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Key takeaways from recently proposed 162(m) regulations

Executive Compensation|Health and Benefits

By Gary Chase , William (Bill) Kalten and Steve Seelig | February 7, 2020

The proposals offer guidance on the steps necessary to determine whether compensation paid is subject to the $1 million tax-deduction limitation.

The IRS recently issued proposed regulations on the amendments made to section 162(m) of the Internal Revenue Code under the Tax Cuts and Jobs Act of 2017 (TCJA), supplementing its prior guidance in Notice 2018-68. Section 162(m) limits the allowable deduction for compensation paid to covered employees of publicly held corporations to $1 million per year. The proposed regulations address how the grandfather rules apply to compensation under a written binding contract in effect on the law’s November 2, 2017 effective date (the grandfather date)1 and whether those plans can be amended without harm. Corporations will still need to monitor equity granted before that date as they vest — and options/stock appreciation rights (SARS) that are exercised — to determine if they are grandfathered.

In particular, the proposed regulations provide significant new guidance on how companies must keep track of the “once a covered employee, always a covered employee” rule introduced by the TCJA, particularly for corporations with mergers/acquisitions/spinoffs, and how 162(m) applies to unusual business structures. Finally, the proposed rules clarify that determination of covered employee status for the three most highly paid executive officers is not a year-end exercise: Anyone who reaches that status during the year would be considered.

Fundamental concepts

The proposed regulations provide guidance on each of the following three steps publicly held corporations must take to determine whether compensation paid is subject to the $1 million tax-deduction limitation.

  1. 01

    Determine if the payee is a covered employee

    Determining newly covered employees each year. The proposed regulations maintain the definition of covered employee provided in Notice 2018-68, which applies for taxable years ending on or after September 10, 2018. Covered employees include any employee who is, or acts as, the principal executive officer or principal financial officer of a publicly held corporation at any time during the taxable year. Covered employees also include any executive officer whose total compensation for the company’s taxable year places him or her among the three highest compensated officers for the taxable year.

    Note that the proposed rule for identifying the three highest compensated officers for purposes of 162(m) differs from the proxy disclosure rule, which requires that the employee be an executive officer at the end of the taxable year. Thus, this group may be different from that disclosed on the proxy. 

    Finally, the proposed regulations provide special rules where the company’s fiscal year differs from its taxable year.

    Tracking covered employees in future years. Not only must companies track their own covered employees into future years, including years beyond retirement and death, they also must track covered employees who were employed at predecessor employers acquired by public corporations. Companies should now take another look to determine whether their number of covered employees increased due to acquisitions that took place after the grandfather date.

    Determining applicability to unusual corporate structures. The proposed regulations provide guidance on which entities are considered publicly held corporations for purposes of 162(m), focusing on whether (1) a corporation’s securities are required to be registered under section 12 of the Exchange Act of 1934, or (2) a corporation is required to file reports under section 15(d) of the act. Such status is determined as of the last day of a corporation’s taxable year.

    Under the proposed regulations, the following are considered publicly held corporations:

    • S corporations that issue registered securities or have issued publicly traded debt
    • Wholly owned subsidiary corporations of publicly held corporations that meet (1) or (2) above (so subsidiaries will have their own set of covered employees)
    • Foreign private issuers that meet (1) or (2) above
    • Publicly traded partnerships that meet (1) or (2) above
    • Certain affiliated groups and disregarded entities where the parent is private and the subsidiary is publicly traded
  2. 02

    Consider what constitutes compensation paid and whether it is grandfathered

    Counting compensation. Companies are required to count compensation paid to a covered employee if he or she returns after separation in any capacity, including as a common law employee, a director or an independent contractor.

    The proposed regulations eliminate the regulatory exception that allowed newly public corporations to avoid applying 162(m) to future compensation if those payments were authorized before they became public. In addition, public corporations that own partnerships would need to count compensation paid to covered employees who are also partners in those entities.

    Grandfather rule. Under the proposed regulations, remuneration is payable under a written binding contract that was in effect on November 2, 2017, only when the corporation is legally obligated to pay the remuneration under the contract if the employee performs services or satisfies the applicable vesting conditions.

    The proposed regulations exclude from the grandfather rule compensation that is subject to reduction or recovery by the company. Under Notice 2018-68, negative discretion plans that permitted the board to reduce or eliminate promised bonus compensation are not considered to be provided under a written binding contract. The proposed regulations adopt this rule, noting that state law may limit the amount of compensation that can be reduced using negative discretion. The existence of a provision that claws back compensation that should not have vested, or that can be clawed back by exercise of discretion, does not affect the existence of a written binding contract, except for amounts that actually become subject to clawback.

    Under the proposed regulations, both credits and earnings or interest accruing under a nonqualified deferred compensation plan (NQDC) after November 2, 2017, are not grandfathered when the corporation retains the right under applicable law to amend the plan at any time either to stop or to reduce future credits (including earnings). One exception to this rule is for plans that are required by the tax code and plan document to guarantee earnings or interest from the date of plan termination until distribution. We expect more guidance from the IRS addressing several interpretational questions related to NQDC.  

    Because severance amounts often are tied to salary and bonus levels in place at termination, the proposed regulations clarify that severance is grandfathered only if the amount and the underlying salary and bonus upon which it is based are under a binding written contract in effect as of November 2, 2017. The grandfathered amount would be based only upon the salary and bonus in place on the grandfather date; future increases would not be grandfathered unless guaranteed by contract.

    For NQDC that is distributed over a period of years where only a portion of the compensation is grandfathered, the grandfathered amount is allocated to the first otherwise deductible payment. If the grandfathered amount exceeds the payment, then the excess is allocated to the next otherwise deductible payment, repeated until the entire grandfathered amount has been paid.

  3. 03

    Determine if there has been a material modification

    Under the proposed regulations, a material modification is one that amends a contract to increase the employee’s compensation. If that happens, the contract loses its grandfathered status, and any future payments are treated as a new contract entered into when modified, subject to the TCJA revisions to 162(m).

    Corporations must monitor whether any action they take would change the value of any grandfathered amount. A supplemental contract or agreement that provides for increased or additional compensation is a material modification if the additional compensation is paid on substantially the same basis as the compensation under the written binding contract. An exception is if the supplemental payment is equal to or less than a reasonable cost-of-living increase over the payment made in the preceding year under that written binding contract. 

    Accelerating future payments of compensation would be considered material modifications unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Similarly, deferrals of compensation would be considered material modifications unless the amounts paid in excess of the original compensation are based on either a reasonable rate of interest or a predetermined actual investment (real or notional). However, the interest itself will not be grandfathered.

    An exception to the acceleration prohibition is for compensation that was subject to a substantial risk of forfeiture as of November 2, 2017 (e.g., a company could accelerate vesting of restricted property, a stock option or SAR, or the right to vest in cash, without it being considered a material modification).

    Finally, the failure to exercise negative discretion to reduce compensation under a contract does not result in the material modification of that contract.


1The grandfather rule provides that remuneration pursuant to a written binding contract that is in effect on November 2, 2017, and is not modified in any material way on or after such date, is deductible when paid — if it would have been deductible under pre-TCJA 162(m) rules. This can apply to “performance-based” compensation or nonqualified deferred compensation (NQDC) under a written binding contract on the grandfather date.


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