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

| 9/20/2018
On Aug. 21, the IRS issued Notice 2018-68, which answers certain questions that were raised after Congress made changes to Section 162(m) of the IRC as part of last year’s tax reform legislation. 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 its covered employees. Before the changes made by Congress, an exception existed 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) 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 closed 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. A contract in effect as of Nov. 2, 2017, but that is terminable or cancelable by the corporation without the employee’s consent is treated as renewed and loses its grandfathering 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.

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 the ability of a corporation to exercise negative discretion will cause 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 not 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 subject to 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 received criticism. It remains to be seen if future guidance will clarify situations in which grandfathering will be maintained when the contract contains negative discretion.

Note that if a corporation has a written binding contract that is grandfathered under the old rules and that qualifies as performance-based compensation under the old rules, it is important not only to avoid materially modifying the contract but also to continue the independent compensation committee and have the committee certify the achievement of performance goals.

Material modifications
As indicated earlier, an arrangement that does qualify under the grandfathering rules may lose its grandfathered status if it is materially modified after Nov. 2, 2017. The notice clarifies that a material modification occurs if a contract is amended to increase the amount of compensation payable.

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Tim Daum
Managing Director, Washington National Tax