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IRS Issues Guidance on Application of Code Section162(m) Coverage and Grandfathering Rules

Last week the IRS issued Notice 2018-68, providing guidance under Section 162(m) of the Internal Revenue Code, as amended by the 2017 Tax Cuts and Jobs Act (the “2017 Act”). Section 162(m) disallows the deduction of compensation paid by public companies to covered employees to the extent such amounts exceed $1 million per year. The 2017 Act changed the definition of covered employees, expanded the entities subject to Section 162(m), and eliminated the exception for commission and performance-based compensation. Application of the new rules commences in 2018, except that compensation paid pursuant to a binding written contract that was in effect on November 2, 2017, is grandfathered as long as such contract is not modified in any material respect after that date.

The Notice is intended to provide guidance on the definition of a “covered employee” and the operation of the grandfather rule. The Notice does not address the $1 million limitation applicable to compensation paid to executives by tax-exempt organizations.

Covered Employee

A covered employee is defined as including any employee who is (or is acting as) the principal executive officer (PEO) or principal financial officer (PFO) of the publicly held corporation at any time during the tax year. In addition, a covered employee includes any employee among the three highest-compensated officers for the tax year (other than the PEO or PFO) as computed under the Securities Exchange Act of 1934, even if his or her compensation is not required to be reported. The Notice specifically provides that a covered employee does not need to have qualified as such at the end of the tax year as long as he or she met the definition at any time during the tax year. The Notice also clarifies that an employee will be considered a covered employee in 2018 and thereafter, if he or she qualified as a covered employee in 2017 under the former rules or under the new rules in any year thereafter.

Binding Contract

The grandfather rule will only continue to exempt compensation if it is paid pursuant to a binding written contract that was in effect on November 2, 2017. Amounts will be grandfathered only if the employer is obligated under applicable state law to pay such amounts if all applicable performance criteria and vesting conditions are met. If an award is subject to negative discretion, because the employer has the right to adjust the payment downward based on discretionary criteria, the Notice provides that there will not be considered to be a binding right to the extent of such negative discretion. Thus, for example, if a contract provides that an award which is dictated by specified performance criteria is subject to a 20% downward adjustment at the discretion of a company’s compensation committee, only 80% of the amount produced by the performance formula will be grandfathered. However, failure to exercise negative discretion will not be considered a material modification so that if the employer pays the full 100% produced by the award formula, 80% will still be grandfathered and the other 20% will be counted against the compensation limitation. Also, if the employer may cancel or terminate a binding written contract without the employee’s consent, that contract is treated as renewed as of the date that any such termination or cancellation, if made, would be effective.

Material Modification

The Notice clarifies that a “material modification” will be deemed to occur only if a contract is amended to increase the amount of compensation paid to the employee. If a modification accelerates the timing of payment, it will be considered material unless the payment is discounted to reasonably reflect the time value of money. If the award is modified to defer payment, it will not be considered material unless the amount payable is increased by more than a reasonable rate of interest or crediting based on a predetermined actual investment. The adoption of a supplemental contract or agreement that provides increased compensation may also be considered a material modification of an existing right if facts and circumstance suggest that it is based on the same elements or conditions as the original award such that it constitutes a de facto increase in the original award right.