The Internal Revenue Service has published Notice 2018-68 (the “Notice”), which provides long awaited, but limited guidance on the recent amendments to Section 162(m) of the Internal Revenue Code (“Section 162(m)”) by the Tax Cuts and Jobs Act of 2017 (the “TCJA”). Specifically, the Notice provides guidance regarding the identification of a “covered employee” and the grandfathering rules governing written and binding arrangements in effect on November 2, 2017. The Notice applies to any taxable year ending on or after September 10, 2018. This post summarizes the key points of the Notice and the likely impact of the Notice on publicly held corporations.
Background. Section 162(m) limits the deductibility of remuneration to “covered employees” of certain publicly held corporations to the extent the remuneration for a taxable year exceeds $1 million. The TCJA made significant changes to Section 162(m) as follows: (1) expanded the definition of covered employees; (2) expanded the definition of “publicly held corporations” subject to Section 162(m); (3) eliminated exceptions to the Section 162(m) deduction limitations for commission and qualified performance-based compensation; and (4) established transition rules for certain outstanding arrangements (i.e., grandfathering rules). The TCJA applies to taxable years beginning on or after January 1, 2018. For more information on the TCJA’s amendments to Section 162(m), please see Proskauer’s previous post related to the passage of the TCJA.
Covered Employees. Amended Section 162(m) provides that the term “covered employee” includes (1) any employee who was the principal executive officer (“PEO”) or principal financial officer (“PFO”) of the publicly held corporation any time during the taxable year and (2) any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than the PEO or PFO). The Notice provides that officers do not need to be serving with the publicly held corporation at the end of the taxable year in order to be covered employees.
The Notice further clarifies that executives may be covered employees if their compensation is not required to be disclosed by the applicable publicly held corporation even under the Securities and Exchange Commission (the “SEC”) rules. For example, covered employees of smaller reporting companies and emerging growth companies are determined in the same manner as other publicly held corporations, regardless of whether the disclosure of their compensation is required under the less expansive disclosure requirements applicable to such companies under the SEC rules.
Based on the Notice, there may be a difference between the executives reported on a publicly held corporation’s summary compensation table and the executives who are treated as covered employees for purposes of Section 162(m). Publicly held corporations should separately identify and track their covered employees for Section 162(m) purposes.
Grandfathering Rules. The amendments made to Section 162(m) by the TCJA do not apply to remuneration payable under a written binding contract which was in effect on, and not materially modified after, November 2, 2017. A contract is considered binding only to the extent that a corporation is obligated under applicable law (e.g., state contract law) to pay the remuneration if the employee performs services or satisfies any applicable vesting conditions.
Renewal. A contract that is terminable or cancelable by the corporation without the consent of the employee is not grandfathered under the rules. In addition, contracts that are renewed after November 2, 2017 are not grandfathered under the rules, unless that renewal is in the sole discretion of the employee. However, the Notice provides that a contract is not considered terminable or cancelable by the corporation if it can be terminated or canceled only by terminating the employment of the employee.
Negative discretion. One of the areas of guidance most awaited by practitioners was whether negative discretion on the part of the corporation to reduce or eliminate compensation otherwise payable pursuant to an otherwise grandfathered contract affected the grandfathering provisions under the TCJA. The Notice contains several examples that illustrate the guidance. While the body of the Notice does not directly address the effect of negative discretion on grandfathering, one of the key examples (Example 3 under Material Modification) illustrates the effect. The example implies that the ability of a corporation to exercise discretion to reduce the amount payable to a covered employee eliminates grandfathering for the amount the corporation had the ability to reduce. In the example, a PEO participates in a bonus plan that would otherwise be qualified performance-based compensation before the TCJA amendments. The example provides that the amount that is not subject to negative discretion by the corporation is grandfathered. The remainder of the bonus in the example is subject to the Section 162(m) limitations even though the bonus is otherwise earned under the terms of the bonus plan and negative discretion is not exercised by the corporation.
Material modification. If a written binding contract is materially modified after November 2, 2017, it is treated as a new contract. The Notice provides that a modification that increases compensation above a reasonable cost of living increase is generally considered material. Likewise, accelerations of compensation may be viewed as material unless the accelerated amount is discounted to reflect the time value of money. Deferrals of compensation are not material modifications if the increase (or decrease) in the amount deferred is based on a reasonable rate of interest or a predetermined actual investment (although actual investment is not required).
Supplemental Payments. An agreement to provide increased or additional compensation is treated as a material modification of the underlying contract if the facts and circumstances demonstrate that the increased or additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid pursuant to the contract. For example, an increase in an executive’s base salary that is higher than provided in the executive’s employment contract (and greater than a cost of living increase) would be viewed as a material modification to the employment contract.
Further requests for comment. Further guidance on Section 162(m) is expected from the Treasury Department and the IRS. In particular, the Notice did not address and the Treasury Department and IRS requested further comment on the application of Section 162(m) to newly public corporations.
 Presently, Section 162(m) provides relief for newly public corporations whereby, generally, compensation paid (and, in certain limited cases, equity-linked compensation granted) during a limited period following the corporation’s initial public offering pursuant to a plan or agreement that exists prior to the corporation becoming public, and that is disclosed in connection with the initial public offering of the corporation’s securities, is not subject to the deduction limitation of Section 162(m).