Dec. 31 deadline approaching for Section 162(m) arrangements

| 12/3/2020
Dec. 31 deadline approaching for Section 162(m) arrangements

The 2017 tax reform (known as the TCJA) significantly amended IRC Section 162(m). Arrangements that were in effect pre-TCJA and subject to (or potentially subject to) Section 162(m) often include certain language to avoid significant Section 409A tax penalties for employees and related payroll and deduction exposures for employers. Ironically, certain TCJA changes to Section 162(m) result in this same language creating 409A tax exposures for arrangements subject to the new law. The U.S. Department of the Treasury and the IRS provide relief if certain actions are taken no later than Dec. 31, 2020 – a deadline that is fast approaching.

Section 162(m)

Congress added Section 162(m) to the IRC via the Omnibus Budget Reconciliation Act of 1993. Section 162(m) limits an employer’s compensation deduction to $1 million per year for each covered employee of a publicly held corporation. As enacted, employers could use various loopholes to avoid the deduction limit – including delaying payment of compensation earned by a covered employee until the related deduction was attributable to a taxable year when the individual no longer was a covered employee.

The TCJA eliminated this loophole by treating a covered employee for any taxable year beginning with 2017 as a covered employee for all time, even with respect to payments beyond the individual’s death. Moreover, effective beginning with the 2018 tax year, the TCJA expands the definition of covered employee (previously the principal executive officer (PEO) and the three highest-compensated officers other than the PEO, based on holding that position at year-end) to include anyone who is the PEO or principal financial officer (PFO) at any time during the taxable year, along with the three highest-compensated officers during the taxable year other than the PEO and PFO. Thus, for a given taxable year, the deduction limitation applies with respect to compensation of not only the five covered employees meeting this definition for a taxable year but to anyone who met that definition in a prior taxable year.

Other significant Section 162(m) changes include expanding the definition of a publicly held corporation to include certain nonpublicly traded companies and removing the exemption for compensation meeting various performance-based requirements. The TCJA permits grandfathering of compensation subject to a written binding contract in effect on Nov. 2, 2017, and not materially modified after this date. Specific complex rules apply for this determination, but even grandfathered arrangements are exempt from Section 162(m) only if exempt under pre-TCJA Section 162(m).

Proposed regulations under Section 162(m) released on Dec. 20, 2019, provide significant guidance on the various TCJA changes and include relief in connection with Section 409A’s intersection with Section 162(m).

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Section 409A

Effective in 2005, Congress enacted Section 409A to impose strict rules on nonqualified deferred compensation. Among other requirements, 409A arrangements must designate in writing the objectively determinable amount and time of future payments, and arrangements must be administered in compliance with such language as well as Section 409A generally. Noncompliance results in inclusion of amounts subject to Section 409A in current income (as wages subject to income tax reporting and withholding for employees or reportable compensation for nonemployees) and additional 409A income taxes of at least 20% – often in a year before the compensation is payable. When a prior-year 409A violation occurs, an employer can face significant payroll exposure and incorrect or lost compensation deductions.

As noted, employers wish to delay paying compensation subject to pre-TCJA Section 162(m) until a taxable year when Section 162(m) no longer limits the related deduction. Absent 409A relief, this payment timing would be impermissible under Section 409A and likely result in a 409A violation. Years ago, Treasury and the IRS provided such relief in 409A regulations to permit delayed payment of compensation otherwise subject to Section 162(m) only if payment occurs as soon as Section 162(m) no longer bars the related deduction. As a result, employers often include language in various compensation arrangements to avoid a Section 162(m) deduction limitation and a Section 409A violation.

These 409A provisions still apply to compensation subject to pre-TCJA Section 162(m) but create an inadvertent 409A issue for compensation subject to post-TCJA Section 162(m). A covered employee’s compensation subject to post-TCJA Section 162(m) may never become deductible, and, as such, its payment would violate Section 409A language intending to address pre-TCJA Section 162(m) rules. Recognizing this issue, the Section 162(m) proposed regulations provide that if employers amend arrangements to remove such language no later than Dec. 31, 2020, the amendment won’t result in a Section 409A violation and will not materially modify an arrangement otherwise grandfathered from the TCJA’s Section 162(m) changes. However, if an amended plan requires any payment(s) prior to Dec. 31, 2020, the payment(s) must be made no later than Dec. 31, 2020.

Take action now

Employers should review compensation arrangements (including bonus and incentive plans; equity compensation; deferred compensation; and change-in-control, severance, and retention arrangements) with this Section 409A language – such as plan documents, award agreements, employment agreements, and even employee communications. Because the 409A provision continues to apply to Section 162(m) arrangements grandfathered from the TCJA, relevant arrangements should be carefully analyzed by a compensation tax specialist to determine which require amendment and payment before the Dec. 31 deadline and which do not. Incorrect analysis (and amendments and payments) can result in adverse tax consequences.

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Veena Murthy
Veena Murthy
Principal, Washington National Tax