Section 162(m) – The Narrow Path to Grandfathering

by Nelson Mullins Riley & Scarborough LLP

Nelson Mullins Riley & Scarborough LLP

On August 21, 2018, the IRS released IRS Notice 2018-68 which contains much-anticipated initial guidance on the application of the grandfathering rules under amended Section 162(m) of the Internal Revenue Code.  Publicly-traded companies and other entities subject to the $1 million deduction limit under Section 162(m) can now begin to take action.

As we summarized in our prior Comp and Benefits Brief addressing the changes in the tax treatment of executive compensation brought to us under the 2017 Tax Reform Act, Code Section 162(m) was amended, generally effective for tax years beginning on January 1, 2018 or later, to eliminate the commission and performance-based compensation exceptions to the $1 million deduction limit. As a result of the amendment, performance-based compensation, such as annual incentive plans and equity rights (e.g., stock options or stock appreciation rights), and other forms of qualified performance-based compensation are no longer excluded from the application of the $1 million deduction limit. Section 162(m), as amended, also provides that for 2018 and later tax years, the term “covered employee” includes the principal financial officer (PFO) as well as the principal executive officer (PEO), plus the three highest paid executive officers in addition to the PFO and the PEO. In addition, any individual who is a “covered employee” for any tax year beginning after December 31, 2016 will continue to be treated as a “covered employee” for all subsequent tax years, including tax years after the termination of employment and after the death of the individual. Under a special “grandfathering rule,” the amended provisions of Code Section 162(m) do not apply to compensation that is provided pursuant to a “written binding contract” that was in effect on November 2, 2017 and that was not “modified” in any material respect on or after such date (i.e., “grandfathered” performance-based compensation would continue to be excluded from the $1 million deduction limitation). It is the grandfathering rule that is the primary focus of IRS Notice 2018-68. A summary of key points under Notice 2018-68 follows:

Written Binding Contracts

  • A written contract (e.g., an employment agreement; a deferred compensation plan or agreement; a grant of equity compensation, etc.) in effect on November 2, 2017 is a “written binding contract” only if the employer is obligated under applicable law (which can include, but is not limited to, state contract law) to pay the compensation set forth under the contract upon the employee’s performance of services or satisfaction of applicable vesting conditions

    • If a deferred compensation plan contains a provision that permits the employer, at its discretion, to prospectively cease the amount of future accruals under the plan (but no cutback in current accruals is permitted), only the benefit accrued through November 2, 2017 is grandfathered
    • In an example provided in the Notice, a plan with a “negative discretion” provision that is implemented on or after November 2, 2017 (i.e., under the terms of the plan, the employer retains the discretion to reduce or eliminate the amount of compensation to be paid and, in fact, applies such discretion) failed the “written binding contract” standard to the extent the compensation could be reduced or eliminated (i.e.,  if a  minimum payment amount was built into the “negative discretion” provision, then such minimum payment amount can remain eligible for pre-amended 162(m) treatment)
    • The failure, in whole or in part, of the employer to exercise negative discretion under a contract does not result in the material modification of that contract (i.e., if negative discretion is not used to reduce the payment amount, then the mere inclusion of such a provision will not taint the compensation)
  • Written binding contracts that are “renewed” after November 2, 2017 are not considered “grandfathered”

    • An automatic renewal provision in the contract which applies absent the employer or employee giving advance notice of termination of the contract will cause the contract to be treated as renewed (and no longer grandfathered) as of the first date on or after November 2, 2017 that the contract termination would be effective if such notice were given, unless the contract can be terminated only by also terminating the employee’s employment
    • An automatic termination provision in the contract which provides that the contract will terminate as of a certain date unless the employer or the employee elects to renew within a renewal period prior to such date will cause the contract to be treated as renewed by the employer (and no longer grandfathered) as of that certain date (unless actually renewed before that date, in which case, it is treated as renewed, and no longer grandfathered, on that earlier date)
    • A contract will not be treated as renewed at the end of the contract term if upon termination of the contract the employment relationship continues but would no longer be covered by the contract (but any payments made with respect to such continued employment are not grandfathered)
  • Compensation paid with respect to a plan that was a written binding contract on November 2, 2017 (which is not modified) will be grandfathered, even if the employee is not eligible to participate in the plan on November 2, 2017; provided that the employee was employed by the employer on November 2, 2017  and had the right to participate in the plan under a binding contract on November 2, 2017

Material Modifications

  • Upon a material modification after November 2, 2017, a contract is considered to be a new contract and no longer grandfathered.  Any compensation paid under such contract thereafter is not grandfathered
  • Examples of a “material modification” include an amendment which

    • increases the amount of compensation payable, if the increase is based on substantially the same elements or conditions as the compensation under the existing contract
    • provides for accelerated timing of payment (unless a reasonable discount is applied to reflect the time value of money)
  • Examples of modifications which are not material include an amendment which

    • provides for a supplemental payment under the contract that does not exceed a reasonable cost-of-living increase over the preceding year’s payment
    • defers payment, as long as earnings on the deferred amount are based on either a reasonable rate of interest or a pre-determined actual investment subject to gains and losses

Covered Employees

Amended 162(m) expanded the definition of “covered employee” to include an employee of a public company who (i) served as the PEO or the PFO at any time during the taxable year or (ii) is among the three most highly compensated executive officers for a taxable year (other than the PEO or the PFO). In addition to providing guidance on the grandfathering rules, Notice 2018-68 clarifies that the determination of who is a “covered employee” does not take into consideration whether or not the person is serving as the PEO, the PFO or an executive officer on the last day of the tax year (i.e., the definition is not entirely aligned with the definition of a “named executive officer” for SEC disclosure purposes). Any employee having the status of PEO or PFO at any time during the year results in “covered employee” status. The Notice also clarifies that, for purposes of identifying an employer’s “covered employees,” it is not relevant whether or not the SEC scaled disclosure rules for smaller reporting companies and emerging growth companies are applicable.  Employers will need to maintain a clear historical record of which employees may be determined to be “covered employees” (including those employees who terminate employment or die mid-year) and retain such information until all payments of all applicable compensation have been made to each identified employee and his or her beneficiaries.



 Result based on Notice 2018-68

Deferred compensation arrangement entered into between the employer and the PFO on January 1, 2015; accrues $50,000 each December 31 for five years to the PFO’s plan account balance provided a pre-determined qualified performance objective is met and he or she remains in active employment on such date;  payment of the account balance is to be made in a lump sum at separation from service after December 31, 2019, provided that the participant remains an active employee through the end of 2019; Board of Directors can unilaterally amend at any time to freeze future accruals or terminate the plan; the performance objectives are met each year and the PFO terminates employment in 2020 and is paid $250,000


The employee is the PFO following the amendment to Section 162(m) and is a “covered employee”; $100,000 of the $250,000 payment is grandfathered (while the arrangement is a written binding contract on November 2, 2017, due to the employer’s right to stop future accruals, only the amount accrued as of such date is grandfathered)



Stock options are granted by action of the Board of Directors of the employer on October 1, 2017 to a “covered employee”; the options vest ratably over a three-year period

As long as approvals for the grant were secured not later than November 2, 2017 and no material changes are made to the option, such options are grandfathered and exempt from the application of the $1 million deduction limitation


Employment agreement dated as of November 1, 2017 promised the PEO that he or she will receive a grant of non-qualified stock options on January 1, 2018, subject to approval of the Board of Directors of the employer; Board takes action to approve a grant of options on January 1, 2018


The potential option grant is not a written binding contract on November 2, 2017; not grandfathered; subject to the $1 million deduction limitation upon exercise of the option

Employment agreement with PEO entered into January 1, 2017 provides for base salary of $1,500,000 for each year of the 3-year term of the agreement; the agreement also provides for payment of a qualified performance bonus immediately following the end of the 3-year term if certain pre-established performance goals are met for the three-year determination period; effective January 1, 2019, the employer increases the PEO’s base salary to $2,000,000 for the year

The agreement is a written binding contract in effect on November 2, 2017; the salary increase in 2019 is a material modification which is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the contract and it is greater than a reasonable annual cost-of-living increase; all compensation paid in 2019, or thereafter, under the terms of the employment agreement, including the performance-based bonus, is not grandfathered and is subject to the $1 million deduction limitation


Note: If, in 2019, in lieu of the raise in salary, the employer had granted, under a separate agreement, $500,000 in restricted stock to the PEO in 2019 with the restrictions lapsing upon his or her continued employment through December 31, 2020, the grant of restricted stock would not have resulted in a material modification of the employment agreement (the grant is not based on the same elements and conditions) and therefore, the performance bonus paid after the end of 2019 under the terms of the employment agreement would still be grandfathered and not subject to the $1 million deduction limitation. The compensation attributable to the restricted stock grant is subject to amended Section 162(m)


On January 10, 2017, the employer adopted an annual bonus plan for 2017 which provides for a payment of $1,000,000 to the PEO if certain performance goals are satisfied for the year; the Board retains the “negative discretion” to reduce the bonus amount to no less than $400,000; in March of 2018, the Board certifies that the performance goals have been met, but reduces the award to $800,000


Partially grandfathered; $400,000 is grandfathered (the protected minimum payment) and is not subject to the $1 million deduction imitation; the amount paid in excess of $400,000 is not grandfathered and is subject to the $1 million deduction limitation

For publicly-traded companies, the legal determination of what is and is not a “written binding contract” and what is or is not a “modification” is critical and it is not simple. We encourage all publicly-traded employers to seek assistance from their counsel in undertaking an analysis of all executive compensation arrangements currently in place in order to determine whether or not such arrangements, or all or any portion of payments made thereunder, may or may not be grandfathered from the amended Code Section 162(m) rules.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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