162(m) for grandfathered performance-based awards. In light of that uncertainty, many companies opted to hold off on immediately amending their pre-November 2, 2017 arrangements per TCJA changes until the IRS issued further guidance on grandfathering. Now that such guidance has been issued, public companies subject to Section 162(m) deduction limitations will need to ascertain exactly how the guidance impacts their existing executive compensation arrangements, and should be very careful in structuring any future amendments to such arrangements if preservation of grandfathered status is a priority. Conversely, companies who discover that certain arrangements now cannot be grandfathered under Notice 2018-68 may wish to adjust their focus now that deductibility is no longer a factor driving compensation design (noting, however, that performance-driven compensation may still be appropriate based on other important business and proxy-voting considerations). In any event, public companies subject to Section 162(m) limitations will need to carefully consider this latest guidance in connection with filing upcoming periodic reports with securities regulators, and may need to revisit certain pre-TCJA tax or reporting positions in their financial statements.