On August 21, 2018, the IRS released Notice 2018-68 (“Notice”) providing its initial guidance on the Tax Cuts and Jobs Act (“Act”) transition rule for changes made to Section 162(m) of the Internal Revenue Code of 1986, as amended (“Section 162(m)”). As we described in a prior SW Benefits Update, before the Act, Section 162(m) prohibited a public company from deducting annual compensation paid to its “covered employees” (before the Act, the chief executive officer and the company’s next three highest paid officers (other than its chief financial officer)) in excess of $1 million, unless the compensation paid qualified for the “performance-based compensation” exception to Section 162(m).

The Act substantially expanded the definition of “covered employee” and eliminated the performance-based compensation exception effective for tax years beginning after December 31, 2017. However, the Act offered a transition rule for written binding contracts in effect as of November 2, 2017 that are not materially modified after that date (“Transition Rule Contract”). The Notice outlines the IRS’ transition rule position on the following issues:

Covered Employees

• Under the pre-Act rules, if an executive was not employed on the last day of the year, the executive was not considered a covered employee. The Notice and its examples clarify that, for purposes of the Act, the term “covered employee” includes the CEO, the CFO and the company’s next three highest paid officers even if: (i) the executive is not employed in the same role at year end (for example, because the executive terminates employment, dies or changes positions), or (ii) the company is otherwise not required to disclose the executive’s compensation under the SEC rules (for example, if the company’s securities are delisted).
• Certain executives who are employed by companies that are not required to file proxy statements, but nevertheless fall within the revised definition of “publicly held corporation,” are also now considered “covered employees.”
• Any individual who was identified as a “covered employee” in 2017 (under the pre-Act rules) will continue to be a covered employee in 2018 and beyond.

Written Binding Contract

• For purposes of determining whether a “written binding contract” was in place as of November 2, 2017, the Notice provides that the transition rule is available only to the extent the public company is obligated under relevant state law to pay compensation under the Transition Rule Contract if the employee performs services or satisfies vesting conditions. Any amount paid in excess of the company’s contractual obligation under the Transition Rule Contract is not subject to the transition rule.
  • S&W Note: It was rumored the IRS would rule that the mere existence of a negative discretion clause (a very common provision in executive compensation programs that satisfied the pre-Act rules) could render the Transition Rule Contract non-binding for the transition rule. The IRS did not expressly take that position in the Notice and instead deferred to “applicable law” (presumably state law), to determine whether such a clause would render a contract non-binding. Companies with Transition Rule Contracts that include negative discretion provisions will need to be especially diligent in ensuring that applicable state law supports the position that a binding contract exists despite the existence of negative discretion.
• The transition rule does not apply to any Transition Rule Contract that is renewed after November 2, 2017.
  • If the company can terminate/cancel a Transition Rule Contract without the employee’s consent, the Transition Rule Contract is deemed to be renewed as of the date the company could have terminated/cancelled the contract, and, as a result, loses its transition rule status at that time. The Notice provides the following helpful example: [I]f the terms of a contract provide that it will be automatically renewed or extended as of a certain date unless either the corporation or the employee provides notice of termination of the contract, at least 30 days before that date, the contract is treated as renewed as of the date that termination would be effective if that notice were given.
  • If the Transition Rule Contract terminates/cancels as of a certain date unless either party elects to renew within, for example, 30 days of that date, the Transition Rule Contract is deemed renewed as of that date and, thus, loses its transition rule status at that time.
    • A contract that can only be terminated/cancelled by the employee is not deemed to be renewed when the employee continues employment (i.e., is not materially modified and retains its status as a Transition Rule Contract).
    • If the only way a Transition Rule Contract can be terminated/cancelled is by terminating the employment relationship, the Transition Rule Contract is not considered terminable or cancelable (i.e., is not materially modified and retains its status as a Transition Rule Contract).
• Compensation that is required to be paid under a binding plan/arrangement as of November 2, 2017, can be subject to the transition rule even if the employee was not eligible to participate in the plan/arrangement as of that date, provided, however, the employee must have either: (i) been employed on November 2, 2017, or (ii) had the right to participate in the plan/arrangement under a Transition Rule Contract as of that date.

Material Modification

• A Transition Rule Contract is materially modified if (i) the contract is amended to increase the amount of compensation payable to the employee, (ii) the payment of compensation to the employee is accelerated, unless the amount of compensation paid is discounted to reasonably reflect the time value of money, (iii) the payment of compensation to the employee is deferred and the employee receives additional compensation, except to the extent that any additional compensation paid to the employee is based on a reasonable rate of interest or a predetermined actual investment, or (iv) a supplemental contract or agreement provides for increased or additional compensation, payable on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the written binding contract.
• If materially modified, the contract is treated as a new contract entered into as of the date of the modification and any amounts received after the modification will not be subject to the transition rule.
• A company’s failure to exercise negative discretion under a Transition Rule Contract does not result in a material modification.

The IRS expects that the guidance in the Notice will be incorporated into future regulations that will apply to tax years ending on or after September 10, 2018 and the Service has asked for comments on, among other things, how the Act should apply to companies immediately after they become publicly held through an initial public offering or similar transaction. Thankfully, the Notice provides that any future guidance that would broaden the definition of “covered employee” or further restrict the definition of “written binding contract” will apply prospectively only.

The transition rule guidance contained in the Notice are complex and we encourage you to carefully review the rules and their application to determine whether the Section 162(m) transition rule applies to one or more of your existing contracts/plans/arrangements.