Treasury issued proposed regulations on Dec. 16, 2019, to implement changes to Internal Revenue Code (Code) section 162(m). The Tax Cuts and Jobs Act of 2017, P.L. 115-97 (TCJA) significantly amended section 162(m) by changing the definitions of: i) publicly-held corporation; ii) covered employee; and iii) applicable employee remuneration. The TCJA also provided a transition rule for existing compensatory arrangements (the so-called “grandfather rule”). In August 2018 the IRS released interim guidance on amended section 162(m) in Notice 2018-68 (the Notice). The proposed regulations largely follow much of the guidance provided in the Notice, with certain additional clarifications and numerous examples. Following the statutory changes, the regulations focus on the main categories summarized here.
The proposed regulations (consistent with the updated law) define a publicly-held corporation as any corporation that issues securities required to be registered under section 12 of the Securities Exchange Act of 1934 (Exchange Act) or that is required to file reports under section 15(d) of the Exchange Act. Under this definition, the following types of entities may now be subject to section 162(m):
- S corporations;
- Publicly-held subsidiaries;
- Foreign-private issuers;
- Publicly-traded partnerships;
- Affiliated groups with private parent company and public subsidiary or domestic public parent and its foreign private subsidiary (e.g. CFC); and
- Certain disregarded entities of private corporations and qualified subchapter S subsidiaries.
The explanation and examples in the regulations provide insight and bring to light some entities that may have been overlooked since TCJA changed the definitions of publicly traded corporation so companies should closely review these sections before ruling out the applicability of section 162(m).
The TCJA amended the definition of covered employee in section 162(m)(3) to include the following employees: i) the principal executive officer (PEO) or principal financial officer (PFO) at any time during the tax year; ii) an employee whose total compensation is required to be reported under the Exchange Act because such employee is among the three highest-paid officers for the tax year; and iii) any covered employee of the taxpayer (or predecessor) for any taxable year beginning after Dec. 31, 2016. The proposed regulations clarify that the amount of compensation used to identify the three highest-paid officers is determined based on the executive compensation rules under the Exchange Act using the tax year as the fiscal year. It should be noted that under this definition, the PEO and PFO are covered employees by virtue of their positions, whereas the three highest-paid officers are covered employees based on the amount of their compensation. The regulations clarify that because the SEC executive compensation disclosure rules only require disclosure of the three highest-paid executive officers’ compensation, only an executive officer may be a covered employee (including executive officers of disregarded entities and QSubs if those executive officers perform policy making functions for the owner).
The proposed regulations adopt the position set out in Notice 2018-68 that a covered employee means any employee who is among the three highest-compensated executive officers for the tax year regardless of whether: i) the executive officer is employed by the publicly-held corporation on the last day of its tax year; and ii) his or her compensation is subject to disclosure for the prior fiscal year under SEC rules.
It should also be noted that the definition of covered employee applies to anyone who was a covered employee of a predecessor entity for tax years beginning on or after Jan. 1, 2017. The proposed regulations provide that a predecessor of a publicly-held corporation includes:
- The publicly-held corporation, itself, if it was public in a prior tax year (with certain timing rules);
- A publicly-held corporation that is acquired, or the assets of which are acquired, by another publicly-held corporation in the following transactions:
o Reorganizations described in section 368(a)(1);
o Corporate divisions, e.g., where public distributing corporation distributes controlled corporation thus becoming publicly-held in a section 355(a)(1) transaction;
o Stock acquisitions; or
o Asset acquisitions of at least 80% of the fair market value of operating assets. In the case of a deemed asset acquisition under section 336(e) or 338, the corporation is treated as the same corporation before and after the election.
In addition, the regulations provide that these rules are applied cumulatively such that a predecessor includes predecessors of prior predecessors.
Applicable employee remuneration
The TCJA eliminated the exclusions under prior law for commission and performance-based compensation as well as providing that remuneration paid to a beneficiary (and not to the covered employee) is applicable employee remuneration.
The proposed regulations clarify that section 162(m) is not limited to deductions for compensation paid by the publicly-held corporation, it would also cover deductions for compensation paid to the corporation’s covered employees to the extent the corporation is allocated a share of the deduction from a lower tier partnership. Accordingly, section 162(m) applies in the case of a publicly-held corporate partner’s allocated distributive share of the partnership’s compensation deduction even though the corporation did not pay the compensation to the covered employee. Because this issue may come as a surprise, the proposed regulations provide transition relief for this rule with respect to existing compensation arrangements where compensation is paid by a partnership (i.e. in effect on Dec. 20, 2019 and not materially modified after that date), as well as an anti-avoidance rule to prohibit formation or expansion of these types of structures to circumvent section 162(m).
Further, the proposed regulations take the position that compensation earned by a covered employee, through a non-employee position, such as director, is not outside the scope of section 162(m) applicable employee remuneration.
No transition relief
In the case of a privately-held corporation that becomes publicly held, section 162(m) applies to the deduction for any compensation that is otherwise deductible for the taxable year ending on or after the date the corporation becomes publicly held. In effect, the proposed regulations eliminate the transition relief in the prior, pre-TCJA final regulations for newly public entities. As this is a departure from previous regulations (although not a necessarily unexpected one), this lack of transition relief is proposed to apply to corporations that become publicly held after Dec. 20, 2019.
The proposed regulations primarily mirror prior guidance in Notice 2018-68 with respect to the application of the grandfather rule and include illustrative examples.
Amendments under the TCJA generally apply to tax years beginning after Dec. 31, 2017, however they do not apply to remuneration paid pursuant to a written-binding contract in effect on Nov. 2, 2017 that is not materially modified thereafter. The proposed regulations replaced certain examples in Notice 2018-68 with new examples purportedly for clarity and not as a substantive changes to the definitions of written-binding contract and material modification under the Notice. The grandfather rule continues to rely on state law in making the written-binding contract determination and whether the corporation may exercise negative discretion. Treasury and IRS considered comments on applying a safe harbor based upon generally accepted accounting principles but did not adopt that in the proposed regulations.
Examples and provisions in the regulations explain the application of the grandfathered status of account and nonaccount balance plans, and earnings on those plans, as well as severance arrangements.
The regulations include a welcome clarification that the lapse of the substantial risk of forfeiture is not considered a material modification in certain circumstances. The proposed regulations also provide ordering rules for mixed payments, i.e., payments consisting of grandfathered and non-grandfathered amounts.
Coordination with section 409A
The proposed regulations also coordinate with section 409A such that in circumstances in which the service recipient has discretion to delay payment based upon deductibility under section 162(m), the service recipient may delay the scheduled payment of grandfathered amounts without delaying payment of non-grandfathered amounts, and such delay is not treated as a subsequent deferral election.
Taxpayers must amend non-qualified deferred compensation plans by Dec. 31, 2020, in order to remove any provision requiring the corporation to delay a payment if it reasonably anticipates at the scheduled time of payment that the deduction would not be permitted under section 162(m) and not have such amendment result in: i) a material modification for purposes of the grandfather rule; or ii) an impermissible acceleration of payment under regulation section 1.409A-3(j).
Take-away and action items
Overall, the regulations closely match guidance from Notice 2018-68 that many companies have already analyzed for purposes of reporting prior periods. However, new examples and certain clarifications will provide more guidance to some situations that were still not entirely clear under prior guidance. Because most provisions closely match the Notice, most items are proposed to apply to tax years ending on or after Sept. 10, 2018 (i.e., the effective date of the Notice). However, certain positions that are considered departures from previous guidance or previously unaddressed areas are not effective until final regulations are published in the federal register.
Treasury and the IRS are asking for additional comments on the proposed regulations, with a public hearing scheduled in March 2020 so there is still a chance that final guidance will reflect different positions. Nonetheless, most employers will need to carefully review prior section 162(m) positions in relation to the proposed regulations to determine whether any positions will change based upon this new guidance. In particular, the main areas to review include:
• Comparison to entities that are now subject to section 162(m) – this now includes certain entities who have never previously been considered and the examples in the regulations may bring to light entities that have been overlooked since release of the TCJA,
• Review of covered employee groups, especially considering corporate transactions and predecessor rules that are now clarified, and
• Review of grandfathered status of existing arrangements based upon state law determinations.