On December 20, 2019, the IRS issued proposed regulations under Section 162(m) of the Internal Revenue Code.
Section 162(m) generally caps the tax deduction available to publicly traded companies for compensation paid to a named executive officer at $1 million per year. Before the Tax Cuts and Jobs Act of 2017 (TCJA), qualified performance-based compensation was excepted from this cap. The TCJA eliminated this exception, so that effectively all compensation now counts toward the $1 million cap. The TCJA also expanded the reach of Section 162(m) to a broader group of companies and executives. We discussed the enactment of these changes in a prior alert.
In 2018, the IRS issued Notice 2018-68 to provide preliminary guidance on the TCJA’s changes to Section 162(m), including guidance on which preexisting compensatory arrangements would receive “grandfathered” status, therefore remaining deductible under the pre-TCJA framework. For the most part, the proposed regulations confirm that the IRS will take a narrow view as to which compensation is grandfathered, and a broad approach as to the companies and executives subject to Section 162(m).
Highlights of the Proposed Regulations
Remuneration that is provided pursuant to a written, binding contract in effect on November 2, 2017, and that is not materially modified thereafter, is not subject to the TCJA amendments. The proposed regulations confirm that many preexisting compensatory arrangements will not qualify for grandfathering.
Incentive compensation awards will not receive grandfathered status if a “negative discretion” provision is included in the incentive plan. Many incentive arrangements that were structured to qualify as performance-based compensation before the TCJA was enacted contain provisions allowing the company to reduce the compensation otherwise payable, even if applicable performance-based targets are achieved (these are known as “negative discretion” clauses). The proposed regulations confirm that, to the extent performance-based compensation is subject to a negative discretion clause, it will not be grandfathered (unless state law would prohibit the use of such discretion). These negative discretion clauses would not have been included in performance-based compensation programs, but for prior IRS guidance specifically authorizing them. Accordingly, to many taxpayers and practitioners, the IRS’s position on this point raises questions of fairness — especially in cases where the negative discretion was rarely or never used.
Each component of a severance formula will be analyzed separately to determine grandfathered status. Before the TCJA, Section 162(m)’s deductibility cap only applied to compensatory payments while an executive was employed by the company. The TCJA extended the reach of Section 162(m) so that the cap now applies to all compensation payable after a person becomes a covered executive, even if paid following termination of employment (such as severance or death benefits).
The proposed regulations provide that, if severance is payable under a preexisting contract and calculated based on compensation elements the company is also contractually obligated to pay (e.g., base salary and bonus), the severance will be grandfathered. However, it will only be grandfathered to the extent the severance would have been payable upon the executive’s hypothetical termination on November 2, 2017, based on the compensation levels then in effect. Any incremental amounts to which the covered executive becomes entitled in excess of the amounts payable upon a hypothetical termination occurring on November 2, 2017 will not be grandfathered. In addition, a significant increase to the underlying components of the severance (e.g., a salary increase greater than a reasonable cost of living adjustment) may constitute a material modification of the agreement, in which case the entire agreement will lose grandfathered status. Even less favorably, if the employment agreement has a specified “term” that may be renewed automatically, the mere expiration of the term in effect on November 2, 2017 — even if automatically renewed — will also result in the complete loss of grandfathered status.
No Transition Period Following IPO
Before the enactment of the TCJA, newly public companies enjoyed a transition period to implement compensation programs that were appropriate for public companies, including programs that met the qualified performance-based compensation exception. The proposed regulations eliminate the transition relief and immediately subject new public companies to Section 162(m). The stated rationale is that a transition period is no longer necessary, as there is no longer a qualified performance-based compensation exemption. However, this does not account for compensation arrangements put in place by the previously private company to encourage its executives to complete the IPO, which arguably should have remained exempt from Section 162(m).
In line with Notice 2018-68, a covered employee for any year means the CEO, CFO and the three most highly compensated executive officers for that taxable year. The executives are considered “covered” regardless of whether they are serving in their position as of the last day of the fiscal year, and regardless of whether their compensation must be disclosed in the company’s proxy statement for that fiscal year pursuant to SEC rules. Thus, smaller reporting companies, emerging-growth companies and certain other public companies will need to determine their “extra” named executive officers for Section 162(m) purposes, even though that determination would not otherwise be required for SEC disclosure purposes. In addition, the TCJA provides that once an employee becomes “covered,” he or she will forever remain covered. This means, as noted above, even post-termination payments are subject to Section 162(m)’s deductibility cap. Moreover, an executive officer whose compensation rises temporarily, but enough to make him or her one of the company’s top three most highly compensated executive officers for a single year, will thereafter forever be subject to Section 162(m)’s deductibility cap.
The proposed regulations also make it clear that more entities are now subject to Section 162(m). A “publicly held corporation” subject to Section 162(m) now includes a corporate subsidiary of a publicly held corporation, a foreign private issuer, a publicly traded partnership, a privately held parent that is in the affiliated group of a subsidiary that is a publicly held corporation, and certain disregarded entities and S corporations.