Notice 2018-68 Provides Guidance Under New 162(m) Rules

By Timothy A. Daum, CECP, CEP
| 11/28/2018
On Aug. 21, 2018, the IRS issued Notice 2018-68, which answers certain questions that were raised after Congress made changes to Section 162(m) of the Internal Revenue Code as part of the 2017 tax reform. Specifically, the notice addresses issues pertaining to the definition of covered employees, what arrangements qualify under the grandfathering rule, and what constitutes a material modification. 

Section 162(m) limits to $1 million per year the amount that public companies can deduct for compensation paid to each of their covered employees. Before the changes made by Congress, there was an exception for compensation that qualified as performance-based compensation. However, that exception no longer exists under the new Section 162(m) rules. In addition, the new rules have broadened the definition of covered employees so that moving forward, more employees will be considered covered employees.

Covered employees

Prior to tax reform, the principal financial officer (PFO) generally was excluded from the definition of a covered employee. Tax reform modified the definition of a covered employee to include the principal executive officer (PEO), the PFO, and the three highest-paid officers other than the PEO and PFO. Under the new Section 162(m) rules, a “once a covered employee, always a covered employee” provision applies to any individual who was a covered employee at any time in a tax year beginning in 2017 or later, even if the covered employee is not employed at the end of the year. This effectively closes a planning opportunity under the old rules that could be used to avoid Section 162(m) for payments to a covered employee who was not employed at the end of the year. For example, under the old rules, a significant payment made to a covered employee who terminated employment during the year was fully deductible even if not subject to performance-based conditions.  

Grandfathering rule

Compensation paid under a written binding contract that was in effect as of Nov. 2, 2017, may be grandfathered under the old Section 162(m) rules, which are more favorable than the new Section 162(m) rules, unless and until such contract is “materially modified.” Any payments made after a material modification (discussed later) are not grandfathered, even if the compensation was fully earned prior to the material modification.  

A written binding contract in effect as of Nov. 2, 2017, that is terminable or cancelable by the corporation without the employee's consent is treated as “renewed” as of the earliest date that any such termination or cancellation, if made, would be effective. On the other hand, if the corporation will remain legally obligated by the terms of a contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed as of that date if the employee exercises the discretion to keep the corporation bound to the contract. Payments made under the terms of a renewed contract generally are subject to the new rules. However, amounts earned under the grandfathered contract prior to renewal might continue to be subject to the old rules even if payment of such amounts occurs after renewal.

Many executive compensation agreements provide for negative discretion, which generally allows the employer to pay an amount less than the amount otherwise payable to the executive in certain circumstances. Notice 2018-68 provides that a corporation’s ability to exercise negative discretion causes an otherwise grandfathered amount to lose its grandfathering. The notice provides an example of a written binding contract entered into on Feb. 1, 2017, that allowed an employee to earn a bonus of up to $1.5 million based on specified performance goals. The compensation committee retained the right – if the performance goals were met – to reduce the bonus amount to no less than $400,000, if, in its judgment, other subjective factors warranted a reduction. The performance goals were achieved, but negative discretion was applied and the executive was paid a bonus of only $500,000. The notice indicates that under this scenario, $400,000 is paid under a written binding contract and is grandfathered under the old rules and $100,000 is not grandfathered and would be subject to the new rules. 

The negative discretion position articulated in the notice has been a source of some confusion. Many have interpreted the notice to mean that the mere presence of negative discretion eliminates the possibility of grandfathering, but the proper interpretation seems to be more nuanced. If a negative discretion provision is not enforceable under applicable law (for example, under state law), then the provision should not jeopardize grandfathering. Although in most cases negative discretion provisions seemingly should be enforceable under applicable law (and thus grandfathering would be unavailable), certain factors potentially could support the opposite conclusion, such as when negative discretion has never been used or when negative discretion can be exercised only in certain situations that do not materialize with respect to the contract.

Whether negative discretion provisions are enforceable under applicable law is a legal question. In most cases, the presence of negative discretion will make grandfathering unavailable, but banks that have large dollar amounts at stake might want to obtain an opinion letter concluding the negative discretion is unenforceable. It is important to note that the burden is on the taxpayer to demonstrate grandfathering eligibility rather than on the IRS to demonstrate the contrary.

If a bank has a written binding contract that is grandfathered and qualifies as performance-based compensation under the old rules, it is important to avoid materially modifying the contract and to continue the independent compensation committee so the committee can certify the achievement of performance goals.

Material modifications

As indicated earlier, an arrangement that qualifies under the grandfathering rules will lose its grandfathered status if it is materially modified after Nov. 2, 2017, such that any payment made after the date of material modification will be subject to the new rules. The notice clarifies that a material modification occurs if a contract is amended to increase the amount of compensation payable. An amendment to a contract that accelerates payment is not considered a material modification if the accelerated payment is discounted to reasonably reflect the time value of money. An amendment to a contract that delays payment is not considered a material modification if the amount of the delayed payment that is in excess of the originally scheduled payment does not exceed an amount based on either a reasonable rate of interest or a predetermined actual investment.  

Deferred compensation as a planning tool

Deferred compensation plans can be a useful tool for planning around the new 162(m) rules. For example, compensatory payments such as salary or bonus could be automatically deferred to a later year to the extent total payments would otherwise exceed $1 million, with such deferrals to be paid during the first year that such payment would not cause the $1 million limit to be exceeded. Also, incentive stock options might become more prevalent since they generally are nondeductible at the corporate level and can provide favorable capital gain tax treatment for employees.

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