Skip to main content
Article | Executive Pay Memo North America

Updated final 162(m) regulations make few changes

Governance Advisory Services |Executive Compensation

By Gary Chase and Steve Seelig | January 27, 2021

Companies must remain vigilant and not materially modify grandfathered arrangements; continue to track covered employees

The IRS has finalized regulations implementing the amendments to Internal Revenue Code section 162(m) made by the 2017 Tax Cuts and Jobs Act (TCJA) with only minor substantive changes to its prior guidance. The heavy lifting for corporations will remain in preserving grandfather treatment for certain compensation that will be paid in future years, and to track “covered employees” who may receive compensation in future years (including when a corporation acquires new employees in a merger or acquisition).

Because most long-term incentive compensation cycles that were open during 2017 have already paid out, monitoring grandfather treatment will become less important, except perhaps for unexercised stock options and stock appreciation rights (SARS) that tend to have longer (e.g., 10-year) life spans. Nonqualified deferred compensation (NQDC) in its various forms — such as excess 401(k), supplemental executive retirement plans and deferred stock units — will need continued monitoring to support preservation of grandfather treatment.

A quick recap of the new 162(m)

The changes made to 162(m) in the TCJA meant that publicly held corporations had three main tasks in determining whether compensation paid is subject to the $1 million tax-deduction limitation (the $1 million pay cap):

  1. Determine if the payee is a covered employee: TCJA introduced the “once a covered employee, always a covered employee” rule — that is, starting in 2017, an employee who is a covered employee for any year will remain a covered employee for any future year in which compensation is paid by the corporation, even following retirement or death. This is the case even if an employee was a covered employee at certain entities acquired via a merger or acquisition.
  2. Consider what constitutes compensation paid and whether it is grandfathered: Generally, the statute focuses on the concept of compensation paid, including commissions, whether paid to the covered employee or a beneficiary. The grandfather rule provides that remuneration pursuant to a written binding contract that was in effect on November 2, 2017 (the “grandfather date”), and that was not modified in any material respect on or after such date, can remain deductible when paid — if it would have been deductible under pre-TCJA 162(m) rules. This treatment can apply to compensation that was considered “performance-based” or is NQDC under a written binding contract on the grandfather date.
  3. Determine if there has been a material modification for grandfathered amounts: Any action that changes the value of a grandfathered amount must be closely monitored to ensure there are no material modifications that could cause the entire amount to lose grandfather status. This can be as simple as paying grandfathered amounts early, so care should be taken in making these changes.

Here’s what the final regulations tell us about each of these tasks:

1. Covered employee determination

Determining newly covered employees each year: The final regulations continue to define covered employees to include any employee who is the principal executive officer (PEO) or principal financial officer (PFO) of a publicly held corporation at any time during the taxable year (or an individual acting in such a capacity). 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, determined under the proxy disclosure rules, regardless of whether the corporation’s fiscal year and taxable year end on the same date.

But the rule is not the same as the proxy disclosure rule, in that there is no requirement that the employee must be an executive officer at the end of the taxable year. Thus, this group may be different from that disclosed on the proxy, as that rule requires both disclosure of those executive officers employed at year-end, plus up to two additional executive officers not reported at year-end whose compensation was higher. Special rules exist where the company’s fiscal year differs from its taxable year.

Tracking covered employees in future years: The final regulations not only require companies to track their own covered employees into future years when compensation is paid, including years beyond retirement and death, but also include detailed rules about tracking covered employees who were employed at predecessor employers acquired by public corporations. There are a number of examples of how that can occur, including stock-related transactions, asset purchases involving at least 80% of gross operating assets, certain changes from private to public status and even purchases of publicly traded partnerships. Companies must closely monitor acquisitions that have taken and will take place after the grandfather date, since these events may add to their cadre of covered employees.

Applying the rules to unusual corporate structures: The final regulations retain the guidance on those entities that are considered publicly held corporations for purposes of 162(m). The regulations continue to focus on the following two possible scenarios:

(1) A corporation’s securities are required to be registered under section 12.

(2) A corporation is required to file reports under section 15(d) of the Exchange Act of 1934.

Such status is determined as of the last day of a corporation’s taxable year.

In the final regulations, publicly held corporations continue to include S corporations that issue registered securities or have issued publicly traded debt, wholly owned subsidiary corporations of publicly held corporations that meet (2) above, foreign private issuers that meet (1) or (2) above, a publicly traded partnership that meets (1) or (2) above, and certain affiliated groups and disregarded entities where the parent is private and the subsidiary is publicly traded. Application of these rules can be complicated, particularly when compensation is paid to a covered employee by more than one entity within the affiliated group.

Stand-alone private corporations that become public would be subject fully to the 162(m) deduction limits. A special transition rule exists for corporations that became publicly held on or before December 20, 2019, so they would be exempt from the 162(m) deduction limits. The final regulations clarify that the transition rule also applies to a subsidiary of an affiliated service group that becomes a separate publicly traded organization (e.g., as part of a spin-off transaction). Generally, the transition period ends either on the first shareholder meeting at which directors are elected after the close of the third calendar year following the year in which an initial public offering (IPO) occurs or the first calendar year following the year in which a company becomes public without an IPO.

2. Compensation paid and grandfathered amounts

Counting compensation: The general rule continues to apply that compensation paid to a covered employee (by any member of the affiliated service group) is subject to 162(m), regardless of when paid, as does the rule that companies must count compensation paid to former executives who render services as independent contractors, including those who join the board of directors. Companies also 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 final regulations maintain the rule that newly public corporations cannot avoid application of 162(m) to future compensation authorized before they became public, although the grandfather rule might still be helpful for these companies.

The final regulations maintain the rule that public corporations that own an interest in a partnership would need to count a portion of the compensation paid by the partnership to its covered employees when applying the section 162(m) deduction limitation. However, the final regulations add a special transition rule that only includes these amounts as compensation if paid after December 18, 2020. In addition, the final regulations continue to exclude compensation paid by the partnership after December 30, 2020, if the compensation is paid pursuant to a written binding contract that is in effect on December 20, 2019, and that is not materially modified after that date.

Applying the grandfather rule: Amendments made by the TCJA do not apply to remuneration 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. The final regulations maintain the rule that remuneration is payable under a written binding contract that was in effect on November 2, 2017, but only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under the contract if the employee performs services or satisfies the applicable vesting conditions.

The final regulations maintain the rule that negative discretion plans that permit the board to reduce or eliminate promised bonus compensation are not provided under a written binding contract, with the caveat that state law may limit the amount of compensation that can be reduced using negative discretion. Thus, in states with stronger employee wage law protections that would not honor negative discretion, it may be that a larger portion of a promised bonus can be grandfathered regardless of the existence of a negative discretion provision.

The existence of a provision that would claw back compensation that should not have been paid, or can be clawed back by exercise of discretion, continues not to affect the existence of a written binding contract. The final regulations extend this rule so that it applies regardless of whether the amounts actually are clawed back.

The final regulations maintain the approach under the proposed regulations as to determining grandfathered benefits under a NQDC plan, albeit they are structured differently by providing black letter rules instead of only including examples. The final regulations continue to provide that additional benefits, contributions or earnings that accrue under a NQDC plan after November 2, 2017, are not grandfathered but articulate a few exceptions:

  • If a company does not have discretion to terminate or materially amend the plan, the grandfathered amount would include the benefit as of November 2, 2017, plus any additional benefits, contributions or earnings that accrue after that date.
  • If a company has discretion to terminate the plan, then the grandfathered amount includes the lump sum value of the total benefit determined as if the plan was terminated on November 2, 2017 (or, if later, the earliest possible date that termination is permitted under the terms of the plan), plus any additional benefits, contributions or earnings that the company is required to make through the earliest date that the benefit may be distributed to the employee. A similar rule applies where a company has discretion to freeze (but not terminate) a NQDC plan, although these plan provisions are rare.

The final regulations add an alternative grandfather rule that would simply permit corporations to ignore earnings, losses and new contributions from being considered as grandfathered to help companies reduce their administrative burden of performing potentially detailed calculations.

Because severance amounts often are tied to salary and bonus levels in place at termination, the final regulations maintain that severance is grandfathered only if the severance amount and the underlying salary and/or bonus on which it is based are under a binding written contract in effect as of November 2, 2017. In that circumstance, the grandfathered amount would be based only on the salary and bonus in place on the grandfather date; future increases would not be grandfathered unless those were guaranteed by contract. However, severance may be grandfathered if based on salary increases that are hard coded into the agreement or reasonable cost-of-living adjustments but would not be grandfathered if based on discretionary bonuses whose value is determined after the grandfather date.

The final regulation maintains the ordering rule for NQDC that is distributed over a period of years where only a portion of the compensation is grandfathered. In that case, the grandfathered amount is allocated to the first otherwise deductible payment paid under the arrangement. If the grandfathered amount exceeds this payment, then the excess is allocated to the next otherwise deductible payment paid under the arrangement. This process is repeated until the entire grandfathered amount has been paid.

3. Material modifications

The final regulations maintain the rule that a material modification occurs when a contract is amended to increase the amount of compensation payable to the employee. If that happens, the contract loses its grandfathered status and any future payments are treated as a new contract that is subject to the TCJA revisions to 162(m).

A supplemental contract or agreement that provides for increased or additional compensation is a material modification 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 under the written binding contract. An exception exists 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. As we noted above, the failure, in whole or in part, to exercise negative discretion under a contract does not result in the material modification of that contract.

Accelerating future payments of compensation are material modifications unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Similarly, deferrals of compensation will 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. Under this rule, a company could accelerate vesting of restricted property, a stock option or SAR, or the right to vest in cash, and it is not considered a material modification.

The final regulations added an exception to the material modification rule for stock options or SARs whose exercise periods are extended, which sometimes happens when an employer wants a terminating employee whose options/SARs would have expired to have additional time to exercise those rights.

4. General and special applicability dates

The final regulations are generally applicable to tax years beginning on or after December 30, 2020, and taxpayers generally have the option to apply them to tax years beginning after December 31, 2017. There are other detailed rules of application that are hard to summarize and should be consulted in the regulatory release.


Director, Retirement and Executive Compensation

Senior Director, Executive Compensation (Arlington)

Contact Us