August 23, 2018 IRS issues guidance on Section 162(m), as amended by the 2017 Tax Act In Notice 2018-68 (Notice), issued August 21, 2018, the Internal Revenue Service (IRS) provides guidance regarding the changes made to Section 162(m) of the Internal Revenue Code of 1986, as amended, (Code) under Public Law 115-97 (2017) (2017 Tax Act). In particular, the Notice confirms that existing Section 162(m) regulatory standards apply when determining whether compensation is "grandfathered" under a written, binding contract. No relief is provided for so-called negative discretion provisions. In addition, the Notice provides guidance on identifying "covered employees" who are subject to the $1 million deduction limit for tax periods beginning after December 31, 2017. Background Section 13601 of the 2017 Tax Act amended Section 162(m), which prohibits publicly held corporations from taking a deduction for "applicable employee remuneration" over $1 million that is paid to "covered employees" during the tax year. The Notice provides guidance on the effective date, the application of a "grandfather rule," and the identification of "covered employees" whose compensation is subject to the $1 million deduction limit. The Notice also requests comments on a number of other areas that will be addressed in future regulations. Definitions of "publicly held corporation" and "covered employee" Publicly held corporations Before enactment of the 2017 Tax Act, Section 162(m) applied only to "publicly held corporations," which were defined as corporations issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934. Generally, this required the corporation to file a Form 10-K annual statement. The 2017 Tax Act expanded the definition of "publicly held corporation" to include any corporation that is an "issuer," as defined in Section 3 of the Securities Exchange Act of 1934, (1) "the securities of which are required to be registered under section 12 of [the Securities Exchange Act of 1934], or (2) that is required to file reports under [Section] 15(d) of [the Securities Exchange Act of 1934]." Covered employees Section 162(m) applies only to compensation paid to a publicly held corporation's "covered employees." Before the 2017 Tax Act, the term "covered employees" included: (1) any employee of the corporation who, as of the close of the tax year, was the chief executive officer or principal executive officer (CEO or PEO) or an individual acting in that capacity; or (2) any employee whose total compensation for the tax year was required to be reported to shareholders under the Securities and Exchange Act of 1934 by reason of the employee being among the highest compensated officers for the tax year, other than the CEO and the chief financial officer or principal executive officer (CFO or PFO). A company's CFO/PFO was specifically excluded from the definition of "covered employee."1 The 2017 Tax Act amended the definition of "covered employee" to include any employee of the taxpayer: (1) who is the PEO or PFO at any time during the tax year, or is acting in such a capacity, or (2) whose total compensation for the tax year must be reported to shareholders under the Securities Exchange Act of 1934 because the employee is among the three highest compensated officers for the tax year, or (3) who was a "covered employee" of the taxpayer (or any predecessor) for any preceding tax year beginning after December 31, 2016. The 2017 Tax Act also expanded the definition of "covered employee" to include any employee who would be deemed to be a "covered employee" of a company that otherwise meets the definition of "publicly held corporation," as amended by the 2017 Tax Act, but for the fact that the corporation is not required to file a summary compensation table under SEC rules. For example, certain companies (e.g., certain foreign private issuers) meet the definition in the 2017 Tax Act of a "publicly held corporation" but are exempt from the summary compensation table requirements under SEC rules. For companies subject to Section 162(m) that are not required to file a summary compensation table, the determination of "covered employees" is made as if the SEC reporting were so required. Guidance The Notice confirms that, to be considered a "covered employee" under Section 162(m), an employee need only serve as an executive officer (the PEO or PFO) at any point during the tax year or be considered one of the corporation's top three highest compensated employees whose compensation is (or otherwise would be) subject to reporting on the SEC compensation table for the tax year. The employee does not have to serve as an executive officer through the end of the tax year as under prior law. The "last day" rule that applied under Section 162(m) before the 2017 Tax Act is eliminated. Thus, executives who serve as a corporation's PEO or PFO at any point during the tax year, but who are no longer serving as executives at the end of the tax year, will be "covered employees" under Section 162(m) for the year, which is consistent with the SEC summary compensation disclosure requirements. Further, under other provisions of the 2017 Tax Act amendments, those "covered employees" will continue to be "covered employees" for all future years. For the "three highest compensated officers" other than the PEO or PFO, however, the Notice acknowledges that SEC rules may require the inclusion of more than three persons (in addition to the PEO or PFO) on the summary compensation table for a year (such as when mid-year terminations or retirements occur) or may not include an individual who would be one of the highest paid officers reported but for a mid-year departure. The "covered employees" for that year are limited to the top three highest compensated officers; it is possible that one of the three highest paid officers actually does not appear on the summary compensation table because the SEC rules limit the number of former employees who appear in this disclosure. Thus, it is important to coordinate with securities counsel. The IRS further added that, when a publicly held corporation's last completed fiscal year does not end on the same date as its tax year, such as when a corporation has a short tax year due to a corporate transaction, the corporation's three most highly compensated executive officers for its short tax year will still be deemed to be "covered employees." The Treasury Department and the IRS have requested comments on how to determine a publicly held corporation's three most highly compensated executives for a short tax year, and Notice 2018-68 states that corporations should base their determinations on a reasonable, good faith interpretation of the statute until such comments are received and further guidance is issued. Finally, the IRS clarified which officers will be considered "covered employees" for tax years after the 2017 Tax Act effective date on the basis of being a "covered employee" in a tax year beginning after December 31, 2016. For years beginning in 2017, the Notice provides that the pre-amendment definition of "covered employees" will apply, both with regard to the application of Section 162(m) for that tax year but also for determining on behalf of that year which individuals will continue to be "covered employees" for tax years beginning in 2018 and beyond. Implications The language and examples in the Notice confirm that, once an individual is either reported as one of the "top five" executives on an SEC compensation table (or would have been reported had such a compensation table been required of the public company), then the individual remains a "covered employee" and subject to the $1 million deduction limit for all future years in which the employer is a public company. Because the PFO was not previously a "covered employee" under the statute, an individual who serves in such position becomes a "covered employee" only if he or she is in such position or another "covered employee" position in the taxable year beginning after December 31, 2017. Questions may arise as a result of the Notice's clarification that, even when a corporation is disclosing executive compensation on a summary compensation table, it is possible that the individuals listed are not the three highest officers who are the covered employees for the year. It is possible that a former employee who does not appear on the summary compensation table is nonetheless a covered employee for that tax period. It is also possible that employees who appear on the proxy are not covered employees. Example 1 of Part III.A of the Notice illustrates this result when officers depart mid-year and the SEC rules limit the number of former employees who appear on the summary compensation table. Practitioners will also likely want to review the examples and statements in the Notice that address the identification of "covered employees" in a short tax year. Although the definition of publicly held corporation was amended by the 2017 Tax Act, nothing in the 2017 Tax Act causes Section 162(m) to apply to tax periods in which a company no longer meets that statutory definition. The 2017 Tax Act's change makes clear that an otherwise public company does not avoid the deduction limit merely because the SEC does not require a summary compensation table for a tax period; however, the company would still have to meet the definition of a "publicly held corporation" under the statute for the period to be subject to Section 162(m). Example 3 under Part III.A of the Notice addresses a fact pattern in which a public company subject to Section 162(m) undergoes a transaction in which a majority ownership interest is acquired by a private company that is not subject to Section 162(m). The example illustrates how Section 162(m) applies when the tax periods of the public company do not align with the SEC reporting periods. The example assumes that in this transaction SEC reporting is due for both the acquired public company's short year before the transaction and for the "stub" year after the company merges. Presumably, although a majority of the company's shares are held by a private company, the minority interest is still publicly-held and, therefore, the company continues to be subject to Section 162(m) post-transaction. Presumably, Example 3 is not intended to address a "going private" transaction. The facts of the example specifically provide that the relevant SEC reporting is required for the full calendar year, including the post-transaction stub period. Thus, on the stated facts, the conclusion in the example is straightforward; however, it illustrates that analysis under applicable securities requirements and Section 162(m) will be required to assess when a company ceases to be considered a "publicly held corporation" following certain transactions. For example, PLR 200019010 addresses a public company that "goes private" in a merger; the facts specifically state that no further SEC compensation table is required for the period post-transaction and, as a result, the PLR concludes that Section 162(m) does not apply post-transaction. Now that filing a summary compensation table is not the sine qua non of Section 162(m), companies will need to work closely with tax advisors and their securities counsel to understand which SEC reporting obligations continue for the period of the transaction and when those obligations terminate in order to advise on the continued application of Section 162(m) as amended by the 2017 Tax Act. Grandfather Rule The 2017 Tax Act expanded Section 162(m) to apply to compensation that was previously exempt, including performance-based compensation and post-employment payments such as non-qualified deferred compensation and supplemental pension payments. If such payments meet a Grandfather Rule (as discussed later), those payments may continue to be excluded from the $1 million deduction limit in future periods after the statutory effective date of the 2017 Tax Act amendments. The general statutory effective date is for tax years beginning after December 31, 2017. Section 13601(e) of the 2017 Tax Act states that the amendments shall not apply to remuneration that is provided under a written, binding contract that was in effect on November 2, 2017, and was not materially modified on or after that date (Grandfather Rule). The Grandfather Rule provided in the 2017 Tax Act is nearly identical to the transition rule provided when Section 162(m) was first enacted under the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993). Treas. Reg. 1.162-27(h) provides guidance on the transition rule contained in OBRA 1993, including guidance on the definitions of "written, binding contract" and "material modification." As stated in those regulations, contracts that are "materially modified" are ineligible for transition rule treatment from the date of the "material modification." Language describing the Grandfather Rule in the 2017 Tax Act in the Joint Explanatory Statement of the Committee of Conference was also consistent with these prior transition rules. Guidance The Notice confirms that remuneration payable under a written, binding contract that was in effect on November 2, 2017, is eligible for relief under the Grandfather Rule, only if applicable law (e.g., state employment or contract law) obligates the corporation to pay the remuneration if the employee performs the services or satisfies the applicable vesting conditions. Therefore, any amount paid to a "covered employee" that exceeds the amount the corporation is obligated to pay as of November 2, 2017, will be subject to Section 162(m), as amended by the 2017 Tax Act. The Notice also clarifies that, like the transition rule in OBRA 1993, the Grandfather Rule will not apply to all contracts that, although in effect on November 2, 2017, were renewed after that date. This includes any contract that is cancelable by the corporation without the employee's consent after November 2, 2017, which will be treated as renewed on the date on which the contract could first be canceled. Further, contracts that are automatically renewed or extended as of a certain date unless either the corporation or the employee provides notice of termination within a certain time period will be treated as renewed on the date the termination would be effective if the notice were given. A contract is not considered cancelable if could be canceled only by terminating the employment relationship with the employee. Finally, the Notice states that the Grandfather Rule will expire if any written, binding contract is "materially modified" after November 2, 2017. As provided in the regulations for the transition rule contained in OBRA 1993, a "material modification" is deemed to have occurred when the contract is amended to increase the amount of compensation payable to the employee. If a written, binding contract is materially modified, it is treated as a new contract entered into as of the date of the "material modification," and amounts received subsequent to the "material modification" are treated as paid under a new contract. As with the transition rule in OBRA 1993, a modification of the contract that accelerates the payment of compensation is a "material modification" unless the amount of compensation paid is discounted to reasonably reflect the time value of money. However, if the contract is modified to defer the payment of compensation, any compensation paid over the amount that was originally payable will not be treated as a "material modification" if the additional amount is based on either a reasonable rate of interest or a predetermined actual investment. Finally, the adoption of a supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, will be deemed to be a "material modification" of a written binding contract if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid under the written, binding contract. However, a material modification of a written binding contract does not include a supplemental payment that is equal to or less than a reasonable cost-of-living increase. The Notice also clarifies that, if a payment is subject to reduction as a result of negative discretion, payment of an amount above the legally binding minimum will not be a material modification if it results from the failure to apply the negative discretion to amounts otherwise earned. Implications The Notice confirms that the standards in place under the existing Section 162(m) regulations apply to determine whether compensation is paid under a written binding contract. In particular, Example 3 under Part III.B of the Notice illustrates that, to the extent a compensation committee retains authority to reduce a performance-based award payable to a covered employee, notwithstanding the attainment of the stated performance goals, the discretionary authority causes the award to fail to be grandfathered, regardless of whether the discretion is actually exercised. The import of the example is that compensation paid in tax periods beginning in 2018 and thereafter will not be grandfathered if the compensation is subject to negative discretion, notwithstanding that the compensation meets the pre-amendment performance-based compensation standard. While the Notice's conclusion is not surprising given the 2017 Tax Act's statutory language, the committee reports, and the existing regulatory rules, it may be disappointing to taxpayers who requested that IRS and Treasury provide a more lenient approach for performance-based plans. It was pointed out that "negative discretion" provisions were quite commonly adopted, but had not actually been utilized in many instances; thus, taxpayers asked IRS and Treasury to allow them to disregard such language for purposes of determining whether a binding contract was in effect and applying the Grandfather Rule. The Notice does not provide such relief. Thus, if negative discretion language exists in plan documents that govern compensation payments, the underlying compensation grants would be eligible for the Grandfather Rule only if taxpayers could affirmatively demonstrate that a court would not uphold the negative discretion language and that, in effect, the compensation committee has no authority under state law to reduce the compensation payable once the performance goals are met. Traditional "bad act" or claw-back provisions presumably do not affect the Grandfather Rule. The Notice also indicates that, for deferred compensation that is under the Grandfather Rule, earnings on such amounts are only grandfathered to the extent that the earnings were themselves subject to a binding contract as of November 2, 2017. Thus, if a compensation committee retained the right to modify a plan and eliminate earnings after such date, the post-November 2, 2017 earnings would not be grandfathered. There is no indication in the Notice that any separate plan documentation is required to maintain grandfathered treatment for amounts that accrued as of November 2, 2017. Future guidance The Notice does not address many topics and questions raised by the 2017 Tax Act amendments. Notably, the Notice does not address the availability of the exemption period following a company's initial public offering. Other questions remain outstanding regarding the application of Section 162(m) to certain corporate structures when compensation payments are made among related entities, such as the "Up-C" partnership structure or structures involving a mix of US and foreign corporations. The Notice indicates that further guidance will be issued in regulations. To the extent that such guidance adopts a broader definition of "covered employees" or further restricts the rules on written, binding contracts, the guidance would be prospective only. Comments are requested on the following topics for future guidance and regulations: 1. Application of the definition of "publicly held corporation" to foreign private issuers, including the reference to issuers that must file reports under Section 15(d) of the Securities Exchange Act of 1934 2. Application of the definition of "covered employee" to an employee who was a "covered employee" of a predecessor of the publicly held corporation 3. Application of Section 162(m) to corporations immediately after they become publicly held, either through an initial public offering or a similar business transaction 4. Application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a tax year that does not end on the same date as the last completed fiscal year ———————————————
——————————————— 1 The IRS confirmed the exclusion of the CFO in Notice 2007-49, which resulted from a disconnect between the Section 162(m) definition and amended SEC disclosure requirements. With regard to smaller reporting companies, however, the SEC allows for reduced disclosure, generally consisting of three individuals: the PEO and the next two highest compensated officers. For these companies, the IRS confirmed in CCA 201543003 that the CFO would be considered a "covered employee" subject to Section 162(m) if required to be disclosed as part of the smaller reporting company requirements. | |||||||||||||||
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