IRS Guidance Addresses Tax Reform Impact on Executive Comp

Among other things, tax reform made changes to the treatment of executive compensation – now the IRS has clarified some aspects – and taken a firmer position than some had hoped on so-called “excessive” employee remuneration.

The Tax Cuts and Jobs Act eliminated the performance-based pay exception to the $1 million deductibility cap and extended 162(m) to more employees and more companies, effective for corporate tax years beginning after 2017.  However, a grandfathering provision excludes amounts paid under written binding contracts in effect on Nov. 2, 2017, unless they are “materially modified” after that date.

The IRS on August 21 issued Notice 2018-68 providing initial guidance on certain aspects on the amended rules for identifying covered employees and the operation of the grandfather rule, including when a contract will be considered materially modified so that it is no longer grandfathered.

“Covered” Comp

In general, the provision enacted as part of the Tax Cuts and Jobs Act expanded the $1 million yearly limit on the deduction for compensation with respect to a “covered employee” of a publicly traded corporation under Section 162(m) to include the principal executive officer, the principal financial officer and the next three highest paid employees.

A Groom Benefits Brief explains how the guidance clarifies that, for purposes of the grandfather rule, compensation is considered payable under a “written binding contract” in effect on Nov. 2, 2017, only if the employer is obligated under applicable law (e.g., state contract law) to pay compensation under the contract if the employee performs services or satisfies applicable vesting conditions.

Groom comments that the guidance is “unfortunate” for those employers that included “negative discretion” provisions in their incentive plans — many of which were designed to meet the performance-based compensation exception under the prior Code Section 162(m) rules.

Discretion “Erring”?

More specifically, Groom notes that compensation will not be considered payable under a written binding contract if the employer is not obligated to pay it under applicable law.  As such, plans that provide the employer with discretion to reduce or eliminate an employee’s compensation – so-called negative discretion – will fail to satisfy the “written binding contract” standard to the extent the compensation can be reduced or eliminated.

While the notice is most significant for the guidance provided on the grandfather rule, Groom notes that it also provides important clarifications on determining who is a “covered employee.” In particular, the notice clarifies that under the new Section 162(m) rules, an employee is a covered employee even if he or she is not serving as an executive officer at the end of the tax year, the firm explains.

Moreover, the notice clarifies that an employee can be a covered employee even if his or her compensation is not required to be reported under the SEC rules. For example, Groom notes that if an employer does not have to file a proxy statement for a tax year because it delists its securities, employees of the employer who otherwise meet the definition of “covered employee” remain covered employees under the new rules.

Groom’s brief also reminds that, once an employee qualifies as a covered employee, the deduction limitation applies to that person so long as the corporation pays remuneration to that person (or to any beneficiaries) – the so-called “once a covered employee, always a covered employee” provision.

“Employers who are relying on the grandfather rule should carefully review their compensation arrangements in light of this new guidance,” the firm advises.

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