On August 21, 2018, the IRS issued much-anticipated guidance on the changes made to the $1 million deduction limit for compensation paid to certain executive officers under Section 162(m) of the Internal Revenue Code. This guidance relates to the changes made to Code Section 162(m) by the Tax Cuts and Jobs Act (the "Act"). In this newsletter, we focus on this guidance provided in IRS Notice 2018-68 regarding transition relief for certain grandfathered plans and agreements.
Background. Code Section 162(m) generally limits a public company's deduction for compensation paid to its "covered employees" to no more than $1 million per year. Prior to the Act, much of Code Section 162(m)'s impact could be avoided by qualifying for exemptions, for example, for amounts payable after termination of employment and certain qualifying performance-based compensation.
Effective for tax years beginning on or after January 1, 2018, the Act significantly broadens the scope of Code Section 162(m) by:
- eliminating the performance-based compensation exemption;
- expanding the group of individuals who are "covered employees" subject to Code Section 162(m); and
- treating an employee, who for any year is a covered employee, as a covered employee for all future years.
Importantly, however, the Act also provides a transition rule for compensation payable under a "written binding contract" that:
- was in effect on November 2, 2017, and
- is not modified in any "material respect" after that date.
Since such grandfathered arrangements will continue to be subject to the old Code Section 162(m) rules, including the applicable exemptions and the old covered employee definition, a significant tax savings may be available by taking steps necessary to monitor eligibility for this transition relief.
New Guidance on Transition Relief for Grandfathered Arrangements. IRS Notice 2018-68 addresses several key aspects of the transition relief for grandfathered arrangements:
- Impact of Negative
Discretion. The Notice clarifies that compensation is
payable under a "written binding contract" only if the
company is legally obligated under applicable law (e.g.,
state contract law) to pay the compensation if the employee
performs services or satisfies any vesting conditions.
One of the key takeaways of the new guidance is that plans or arrangements that allow the company to reduce or eliminate payments unilaterally (i.e., exercise negative discretion) will be treated as non-binding (and therefore ineligible for transition relief) to the extent that the company may legally exercise such discretion, regardless of whether that discretion actually is exercised.
Ultimately, whether transition relief is available for a plan or other arrangement that provides for negative discretion will depend on the specific terms of the arrangement and the state law applicable to that arrangement. - Material
Modifications. A grandfathered arrangement will lose
its grandfathered status if it is "materially modified"
after November 2, 2017. If a grandfathered arrangement is
materially modified, any amounts paid after the modification will
not be eligible for transition relief.
- The new guidance clarifies that increasing the amount of compensation payable under a grandfathered arrangement will be considered a material modification unless the increase is less than or equal to a reasonable cost-of-living increase. Companies should be aware that an increase in an executive's base pay may impact potentially grandfathered amounts, for example severance benefits that are based on the executive's base pay.
- The guidance also notes that adopting a supplemental agreement that provides for increased compensation on substantially the same elements or conditions as the grandfathered arrangement will be considered a material modification of the grandfathered arrangement, unless the increase is limited to a reasonable cost-of-living increase.
- An acceleration of the payment timing of a grandfathered amount is also a material modification unless the amount paid is discounted to reasonably reflect the time value of money.
- In addition, a deferral of the payment timing of a grandfathered amount is considered a material modification, unless any additional amount that will be paid at a later date as a result of the deferral is based on either a reasonable rate of interest or a predetermined actual investment. Companies should be aware of the impact of this rule on any deemed earnings credited on potentially grandfathered amounts accrued under the company's nonqualified retirement plans.
- Renewals and Evergreen Provisions. A grandfathered arrangement that is renewed after November 2, 2017, will lose its grandfathered status as of the date of the renewal, meaning that any amounts paid after the date of renewal will not be eligible for transition relief.
The guidance provides that a written binding contract that is terminable or cancelable by the company without the employee's consent is treated as renewed on the earliest date that a termination or cancellation, if made, would be effective. For example, if a deferred compensation plan allows the company to cease future benefit accruals at any time, benefits accrued under the plan after November 2, 2017, generally will not be eligible for transition relief.
The guidance clarifies that if an employment agreement provides that its term will automatically renew as of a certain date unless the company or the employee provides prior notice, the agreement will lose its grandfathered status as of the date the termination would be effective if notice were given. However, the guidance also clarifies that a contract is not treated as terminable or cancelable if it can only be terminated or canceled by terminating the employee's employment.
Next Steps. Identification of potentially grandfathered arrangements and maintenance of records supporting eligibility for this transition relief could result in preservation of significant amounts of future tax deductions for some companies. Additionally, many company accountants and auditors will have questions regarding amounts that may be deductible in the future and their impact on financial statements. Because these rules are complex, companies will want to carefully consider how this guidance may impact their compensation plans and agreements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
