We previously blogged about the guidance released by the IRS in Notice 2018-68 (the “Notice”), which addressed some of the changes made to Section 162(m) of the Internal Revenue Code (“Section 162(m)”) in the 2017 tax reform law (the “Act”). In that post, we focused on the general changes in the definition of covered employee and guidance as to what constitutes a written binding contract eligible for grandfather relief. In this post, we will address 5 of the most common questions we’ve heard companies ask about the guidance and describe potential next steps.
Q 1: If a performance based compensation arrangement permits negative discretion to zero, are all payments made pursuant to that arrangement subject to 162(m)’s $1 million deduction limit?
A: Most likely, yes. The Notice clarifies that a compensatory arrangement is not a written binding contract to the extent that any amounts payable under the arrangement may be reduced to $0 upon the company’s exercise of negative discretion. However, if a portion of that amount is required to be paid under state law, then that portion of the payment would be grandfathered under Section 162(m) and would not be subject to its $1 million deduction limit. Companies covered by Section 162(m) should review their current compensation arrangements now to identify the contracts and plans that may be impacted by this guidance.
Q 2: What changes will constitute material modifications of grandfathered arrangements?
A: The Notice states that a material modification occurs, and therefore grandfathered status is lost, when an arrangement is amended to increase the amount of compensation payable to the employee. However, the Notice also clarifies that the following actions will not constitute material modifications to an otherwise grandfathered arrangement:
- Acceleration of a payment if the payment is discounted to reasonably reflect the time value of money;
- Deferral of a payment if any amount paid in excess of the amount deferred is based on either a reasonable rate of interest or a predetermined actual investment;
- A supplemental payment that does not exceed a reasonable cost-of-living increase over the payment made in a prior year (e.g., a modest increase in base salary or target bonus); or
- A supplemental payment that is not based on substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the arrangement (e.g., new equity awards).
Companies should closely monitor any proposed changes to grandfathered compensation arrangements to verify that such changes do not result in the loss of grandfathered status.
Q 3: What happens when a grandfathered arrangement is renewed or extended?
A: The arrangement generally loses grandfathered status, effective as of the date that it was to be renewed or extended. The Notice provides that a grandfathered contract that is renewed or extended (whether automatically or otherwise) after November 2, 2017 will lose grandfathered status as of the date of renewal or extension, unless the employee had a unilateral right to require renewal in his or her sole discretion. For example, employment contracts commonly provide that they automatically renew as of a certain date unless either the company or the employee provides notice of termination at least 30 days before the termination date. These contracts will lose grandfathered status as of the date that termination would have been effective if that notice were given. Therefore, companies covered by Section 162(m) will want to monitor the renewal and termination dates of their grandfathered arrangements in order to determine and track when grandfathered status will be lost.
Q 4: How do the new Section 162(m) rules apply to compensatory arrangements with an individual who was not a covered employee as of November 2, 2017?
A: The Notice provides that if an individual became a covered employee solely as a result of the Act, then any payments made to that individual pursuant to a written binding contract as of November 2, 2017 are grandfathered and are not subject to Section 162(m)’s $1 million deduction limit. Therefore, with respect to a principal financial officer who first became a covered employee solely as a result of the Act, any payments made pursuant to written binding contract as of November 2, 2017 (e.g., an employment agreement or nonqualified deferred compensation plan) will not be subject to the $1 million deduction limit, provided that such contract has not been materially modified after November 2, 2017.
Q 5: What’s the best way to determine and monitor covered employees for 2018 and beyond?
A: Companies covered by Section 162(m) will need to develop and maintain a separate recordkeeping system for covered employees. The Notice clarifies that the Act expanded the individuals who are “covered employees” under Section 162(m) to any individual who is or was a covered employee for any taxable year beginning after December 31, 2016, regardless of whether
- there is a subsequent change in the individual’s officer status, compensation, employment or death;
- the individual’s compensation is required to be disclosed under applicable SEC disclosure rules (e.g., there is no relief for smaller reporting companies or emerging growth companies); or
- the individual is employed by the company at the end of the applicable taxable year (e.g., in event of a corporate transaction that results in a shortened tax year).
Stay tuned for further developments.