The IRS recently released guidance regarding the 2017 Tax Act amendments to Section 162(m) of the Internal Revenue Code, which generally apply to taxable years beginning or after Jan. 1, 2018. IRS Notice 2018-68 provides additional guidance around the definition of “covered employee” and the grandfathering rules for arrangements that were in place before Section 162(m) was amended.
Definition of Covered Employee
The 2017 Tax Act provides that a “covered employee” includes anyone who served as the principal executive officer or principal financial officer (PEO or PFO) of a publicly held company at any time during a taxable year, and any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 due to the employee being among the three highest-compensated officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity).
- The notice clarifies that “covered employee” for any taxable year means any employee who is among the three highest-compensated executive officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity), regardless of whether the executive officer is serving at the end of the publicly held corporation’s taxable year, and regardless of whether the executive officer’s compensation is subject to disclosure for the last completed fiscal year under the applicable Securities and Exchange Commission (SEC) rules.
- The notice also clarifies that, for purposes of identifying a corporation’s covered employees under Section 162(m), it is not relevant whether the SEC scaled disclosure rules for smaller reporting companies and emerging growth companies apply to the corporation.
This may lead to some disconnects between which officers a company reports as its “named executive officers” for a given year in its proxy statements and which officers are “covered employees” for Section 162(m) purposes for that same year.
For example, if a company reports six named executive officers in its proxy statement for a given year — its PEO and PFO; executives A, B and C, who are the three highest-paid executive officers serving at the end of the year; and former executive D, who earned more than executive C for the year but who was not serving as an executive officer at the end of the year — the covered employees for Section 162(m) purposes would be the PEO, the PFO, and executive officers A, B and D (but not executive C).
There may be additional disconnects where a public company’s taxable year does not end on the same date as its fiscal year for SEC reporting purposes — for example, in the case of a merger or acquisition. The IRS has requested additional comments on this issue, but for now has instructed companies to use good faith in seeking to comply with the new requirements in this scenario.
Grandfathering Rules
The 2017 Tax Act provides that its amendments to section 162(m) do not apply to remuneration payable under a written binding contract that was in effect on Nov. 2, 2017, and is not modified in any material respect on or after such date.
- Written Binding Contract The notice clarifies that remuneration is payable under a written binding contract that was in effect on Nov. 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.The amendments apply to any written binding contract renewed after Nov. 2, 2017. A contract that is subject to termination at the unilateral discretion of the company — for example, an employment agreement that is automatically renewed unless either the employee or the company provides notice of nonrenewal — is treated as renewed on the date that such termination could have been effective, unless the contract can be terminated only by also terminating the employee’s employment.Compensation paid pursuant to a binding compensation plan in effect on Nov. 2, 2017, may be grandfathered even if the employee did not participate in the plan on Nov. 2, 2017, as long as the employee was employed by the company sponsoring the plan on that date and had the right to participate in the plan under a written binding contract.
- The notice clarifies that remuneration is payable under a written binding contract that was in effect on Nov. 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.
- The amendments apply to any written binding contract renewed after Nov. 2, 2017. A contract that is subject to termination at the unilateral discretion of the company — for example, an employment agreement that is automatically renewed unless either the employee or the company provides notice of nonrenewal — is treated as renewed on the date that such termination could have been effective, unless the contract can be terminated only by also terminating the employee’s employment.
- Compensation paid pursuant to a binding compensation plan in effect on Nov. 2, 2017, may be grandfathered even if the employee did not participate in the plan on Nov. 2, 2017, as long as the employee was employed by the company sponsoring the plan on that date and had the right to participate in the plan under a written binding contract.
The notice does not directly address whether a contract that provides for “negative discretion” — that is, discretion to reduce or eliminate a payment entirely at the discretion of the company, common in pre-2018 executive compensation arrangements to facilitate compliance with the old Section 162(m) rules — prevents an arrangement from qualifying as a written binding contract. However, there is an example in the new guidance that suggests that arrangements that provide for negative discretion based on subjective factors may fail to qualify for the grandfathering rule except to the extent there is a minimum required payment. Ultimately, this question may require an analysis of applicable law — state contract law, in most cases — to determine whether the arrangement can be considered grandfathered.
For a deferred compensation plan that provides that the plan may be amended prospectively to stop or reduce the amount of future credits to the account balance in the company’s discretion, but which may not be amended to deprive a participant of any benefit accrued before the date of any such amendment, the notice clarifies that only the benefit accrued through Nov. 2, 2017, would be considered grandfathered.
The notice also indicates that if a grant of equity awards is promised before Nov. 2, 2017, but the grant is subject to the approval of the company’s board of directors, the promise to grant the equity award would not constitute a written binding contract for purposes of the grandfathering rules.
- Material Modification The notice clarifies that a material modification occurs when the contract is amended to increase the amount of compensation payable to the employee.If a contract is materially modified, only amounts received subsequent to the material modification are treated as paid pursuant to a new contract.A modification of the contract that accelerates the payment of compensation is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Similarly, a contract modification that defers the payment of compensation is a material modification unless the additional amount of compensation is based on either a reasonable rate of interest or a predetermined actual investment.The adoption of a supplemental contract that provides for increased compensation, or the payment of additional compensation, is a material modification of a written binding contract if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the existing contract, unless the supplemental payment does not exceed a reasonable cost-of-living increase over the payment made in the preceding year under the existing contract.For example, a material increase in the base salary provided for under an employment agreement would likely constitute a material modification of the employment agreement; however, somewhat surprisingly, the grant of an equity award in lieu of an increase in salary likely would not be treated as a material modification of the employment agreement, because the equity award is not paid based on the same elements or conditions as the salary.Failure to exercise negative discretion is not treated as a material modification of a written binding contract.
- The notice clarifies that a material modification occurs when the contract is amended to increase the amount of compensation payable to the employee.
- If a contract is materially modified, only amounts received subsequent to the material modification are treated as paid pursuant to a new contract.
- A modification of the contract that accelerates the payment of compensation is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Similarly, a contract modification that defers the payment of compensation is a material modification unless the additional amount of compensation is based on either a reasonable rate of interest or a predetermined actual investment.
- The adoption of a supplemental contract that provides for increased compensation, or the payment of additional compensation, is a material modification of a written binding contract if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions as the existing contract, unless the supplemental payment does not exceed a reasonable cost-of-living increase over the payment made in the preceding year under the existing contract.
- For example, a material increase in the base salary provided for under an employment agreement would likely constitute a material modification of the employment agreement; however, somewhat surprisingly, the grant of an equity award in lieu of an increase in salary likely would not be treated as a material modification of the employment agreement, because the equity award is not paid based on the same elements or conditions as the salary.
- Failure to exercise negative discretion is not treated as a material modification of a written binding contract.
Effective Date
The guidance is expected to be incorporated in future regulations that will apply to any taxable year ending on or after Sept. 10, 2018. Any future guidance, including regulations, addressing the issues covered by the notice in a manner that would broaden the definition of “covered employee” or restrict the application of the definition of “written binding contract,” as described in section III.B, will apply prospectively only.
For more information, please contact one of the authors of this alert or any member of the employee benefits practice.