On Aug. 21, 2018, the IRS released Notice 2018-68, which offers initial guidance on the application of section 162(m), of the tax code, as it was amended by tax reform legislation passed in December 2018 (commonly referred to as the Tax Cuts and Jobs Act, or TCJA).
Prior to TCJA, Section 162(m) limited a publicly held corporation’s deduction for compensation paid to covered employees to $1 million during the taxable year. TCJA significantly changed section 162(m) by:
- broadening the definition of “publicly held corporations”;
- expanding the group of covered employees; and
- repealing the performance-based compensation and commissions exceptions.
However, TJCA provides a transition rule for compensation payable under a written binding contract that was in effect on Nov. 2, 2017, and which is not materially modified after such date.
Notice 2018-68 addresses the amendments to these rule changes and the operation of the grandfather rule. In several areas, the IRS takes the position that section 162(m) is separate from and generally not tied to the SEC rules, except where specifically stated in the statute (for example, in the definition of a company that is public under SEC rules). Thus, where companies have assumed they can use SEC definitions, the Notice sometimes takes a contrary view.
The Notice provides guidance on the following aspects of section 162(m).
- SEC reporting - The Notice provides that where a company does not have to file a proxy statement for a year (in the year the company is delisted, for example), but is still considered public, the company remains subject to the section 162(m) rules.
- Covered Employee - The Notice provides that there is no end-of-year requirement for 162(m)(3)(B). That is, an employee need not be serving the company at the end of the year in order to be treated as a covered employee (the SEC rules use a modified end of year requirement).
- Covered Employee - The Notice emphasizes that an employee who is among the three highest compensated executive officers during the taxable year (other than the PEO or PFO, or an individual acting in such capacity) is a covered employee regardless of whether the executive officer’s compensation is subject to disclosure under the applicable SEC rules.
Based on this position, there is no distinction made between a large company or smaller reporting company / emerging growth company as there is under the SEC rules. In any public company, section 162(m) deduction limits will apply to the PEO, PFO and the three highest paid employees for the year (and to anyone who was a covered employee in 2017 or any later year).
- Covered Employee - The IRS requests comments on the determination of the covered employee group after a merger or acquisition, but an example in the Notice determines that any employee who was a PEO, PFO or one of the three highest paid employees for a short tax year after a transaction will be counted as a covered employee for that tax year (and thus is likely to be the covered employee group going forward).
The Notice addresses a few of the open issues with regard to what is a “written and binding contract.”
- Grandfather rules – The Notice indicates that the current regulation transition rules and material modification rules can be used in determining whether an agreement is a written binding contract under the TCJA grandfathering rules. This is expected and useful, as the regulations have a number of helpful rules for what is or is not a material modification.
- Grandfather rules - The Notice clarifies that only the portion of an agreement under which the company is fully obligated to make a payment is protected by the grandfathered rule. Thus, if an agreement provides that an executive will receive at least $200,000, but the Company could pay another $50,000 under certain circumstances, only the $200,000 that it is legally obligated to pay is protected.
- Grandfather rules – The Notice clarifies that where a contract is binding but has a renewal provision under which the company can make changes after a stated date, the contract is no longer binding (and amounts under the agreement thus no longer grandfathered) once the company could make changes, even if the parties agree not to make such changes.
The Treasury Department and the IRS anticipate that the guidance in this notice will be incorporated in future regulations that will apply to any taxable year ending on or after Sep. 10, 2018. Any future guidance not addressed will apply prospectively.
The Treasury Department and IRS are requesting public comments on future guidance related to these sections. The notice specifically identifies a need for comments on the following issues: (1) the application of the definition of “publicly held corporation” to foreign private issuers (2) the application of the definition of “covered employee” to an employee who was a covered employee of a predecessor of the publicly held corporation, (3) the application of section 162(m) to corporations immediately after they become publicly held either through an initial public offering or a similar business transaction, and (4) the application of the SEC executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year.
Check RSM’s tax reform resource center for the latest analysis on this and other developments related to tax reform.