enue Code of 1986, as amended (Section 162(m)), generally limits to $1 of a nonqualified stock option that does not qualify for the QPBC exemp-. establishing stock option exercise or strike prices may not be determined by a trailing limitations of Section 162(m) of the Internal. The Treasury Regulations, proposed on June 24, 2011, clarify that in order for stock options and rights to qualify as performance-based compensation.
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New Tax Law Affects Exec Comp Deduction, Other Provisions
While the new tax law avoided making major changes to the existing retirement tax provisions, the same cannot be said for the tax treatment of executive compensation and related provisions.
In the event you’ve been avoiding the news for the past two weeks, President Trump signed the Tax Cuts and Jobs Act (TCJA) into law (H.R. 1/P.L. 115-97) on Dec. 22, delivering a nearly $1.5 trillion net tax cut over the 10-year period 2018-2027. The new law affects every segment of the tax code, including corporations, pass-through entities, individual files and estates. However, in order to comply with the budget requirements, the new law includes several revenue raisers to help offset the cost of the changes, including several compensation and benefit changes.
Following are highlights of the key compensation changes, which include:
- modifying the deductibility of so-called excessive employee remuneration;
- extending an excise tax on “excess tax-exempt organization executive compensation";
- modifying the treatment of qualified equity grants;
- changing the holding period for so-called carried interest; and
- increasing the excise tax for stock compensation of insiders in expatriated corporations.
For our previous coverage of the retirement-related provisions and certain other benefits provisions included in the final conference report, click here. In addition, links to some helpful analyses of the key compensation and benefit changes are provided at the end of this post.
Expansion of Code Section 162(m)
One revenue raiser to help offset the cost of the law is a provision to modify the current limitation on so-called “excessive” employee remuneration under Code Section 162(m). Under the provision, 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) is expanded to include the principal executive officer, the principal financial officer and the next three highest paid employees — conforming the definition of “covered employee” with the current SEC reporting rules.
In addition, the current exceptions for commissions and performance-based compensation is repealed, such that the $1 million deduction limit applies to stock options, stock appreciation rights, performance stock units and performance shares. In addition, for a tax year beginning after 2016, 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.
The TCJA also extends the Section 162(m) limit to include all domestic publicly traded corporations and all foreign companies publicly traded through American depository receipts (ADRs), or which are otherwise treated as reporting companies under Section 15(d) of the Securities Exchange Act.
The provision applies to tax years beginning after Dec. 31, 2017. The law includes a transition rule specifying that the changes do not apply to any remuneration under a written binding contract in effect on Nov. 2, 2017, and that is not modified in any material respect. For purposes of this rule, any contract that is entered into on or before Nov. 2, 2017, and that is renewed after such date is treated as a new contract entered into on the day the renewal takes effect.
Excise Tax on Tax-Exempt Organization Exec Comp
The TCJA imposes an excise tax of 21% on compensation in excess of $1 million paid to any of the five highest-paid employees of a tax-exempt organization (or any person who was such an employee in any preceding tax year beginning after 2016). The tax applies to the value of all credit one bank make a payment paid for services, including cash and the cash-value of most benefits.
Remuneration is treated as paid when there is no substantial risk of forfeiture of the rights to such remuneration. In addition, the definition of remuneration for this purpose includes amounts required to be included in gross income under Section 457(f). The conference agreement clarifies that substantial risk of forfeiture is based on the definition under section 457(f)(3)(B) which applies to ineligible deferred compensation subject to Section 457(f).
Accordingly, the tax imposed by this provision can apply to the value of remuneration that is vested (and any increases in such value or vested remuneration) under this definition, even if it is not yet received.
The excise tax also applies to excess “parachute payments,” or payments in the nature of compensation that are contingent on an employee’s separation and, in present value, are at least three times the employee’s base compensation. The base amount would be the average annualized compensation includible in the covered employee’s gross income for the five tax years ending before the date of the employee’s separation from employment.
Parachute payments do not include payments under a qualified retirement plan, a simplified employee pension plan, a simple retirement account, a tax-deferred annuity or an eligible deferred compensation plan of a state or local government employer. The conference agreement also exempts compensation paid to employees who are not highly compensated employees (within the meaning of Section 414(q)) from the definition of parachute payment, and also exempts compensation attributable to medical services of certain qualified medical professionals from the definitions of remuneration and parachute payment.
The provision is effective for tax years beginning after 2017.
Treatment of Qualified Equity Grants
While not a so-called revenue raiser (as described above), the new law includes a provision permitting private companies to allow employees to elect to defer recognition of income attributable to stock received on exercise of an option or settlement of a restricted stock unit (RSU) until an opportunity to sell some of the stock arises. Qualified employees are permitted to defer recognition for up to five years from the date the employee’s right to the stock becomes substantially vested.
If an employee elects to defer income inclusion under the provision, the income must be included in the employee’s income for the tax year that includes the earliest of:
- the first date the qualified stock becomes transferable;
- the date the employee first becomes an excluded employee;
- the first date on which any stock of the employer becomes readily tradable on an established securities market;
- the date five years after the first date the employee’s right to the stock becomes substantially vested; or
- the date on which the employee revokes their inclusion deferral election.
Elections apply only to stock of the employee’s employer and the options or RSUs would have to be granted in connection with the performance of services by the employee. A written plan must provide that at least 80% of the employees of the company would be granted stock options or RSUs with the same rights and privileges. The conference agreement clarifies that the 80% requirement cannot be satisfied in a taxable year by granting a combination of stock options and RSUs, and instead all such employees must either be granted stock options or RSUs for that year.
In addition, certain employees are not permitted to make the election, including:
- a 1% owner during the current year or any of the 10 preceding calendar years;
- anyone who is or has been the CEO or CFO;
- a family member of a 1% owner or a CEO or CFO; or
- one of the four highest compensated officers in any of the 10 preceding taxable years.
RSUs are not eligible for a Code Section 83(b) election and receipt of qualified stock would not be treated as a nonqualified deferred compensation plan for purposes of Section 409A (the exception applies solely with respect to an employee who may receive qualified stock).
The provision applies to stock attributable to options exercised, or RSUs settled, after 2017, subject to a transition rule.
The TCJA includes a provision stipulating that certain partnership interests received in connection with the performance of services are subject to a three-year holding period in order to qualify for long-term capital gain treatment.
Transfers of applicable partnership interests held for less than three years are treated as short-term capital gain. This treatment affects partnership liberty mutual commercial agent login connection with the performance of substantial services to businesses which consist of engaging in capital market transactions or other specified investments.
The conference agreement clarifies the interaction of Section 83 with the provision’s three-year holding requirement. Under the provision, the fact that an individual may have included an amount in income upon acquisition of the applicable partnership interest or may have made a Section 83(b) election with respect to an applicable partnership interest does not change the three-year holding period requirement for long-term capital gain treatment.
Thus, the provision treats as short-term capital gain taxed at ordinary income rates the amount of the taxpayer’s net long-term capital gain with respect to an applicable partnership interest for the taxable year that exceeds the amount of such gain calculated as if a three-year (not one-year) holding period applies. In making this calculation, the provision takes account of long-term capital losses calculated as if a three-year holding period applies.
The provision applies to tax years beginning after 2017.
Increase Excise Tax for Stock Compensation of Insiders in Expatriated Corporations
Under previous law, certain holders of stock options and other stock-based compensation are subject to an excise tax upon certain transactions that result in an expatriated corporation. An excise tax at the rate of 15% was imposed on the value of specified stock compensation paid to certain officers, directors and 10% owners of an expatriated corporation.
The TCJA increases the 15% rate of excise tax to 20%, effective for corporations first becoming expatriated corporations after the date of enactment (Dec. 22, 2017).
Descriptions and analyses of the key retirement, compensation and other benefits changes in the new law include:
Section 162(m) generally limits to $1 million the amount that a public company can annually deduct with respect to remuneration paid to certain covered employees. This deduction limitation, however, does not apply to remuneration that qualifies as “performance-based compensation” or that is paid in accordance with a transition rule that is available to new public companies. The performance-based compensation exemption is commonly used to ensure that all gains resulting from exercising stock options or stock appreciation rights (SARs) will be deductible. The transition rule for new public companies, often referred to as the initial public offering (IPO) transition rule, allows for compensation to be exempt from the $1 million deduction for a limited period of time even though it does not qualify as performance-based compensation.
On March 31, capital one beginner credit card, the Internal Revenue Service (IRS) issued final regulations clarifying that stock options and SARs will only qualify as performance-based compensation if granted under a stockholder-approved plan that includes an individual limit on the number of such awards that a covered employee may receive during a specified period. In addition, only certain types of stock-based compensation are eligible to be treated as “paid” when granted for purposes of qualifying for the exemption under the IPO transition rule. The final regulations largely follow the rules set forth in the proposed regulations issued in 2011, except for the following changes:
- The change to the IPO transition rule described above applies only to stock-based awards granted on or after April 1, 2015.
- The individual limit described above can be structured to also include types of equity awards other than stock options and SARs.
The final regulations did not change the effective date for the requirement to have a shareholder-approved individual per-employee limit for stock options (and, if applicable, SARs). As a result, stock options and SARs granted under a plan without an individual per-employee limit on or after June 24, 2011, will not qualify as performance-based compensation under Section 162(m). Following is a more detailed description of the clarifications made under the final regulations.
Individual Per-Employee Limit
One of the requirements for “performance-based compensation” is that a stockholder-approved plan must set forth the maximum amount of compensation that may be earned by a covered employee. With respect to stock-based compensation, some public companies took the position that this requirement was met by virtue of stockholders approving a share reserve under a plan with a stated term. The idea was that no employee could receive a combination of stock options and SARs that exceeded the maximum number of shares subject to the share reserve. The proposed regulations stated that an aggregate limit on the number of shares that could be granted under a stockholder-approved plan would not meet the requirement for establishing the maximum amount of compensation that may be received by an individual covered employee. The final regulations, citing to the legislative history under Section 162(m), retain this approach and describe the change as not being “substantive.” However, the clarification in the final regulations does not apply to stock options and SARs granted prior to the issuance of the proposed regulations.
Various alternatives exist when structuring an individual per-employee limit for stock options and SARs to comply with Section 162(m) requirements. This limit can apply to these types of awards only or to all types of stock-based awards, whether or not they are intended to qualify as performance-based compensation under Section 162(m). A public company that wants to maximize flexibility for equity grants can have separate limits for stock options/SARs and for full-value awards (e.g., performance shares, performance-based restricted stock and restricted stock units) that are intended to qualify as performance-based compensation. There is no requirement to have an individual per-employee limit for time-based restricted stock or restricted stock units. For public companies that want to have a stockholder-approved restriction on the number of equity awards that are granted to non-employee directors, it is possible (and appropriate) to impose this limit separate from the individual per-employee limit that is used for Section 162(m) compliance.
IPO Transition Rule
The $1 million compensation deduction limitation does not apply to any compensation “paid” pursuant to a plan that existed before the company becomes publicly held, and the company may rely on this transition relief until the earlier of (1) the expiration of the plan, (2) a material modification of the plan, (3) the issuance of all stock that had been reserved under the plan and (4) the first meeting of the stockholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which the IPO occurs (or, in the case of a company that did not have an IPO, the first calendar year after the calendar year in which the company becomes publicly held). For purposes of demonstrating when stock-based compensation has been “paid” for purposes of this special transition rule, Treas. Reg. Section 1.162-27(f)(3) provided that amounts attributable to stock options, SARs and restricted stock would be treated as “paid” upon the grant date. This means that the Section 162(m) deduction limitation would not apply to gains, irrespective of when deductible to the company, as long as the grant occurred during the transition period. The IRS, in private letter rulings, had also ruled that restricted stock units would be treated as “paid” upon grant irrespective of when shares were actually distributed to the participant (click here for additional details).
The final regulations, similar to the proposed regulations, reverse the favorable result in the private letter rulings. Shares issued upon settlement of restricted stock units, performance shares or other similar stock-based deferred arrangements will not qualify for relief under the IPO transition rule unless the share issuance occurs during the transition period—i.e., these types of awards will not be treated as “paid” upon the date of grant. Fortunately, this change will only apply to restricted stock units, performance shares or other similar stock-based deferred arrangements that are issued on or after April 1, 2015. A less generous transition rule had been provided under the proposed regulations.
Public companies with stock-based plans that are intended to comply with the requirements for performance-based compensation should confirm that their plan document sets forth the required individual per-employee limit. If a plan will be submitted to stockholders, companies should consider whether the structure of the limit set forth in the plan meets the company’s needs, both in terms of who is covered by the limit and whether there should be multiple limits.
Public companies that intend to rely on the IPO transition rule should evaluate whether it remains appropriate to grant performance-based restricted stock units or performance shares. In many cases, these awards will result in shares being issued after the end of the IPO transition period. If these awards are settled in stock after the end of this period, valuable tax deductions may be lost. In many cases, use of restricted stock, in lieu of restricted stock units and performance shares, will ensure an exemption from the $1 million deduction limitation as long as the grant occurs before the end of the IPO transition period.
On Dec. 22, President Trump signed into law the 2017 Tax Act, the most comprehensive set of changes to the Internal Revenue Code since 1986. Some of the changes affect executive compensation and employee benefits. Because many of the provisions take effect in 2018, employers should begin evaluating their potential impact as soon as possible.
It is important to note that the employee benefits and executive compensation changes in the 2017 Tax Act are not as sweeping as they could have been. For example, proposals for limiting retirement plan contributions did not make their way into the 2017 Tax Act, and a major proposed revision to the taxation of nonqualified deferred compensation was dropped before the legislation was finalized. (For reference, the 2017 Tax Act is P.L. 115-97. The proposed short title for the Act, the “Tax Cut and Jobs Act,” was dropped before enactment on procedural grounds.) While some of the proposals did not find their way into the final 2017 Tax Act, they are discussed briefly below because they could resurface at some point.
- Modification of Deduction Limit on Compensation for Public Company Executives: The 2017 Tax Act repeals the exception to the Internal Revenue Code Section 162(m) $1 million deduction limitation for commission and performance-based compensation paid to a covered employee of a publicly traded corporation. This exception currently applies to compensation payable to covered employees defined to include the chief executive officer (CEO) and the three other highest-compensated officers, but excluding the chief financial officer (CFO). The 2017 Tax Act revises the definition of covered employee to include the CFO.
The 2017 Tax Act also expands the categories of public companies subject to the deduction limitation. Currently, Section 162(m) applies only to companies with a registered class of securities. Going forward, it also will apply to any company that is required to file public reports with the Securities and Exchange Commission (SEC).
The 2017 Tax Act also provides that, starting with those persons who are covered employees for 2017, once an officer becomes a covered employee, he or she remains a covered employee forever. This means that deferred compensation still would be subject to the $1 million deduction limitation even if paid in a year after the officer ceases to be CEO, CFO or one of the top-paid officers. The 2017 Tax Act treats beneficiaries of covered employees as covered employees for this purpose. Effective Date — applies for tax years beginning after Dec. 31, 2017. However, compensation paid pursuant to a written binding agreement in effect on Nov. 2, 2017, that has not been materially modified thereafter is grandfathered and can continue to qualify for the performance-based compensation exemption, assuming all other Section 162(m) requirements are met.
Practice Note: Companies should review incentive plan documents and policies to determine what changes may be necessary to reflect the new Section 162(m) rules. Compensation committee charters and directors and officers liability insurance (D&O) questionnaires also should be reviewed and revised, if necessary. Compensation discussion and analysis sections (CD&As) for 2018 proxy statements should be reviewed to determine if any changes are advisable related to the Section 162(m) discussion. Companies should catalog grandfathered arrangements and implement processes to ensure that such arrangements are not unintentionally materially modified. Companies should also re-examine incentive compensation plan designs in light of the new Section 162(m) rules (including equity grant design and practices), as the new rules offer significant new flexibility and, at the same time, may make some practices (such as stock options) less attractive than before. carolina designs realty corolla nc
- New Tax on Excessive Executive Compensation Paid by Tax-Exempt Organizations: The 2017 Tax Act imposes a 21 percent tax on most tax-exempt organizations — including most state governmental organizations and political subdivisions thereof — on compensation in excess of $1 million and any golden parachute compensation paid to the organization’s covered employees, defined to include the five highest-paid executives for the current taxable year or any preceding year after 2016. The tax is imposed on the organization, not the employee (which would have been the case under earlier versions of this provision).
The provision takes into account all W-2 wages paid to any such executive in a taxable year, excluding designated Roth contributions under qualified retirement plans, but specifically including wages under a Section 457(f) deferred compensation plan. There is no grandfathering rule in the 2017 Tax Act for existing arrangements, although the Treasury Department and IRS may consider adding such a rule when implementing regulations are developed.
For purposes of the tax on excess golden parachute payments, an excess parachute payment generally includes a payment contingent on the executive’s separation from employment with an aggregate present value of at least three times the executive’s base compensation. Similar to existing golden parachute rules for taxable organizations under Section 280G, the base amount is equal to the executive’s trailing five-year average W-2 compensation. Effective Date — applies for tax years beginning after Dec. 31, 2017.
Practice Note: Covered tax-exempt organizations should determine who their covered executives are and begin cataloging executive compensation arrangements for those officers to determine if and when the tax imposed by the 2017 Tax Act would apply. This may include employment agreements, Section 457(f) deferred compensation plans, severance agreements, and annual or long-term incentive arrangements, in addition to salary and taxable benefits. Organizations should also monitor regulatory developments, as the IRS is likely to offer significant interpretive guidance under the statute when it issues regulations. Since the golden parachute tax rules are designed to track the existing golden parachute tax rules for taxable entities under Section 280G, organizations may want to familiarize themselves with those rules or seek guidance from outside experts already familiar with the Section 280G provisions.
- Qualified Equity Grants: The 2017 Tax Act offers a significant new tax planning opportunity for private companies that widely distribute stock options or stock-settled restricted stock units (RSUs) to their employees.
If a company distributes stock options or RSUs to at least 80 percent of its U.S. employees (determined on a controlled group basis), an employee (other than a 1 percent shareholder, the CEO or CFO or one of the top four most highly compensated officers at any time during the current or previous 10 years) can elect to defer the income tax associated with the stock option exercise or RSU settlement for up to five years after the option exercise or RSU settlement date. If the stock delivered upon option exercise or RSU settlement is unvested and nontransferable, the employee can defer the tax for up to five years after the stock vests or becomes transferable. The amount of income tax will be based on the value of the shares at the time of option exercise or RSU settlement (or at the time of vesting or transferability, if later). Options or RSUs granted after 2017 must have the same rights and privileges (other than grant size, provided that each employee receives more than a de minimis grant) to qualify for this rule.
The provision applies only to corporations, not limited liability companies taxed as partnerships, and only to grants made to employees. In addition, the favorable tax treatment does not apply if the stock is transferable when it is issued, — including to the employer. An employer is required to give notice to an employee who is issued qualified employer stock and the employee has 30 days after receiving the stock to make the election and may revoke the election at any time. The new rule applies in addition to (and does not supersede) the existing Section 83(b) election regime and the rules relating to qualified stock options (incentive stock options or ISOs, and employee stock purchase plans) — however, the rules cannot be combined. For example, if an employee elects to take advantage of the new rules with respect to an ISO, the ISO treatment 162 m limitation and stock options. Effective Date — applies to stock options exercised or RSUs settled after Dec. 31, 2017.
Practice Note: The new rules offer a potential planning tool around the existing problem with employees of private corporations having to pay income taxes on illiquid shares they receive from incentive awards. However, the requirement that companies have to issue awards to at least 80 percent of their employees may make the new rules unattractive for many companies and relatively limited in application. For a certain type of private company, however, that broadly issues equity awards to its employees or is contemplating doing so, these rules are worth serious mls property search.
Retirement Plans and Individual Retirement Accounts (IRAs)
- Longer Period for Rollover of Certain Plan Loan Offsets: The 2017 Tax Act extends the time period in which employees, whose plans terminate or who separate from employment with outstanding plan loans, may contribute an amount equal to the unpaid balance of such loans to an IRA to avoid that amount being treated as a distribution to the employee. A plan loan is considered outstanding until it is repaid or “offset.” Offset occurs when the participant’s remaining plan balance is used to repay the loan, thus resulting in a deemed distribution to the participant of the repaid loan amount. Deemed distribution can be avoided if the participant’s plan benefits are eligible for rollover and an amount equal to the offset amount is included in the rollover. Previously, such amounts could only be rolled over to an IRA during the 60-day period beginning on the date offset occurred. The 2017 Tax Act extends the deadline for rollover to the due date of the employee’s tax return for the year the plan terminated or the employee separated from employment (as applicable). Effective Date — applies to loan offsets that arise in tax years beginning after Dec. 31, 2017.
Practice Note: Employers that sponsor plans allowing for loans should consider whether plan participant communications should be revised early next year to alert participants to the greater flexibility allowable for rollover of loan offset amounts.
- Repeal of Roth IRA Recharacterizations: The 2017 Tax Act repeals a special rule permitting recharacterization of Roth IRA contributions or conversions as instead having been made to traditional IRA amounts. As a result, a popular technique to unwind Roth IRA conversions will cease to be available. The 2017 Tax Act keeps in place provisions allowing for recharacterization of other contributions, thereby continuing to allow recharacterization of a Roth IRA contribution as a contribution to a traditional IRA. Effective Date — applies for tax years beginning after Dec. 31, 2017.
- Length of Service Award Programs for Public Safety Volunteers: Section 457 provides special tax treatment for certain programs designed to benefit public service volunteers (i.e., those who provide firefighting, emergency medical and ambulance services). The maximum annual benefit limit for such programs is increased under the 2017 Tax Act from $3,000 to $6,000, subject to adjustment for cost-of-living increases. Effective Date — applies for tax years beginning after Dec. 31, 2017.
Other Employer-Provided Benefits
- Qualified Moving Expenses: Employers now will be precluded from reimbursing employees on a tax-free basis for eligible moving expenses (except for certain moves by members of the armed services). Effective Date — applies for tax years 2018 to 2025.
- Employee Achievement Awards: Certain awards granted to employees in recognition of length of service or safety achievement are not taxable to the employee and are deductible by the employer. The 2017 Tax Act clarifies that the following types of awards do not qualify for this special tax treatment: cash, cash equivalents, gift cards, gift coupons or gift certificates (other than arrangements conferring only the right to select and receive tangible personal property from a limited array 162 m limitation and stock options such items preselected or preapproved by the employer), vacations, meals, lodging, tickets to theater or sporting events, stocks, bonds, other securities, and other similar items. Effective Date — applies to amounts paid or incurred after Dec. 31, 2017.
- Individual Mandate Tax Penalty Under the Affordable Care Act (ACA): The 2017 Tax Act effectively repeals the tax penalty assessed on individuals for not obtaining health coverage by reducing the penalty to zero. Effective Date — applies for months beginning after Dec. 31, 2018.
Practice Note: Changes to ACA rules that directly affect employer-provided health coverage were not enacted, such as the employer mandate and the so-called “Cadillac Tax” on high-value health plans. Because the employer mandate remains in effect, covered employers must continue to offer health coverage in order to avoid penalties. However, the effective repeal of the individual mandate may result in reduced enrollment through the ACA exchange and thereby reduce potential exposure for some employers to employer mandate penalties. In addition, the repeal of the individual mandate may provide increased initiative for later legislative action to modify or repeal the employer mandate.
- Qualified Transportation Benefits: Employees are not taxed on and employers may deduct the cost of “qualified transportation fringes” (i.e., certain commuting and parking benefits). Under the 2017 Tax Act, employers can continue to provide qualified transportation fringes to employees on a tax-free basis, except for bicycle commuter reimbursements. Employers will no longer be able to deduct the cost of any qualified transportation fringe. Effective Date — the repeal of the exclusion for bicycle commuter reimbursement applies for tax years 2018 to 2025. The elimination of the employer deduction for all qualified transportation fringes applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017.
- Expenses for Entertainment and Meals: Under prior law, employers were generally permitted to deduct up to 50 percent of entertainment and meal expenses directly connected to a business activity. In addition, employers generally could deduct meals furnished on premises for their convenience. The 2017 Tax Act eliminates the deduction for entertainment expenses. The deduction for meal expenses (subject to the same prior law 50 percent limit) remains in effect, as does the deduction for meals provided for the convenience of the employer (but only until 2025). Effective Date — applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017. The repeal of the deduction for meals provided at the convenience of the employer will apply to amounts paid or incurred after Dec. 31, 2025.
- Certain Fringe Benefits Provided by Tax-Exempt Employers: The 2017 Tax Act creates new rules requiring tax-exempt employers to be taxed on the value of qualified transportation fringes, on-premises gyms and other athletic facilities they provide to their employees. The value of those benefits will now be treated as unrelated taxable income. Effective Date — applies to amounts paid or incurred for tax years beginning after Dec. 31, 2017.
- New Tax Credit chase bank mortgage clause address Paid Leave: Employers will be eligible for a business tax credit equal to 12.5 percent to 25 percent of the wages they pay to certain employees on qualified family and medical leave. To be eligible, an employer must pay employees on leave at least 50 percent of their hourly rate of pay (or a prorated amount for those not paid hourly) and must provide at least two weeks of paid leave per year. The amount of the credit increases by a quarter of a percent for every percent above the minimum 50 percent rate of pay and is capped at 25 percent for leave pay equal to 100 percent of regular pay. Effective Date — applies to tax years 2018 and 2019.
Significant Reform Proposals Not Contained in the 2017 Tax Act
Unlike earlier versions of tax reform, the 2017 Tax Act does not alter the existing tax rules for nonqualified deferred compensation plans under Section 409A. These complex rules, which expose employees to severe adverse tax consequences if nonqualified arrangements fail to comply in form or operation, will continue to apply to such arrangements going forward. The existing tax regime for nonqualified arrangements of tax-indifferent entities under Section 457A also remain in place.
Despite early indications that tax reform might spell doom for the existing favorable tax regime for equity awards in the form of “profits interests” granted to individuals performing services for a partnership or a limited liability company taxed as 162 m limitation and stock options partnership, the 2017 Tax Act leaves the existing profits interest regime mostly intact. It changes only the holding period, from one year to three years, for profits interests to qualify for long-term capital gains treatment, and then only for a capital-raising or investment-related trade or business.
Early versions of the 2017 Tax Act targeted for repeal the tax exclusion for a number of popular employer-provided benefits, such as qualified educational assistance, dependent care assistance and adoption assistance programs. None of those proposals were enacted.
For further information about the 2017 Tax Act and the considerations noted above, please contact any of the members of the McGuireWoods employee benefits and executive compensation team.
New 162(m) Guidance: IRS Notice 2018-68 Clarifies Scope of Tax Reform and Transition Rules
Section 162(m) of the Internal Revenue Code denies a tax deduction to a public company for compensation paid to certain individuals—called “covered employees ”—to the extent that the compensation paid to such individual exceeds $1,000,000 for the taxable year.
In 2017, Section 162(m) was amended to, among other things:
- Expand the definition of a “covered employee”,
- Expand the definition of a “public company” subject to Section 162(m), and
- Apply the 162(m) deduction limitation to commission pay and performance-based compensation, which had been previously exempted from the 162(m) deduction limitation.
These 2017 amendments apply to all taxable years beginning on or after January 1, 2018. However, an exception to this rule provides that compensation payable pursuant to written binding contracts in force as of November 2, 2017, will remain subject to the 162(m)deduction limitations that were in effect prior to the 2017 amendments, until such contracts are materially modified (referred to in this client alert as the “grandfathering rule ” and “grandfathered compensation ”). Please see our prior client alert for additional details, “Congress Approves Tax Reform Bill Impacting Equity Compensation.”
On August 21, 2018, the IRS issued Notice 2018-68 which clarified the scope of the 2017 amendments. These clarifications are effective for taxable years ending on or after September 10, 2018. A summary of key points follows:
- Covered Employees Interpreted Broadly. The passumpsic savings bank lyndonville vt amendments expanded the definition of a “covered employee” to include an employee of a public company who:
- Served as the principal executive officer or the principal financial officer of the company (or acted in such capacity) at any time during the taxable year,
- Is the among the three highest compensated executive officers for the taxable year (other than an individual described in (1)), or
- Was a covered employee of the company or a predecessor at any time after December 31, 2016 (this includes an individual who was a covered employee for 2017 as determined under the pre-amended rules).
- Grandfathering Rule Interpreted Narrowly. The relief provided by the grandfathering rule is narrow. Specifically, compensation will not be treated as payable pursuant to a “written binding contract,” and as such will not be grandfathered, to the extent that the amount of the compensation can be decreased in the company’s discretion after November 2, 2017. Compensation will also not be grandfathered if the grant of the compensation remained subject to a condition as of November 2, 2017, such as a grant that is subject to board approval. Examples of the narrow relief are provided below.
As described above, the 2017 amendments provided that compensation payable pursuant to a grandfathered contract becomes subject to the new Section 162(m)deduction limitation rules once the contract is “materially modified.” The new IRS guidance defines a “material modification” to mean an amendment to increase the compensation payable to the employee under the contract. However, the new IRS guidance provides limited exceptions to this rule for reasonable cost of living increases and additional compensation paid on the basis of elements or conditions that are not substantially the same as the elements or conditions that are the basis for grandfathered compensation.
- Grandfathering. When applying the grandfathering rule, the first consideration should be whether the covered employee would have been a covered employee for the taxable year if the pre-amended rules had continued to apply.
We expect the grandfathering rule to have the greatest impact when the covered employee wouldnot have been a covered employee for the taxable year under the pre-amended rules.1 In this case, all compensation under a grandfathered contract (even non-performance based) will remain deductible until the contract is materially modified.
The grandfathering rule will also apply in the case of a covered employee who would have been a covered employee for the taxable year under the pre-amended rules. However, in this case, grandfathered compensation will remain deductible onlyif such compensation would have qualified as deductible performance-based compensation under the pre-amended rules, and only until the grandfathered contract is materially modified.
- Negative Discretion. Under the pre-amended rules, many performance-based arrangements provided for shareholder approval of a reach target and allowed the compensation committee to use negative discretion to arrive at a lower actual payout. As described above, Notice 2018-68 provides that performance-based compensation under this type of plan will be grandfathered only to the extent that the compensation was not subject to the company’s negative discretion as of November 2, 2017. For example, if a plan established in early 2017 allowed the company’s compensation committee to apply negative discretion to reduce a payout to a covered employee to $0, then none of the compensation payable pursuant to this plan will be grandfathered.
- Recordkeeping. Public companies will now need to implement robust compensation recordkeeping protocols for a greater number of employees. This is because public companies will be required to identify their three highest compensated executive officers (other than their principal executive officer and principal financial officer) in accordance with the SEC’s compensation disclosure framework, even if those persons are not subject to SEC disclosure rules. This includes smaller reporting companies and emerging growth companies, despite the scaled-down SEC compensation disclosure requirements that apply usaa fed savings bank address these companies.
- Incentive Stock Options. When an employee exercises an incentive stock option, he or she has no ordinary taxable income upon exercise, and if the shares are held for requisite holding periods, the sale proceeds are capital gains. As a result of the 2017 amendments, many public companies may no longer receive a deduction when their executive officers exercise their stock options. Since the company would stand to lose the deduction under Section 162(m) anyway, this may make incentive stock options more attractive.
- Alternative Forms of Compensation. A grandfathered contract will be considered “materially modified” if it is amended in order to increase the compensation payable under it. However, it is not a material modification to provide a covered employee with additional compensation in another form—even if that new compensation is subject to the 162(m) deduction limitation under the new rules—so long as the new compensation is paid on the basis of elements or conditions that are not substantially the same as the elements or conditions for grandfathered compensation.2
- More to Come Regarding IPO and M&A Considerations. The recent IRS guidance does not address the application of Section 162(m) to corporations immediately after they become public through an initial public offering or a similar business transaction, or to an employee who was a covered employee of a predecessor of the public company.
Fenwick & West will continue to closely monitor any developments and encourages clients to reach out with questions.
1 For instance, a principal financial officer will qualify as a covered employee for all taxable years beginning after January 1, 2018, but generally was excluded from the 162(m)deduction limitation rules in prior tax years. However, we note that in a Chief Counsel Advice (CCA) legal memorandum issued on August 24, 2015, the IRS concluded that a principal financial officer of a smaller reporting company can be a covered employee for a taxable year if he or she is one of the two highest compensated executive officers of the company. The CCA left open the question of whether the same analysis would apply in the case of a principal financial officer of an emerging growth company.
2 For example, assume that an employee who is not a covered employee receives a written binding commitment on August 1, 2017 to receive $500,000 on June 1, 2018. On January 1, 2018, the employee becomes a “covered employee” due to the tax reform. If the company increases the total payout to $800,000, the entire amount will be subject to the 162(m) deduction limitation. However, if the payment remains $500,000, but the company grants new awards of restricted stock worth $300,000, only the new stock awards will be subject to the 162(m) deduction limitation, and the payout under the original contract will remain grandfathered.
December 22, 2020
Final IRC Section 162(m) regulations have few changes
The IRS published final regulations under IRC Section 162(m) (TD 9932), incorporating Tax Cuts and Jobs Act (TCJA) statutory amendments and making certain other changes to existing rules. The final rules generally follow the proposed rules previously published in December 2019, but there are a few key changes:
- Additional transition relief for a publicly held corporation's distributive share of the deduction for compensation paid by a partnership on or before December 18, 2020 (common in an "Up-C" or "Up-REIT" structure)
- A simplified approach for calculating grandfathered amounts of deferred compensation subject to pre-TCJA rules, making it unnecessary to track losses on amounts deferred as of November 2, 2017
- A different approach to clawbacks, such that the right to recover compensation after it is paid does not affect its grandfathered status
- Clarification that extending the exercise period for a grandfathered stock option or stock appreciation right is not a material modification and does not cause a loss of grandfathered status
The final regulations also include other, less significant new rules and clarifications.
The final regulations generally apply to tax years beginning on or after the date the regulations are published in the Federal Register, although a taxpayer may choose to apply them to tax years beginning after December 31, 2017, if the taxpayer applies them in their entirety and in a consistent manner. There are special applicability dates for some rules, most of which were included in the proposed regulations.
IRC Section 162(m) imposes a $1 million limit on the deduction that a "publicly held corporation" is allowed for compensation paid with respect to a "covered employee." IRC Section 162(m) was originally enacted as part of the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), effective for tax years beginning on or after January 1, 1994. Comprehensive final regulations were published in 1995 (1995 Regulations).
As originally enacted, IRC Section 162(m) defined a "covered employee" as the CEO and the next four highest-compensated officers whose compensation was required to be reported to shareholders under the Securities Exchange Act of 1934 (Exchange Act). When the SEC rules were later amended to require disclosure for the CEO, the CFO and the three highest-compensated officers other than the CEO and the CFO, the IRS concluded that there would be only four "covered employees" in most cases: the CEO and the three highest-compensated officers other than the CEO and the CFO.1 For all "covered employees," the 1995 Regulations imposed a "last day" requirement: compensation (such as severance and deferred compensation) paid to an individual who was no longer a covered employee on the last day of the corporation's tax year was not subject to the $1 million deduction limit.
Only publicly held companies that were required to register their common stock under Section 12 of the Exchange Act were subject to IRC Section 162(m) as it was originally enacted. It did not apply to companies that registered debt, voluntarily registered their common stock or were foreign private issuers traded on US exchanges via American Depository Receipts (ADRs). Moreover, IRC Section 162(m) originally contained a significant exception for performance-based compensation, including cash and stock-based compensation contingent upon the attainment of objective performance goals and meeting other requirements, as well as for most stock options and stock appreciation rights.
The TCJA made several amendments to IRC Section 162(m) to expand its applicability, including:
- Eliminating the exception for performance-based compensation
- Expanding the definition of "covered employee" to include the CFO, plus any individual who had ever been a covered employee of the publicly held corporation or any predecessor for any tax year beginning after December 31, 2016 (thus, under the TCJA amendments, once an individual is identified as a covered employee, the deduction limitation applies to the compensation paid to that individual even after the individual no longer holds that position or has separated from service)
- Expanding the definition of "publicly held corporation" to include certain companies to the extent those companies must report under Section 15(d) of the Exchange Act, including foreign private issuers or private companies that have registered debt offerings
All of these td bank north america headquarters were generally effective for tax years beginning after December 31, 2017, but under a grandfather rule any compensation paid pursuant to a written binding contract that was in effect on November 2, 2017, and not materially modified on or after that date, remains subject to IRC Section 162(m) as it existed prior to the TCJA amendments.
In August 2018, the IRS and Treasury released Notice 2018-68 with guidance on a limited number of issues arising under the TCJA amendments. With respect to the definition of "covered employee," the Notice confirmed that the "last day" rule that applied under the 1995 Regulations was eliminated and, therefore, the compensation of a covered employee may be subject to IRC Section 162(m) in some cases even though it is not subject to disclosure under the SEC rules. The Notice also clarified various aspects of the grandfather rule, generally applying analogous transition rules from the 1995 Regulations (see Tax Alert 2018-1679 for a more detailed description of Notice 2018-68).
Rather than amending the 1995 Regulations to reflect the TCJA amendments, the proposed regulations provided a separate, comprehensive set of rules (see Tax Alert 2019-2229). (The 1995 Regulations continue to apply to grandfathered amounts.) The proposed regulations included: (1) rules related to the TCJA amendments (only some of which 162 m limitation and stock options contained in Notice 2018-68); (2) new rules completely unrelated to the TCJA amendments; and (3) certain existing rules carried over from the 1995 Regulations. The proposed regulations also included more than 80 examples.
Analysis of the Final Regulations
The following sections of this Alert highlight the key rules and definitions set forth in the proposed regulations that were either retained or modified in the final regulations.
Definition of publicly held corporation
Like the 1995 Regulations, the proposed regulations looked to the last day of the corporation's tax year to determine its status as a publicly held corporation. The proposed regulations, however, reflected the TCJA amendments under which a corporation is considered publicly held if any of its securities are required to be registered under Section 12 of the Exchange Act or the corporation is required to file reports under Section 15(d) of the Exchange Act. Under the proposed regulations, a corporation was not considered publicly held while its obligation to file reports under Section 15(d) was suspended. The proposed regulations also clarified that a subsidiary of a publicly held corporation was itself a publicly held corporation and separately subject to IRC Section 162(m) under the affiliated group rules discussed below.
Citing the TCJA amendments and legislative history, the proposed regulations rejected a commenter's suggestion that foreign private issuers be exempt from IRC Section 162(m). The proposed regulations did, however, recognize that a safe harbor for these corporations may be appropriate, given that they are not subject to the SEC executive compensation disclosure rules and thus may incur undue burdens identifying their covered employees.
The proposed regulations generally retained the 1995 Regulations' rules for affiliated groups of corporations. Under those rules, a publicly held corporation included an affiliated group of corporations as defined in Homes for sale fort smith ar Section 1504 (without regard to IRC Section 1504(b)), but each publicly held subsidiary and its subsidiaries (if any) were separately subject to IRC Section 162(m). The proposed regulations included a new rule under which IRC Section 162(m) would apply to a privately held parent corporation with a publicly held subsidiary. The proposed regulations also expanded on the 1995 Regulations' rules for prorating the deduction disallowance among the members of an affiliated group.
The proposed regulations included a new rule for disregarded entities. If a disregarded entity owned by a privately held corporation was an issuer of securities required to be registered under Sections 12(b) or 15(d) of the Exchange Act, the proposed regulations treated the otherwise privately held corporation as a publicly held corporation for purposes of IRC Section 162(m). The proposed regulations included a similar rule for QSubs (certain wholly owned subsidiaries of S corporations).
The final regulations retain the rules from the proposed regulations. Under a new rule, consistent with the proposed rule for QSubs, a real estate investment trust (REIT) that owns a qualified real estate investment trust subsidiary (QRS) is a publicly held corporation if the QRS issues securities required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act. There is no safe harbor for identifying covered employees of foreign private issuers in the final regulations because none was proposed by commenters.
The final regulations modify an example involving the application of IRC Section 162(m) in the case of an individual who is a covered employee for only two of the three publicly held corporations in an aggregated group but who is paid compensation by all three. (This was Example 2 in the proposed regulations, but it is Example 20 in the final regulations.) The aggregate compensation paid by the three corporations is $3 million, and the final regulations conclude that the total deduction disallowance is $1 million, as one might expect. The example in the proposed regulations had concluded that the aggregate deduction disallowance was $1.6 million, which resulted from an allocation method that required double counting of amounts over the $1 million limit. This change was made in response to a comment criticizing the double counting.
Definition of covered employee
The proposed regulations generally followed the methodology for identifying covered employees that was set forth in Notice 2018-68. The IRS and Treasury declined to adopt some comments requesting simplification.
Notice 2018-68 did not address how to identify the three most highly-compensated executive officers if the corporation's fiscal year and tax year did not align, such as when the corporation has a full 12-month fiscal year but a short tax year. Under the proposed regulations, the SEC executive compensation disclosure rules would be applied as if the relevant tax year (a short tax year, for example) were the corporation's fiscal year. This rule was proposed to apply to tax years beginning on or after the publication of the proposed regulations in the Federal Register (December 20, 2019).
Notice 2018-68 also did not address how to identify the predecessor of a publicly held corporation for purposes of the rule that treats an individual as a covered employee if the individual was a covered employee of the publicly held corporation or any predecessor corporation for any tax year beginning after December 31, 2016. The proposed regulations supplied rules for a variety of corporate transactions: reorganizations, divisions, stock acquisitions and asset acquisitions. These rules were proposed to apply to corporate transactions for which all events necessary for the transaction occurred on or after the date the final regulations were published in the Federal Register. The proposed regulations also would treat a corporation as its own predecessor if it went from being publicly held to being privately held and then back to being publicly held again within a three-year period (if the corporation became publicly held again on or after the final regulations were published in the Federal Register). For the period prior to publication of the final regulations, the proposed regulations permitted reliance on the proposed rule, or any reasonable, good faith interpretation of the term "predecessor," and defined certain examples of what would not represent a reasonable, good faith interpretation.
The proposed regulations also treated employees of disregarded entities and QSubs as covered employees of their corporate owners if those employees were executive officers of the corporate owners under the SEC rules.
The final regulations retain the rules from the proposed regulations, with certain minor additions and clarifications. The final regulations provide rules for identifying the covered employees of a REIT that owns a QRS. The final regulations also clarify that for purposes of determining the predecessor of a publicly held corporation in the context of an asset acquisition the 80% threshold for operating assets refers to gross operating assets and not net operating assets.
Definition of applicable employee remuneration
The proposed regulations provided that "applicable employee remuneration" (referred to in the proposed and final regulations as "compensation" for simplicity) meant: (1) the aggregate amount allowable as a deduction under chapter 1 of the Code for the tax year; (2) determined without regard to IRC Section 162(m); (3) for compensation for services performed by a covered employee; (4) regardless of whether the services were performed during the tax year. The proposed regulations reiterated that compensation includes an amount that is includible in the income of, or paid to, a person other than a covered employee, including after the death of the covered employee.
Among the most significant new rules in the proposed regulations were the rules for partnerships. These rules were unrelated to the TCJA amendments and were not in the 1995 Regulations. The proposed regulations would have applied IRC Section 162(m) to compensation payments made to a covered employee by a partnership to the extent the IRC Section 162 deduction for that compensation was allocated to a publicly held corporation (or its affiliate) based on the corporation's interest in the partnership. This result was contrary to four private letter rulings2 and would effectively subject "Up-REITs" and businesses with so-called "Up-C" partnership structures (in which a publicly held REIT or corporation, as applicable, holds an interest in a lower-tier operating partnership) to IRC Section 162(m) for the first time. This part of the proposed regulations had a special grandfather rule under which IRC Section 162(m) would not apply to compensation paid pursuant to a written binding contract in effect on the date the proposed regulations were published in the Federal Register (December 20, 2019) and not materially modified after that date.
Under the proposed regulations, IRC Section 162(m) would not be limited to compensation paid to a covered employee for services as an employee, but instead would also include compensation for services the individual rendered as an independent contractor. What's more, the preamble to the proposed regulations asserted that this has been the rule since the enactment of IRC Section 162(m) in 1993. To reach that conclusion the IRS and Treasury relied heavily on the OBRA '93 legislative history, which states: "If an individual is a covered employee for a tax year, the deduction limitation applies to all compensation not explicitly excluded from the deduction limitation, regardless of whether the compensation is for services as a covered employee and regardless of when the compensation was earned." House Conf. Rep. 103-213, 585 (1993).
The final regulations retain the rules from the proposed regulations but provide additional transition relief for a publicly held corporation's distributive share of a partnership's compensation deductions. In addition to grandfathering compensation paid pursuant to a written binding contract in effect on December 20, 2019 (and not materially modified after that date), compensation paid on or before December 18, 2020, is not subject to the partnership rule. This date corresponds to the date the final regulations were available on the IRS website, which precedes the Federal Register publication date.
Some practitioners had wondered whether the final rules would be expanded even further to apply IRC Section 162(m) to compensation paid by a partnership's corporate subsidiaries (commonly found in an "Up-REIT" structure where the operating partnership holds a taxable REIT subsidiary). The Preamble, however, affirms that, "[a]ssuming the partnership is respected for U.S. federal income tax purposes, [IRC S]ection 162(m) generally would not apply to compensation paid to a publicly held corporation's covered employee by a corporate subsidiary of a partnership for services performed as an employee of the subsidiary because, in this circumstance, the corporate subsidiary would not be a member of the publicly held corporation's affiliated group."
IPO transition rule
The 1995 Account number for walmart money card provided a transition rule for a corporation that becomes publicly held. While this rule was not limited to initial public offerings (IPOs), it is commonly known as the "IPO transition rule." The Preamble to the proposed regulations explained that the rationale for this rule was tied to the performance-based compensation exception, which the TCJA eliminated. Under the proposed regulations, the IPO transition rule would not apply to corporations that became publicly held corporations on or after the date the proposed regulations were published in the Federal Register (December 20, 2019). Instead, the proposed regulations specified that a privately held corporation that became publicly held would be subject to IRC Section 162(m) for the tax year ending on or after the date that its registration statement became effective under either the Securities Act or the Exchange Act.
The final regulations retain the rules from the proposed regulations and clarify that a subsidiary that was a member of an affiliated group may continue to rely on the transition rule if it became a separate publicly held corporation on or before December 20, 2019.
The proposed regulations retained all the grandfather rules from Notice 2018-68, including some of the same examples.
Notice 2018-68 made clear that compensation was not grandfathered to the extent the corporation was not obligated under applicable law to pay it as of November 2, 2017. Stated differently, compensation with respect to which the corporation retained negative discretion (that is, the legal right not to pay) was not grandfathered.
Notice 2018-68 did not address discretionary clawbacks — compensation that the corporation could require the covered employee to repay only if certain circumstances arise. Under the proposed regulations, otherwise grandfathered payments would not lose their grandfathered status so long as the corporation's right to demand repayment was based on conditions objectively outside the corporation's control and the conditions giving rise to the corporation's right to demand repayment had not occurred. If the conditions did occur, however, then only the amount the corporation was obligated to pay under applicable law (taking into account the occurrence of the condition) would remain grandfathered.
Notice 2018-68 included numerous examples that focused on defined contribution plans. The proposed regulations clarified that the same basic rule applied to both defined contribution 162 m limitation and stock options and defined benefit plans: only the amount of compensation that the corporation was obligated to pay under applicable law on November 2, 2017, was grandfathered. To illustrate the application of this rule, the proposed regulations included new examples involving defined benefit plans and other types of arrangements, such as "linked plans" (nonqualified deferred compensation plans linked to qualified retirement plans) and severance agreements, as well as earnings on grandfathered amounts.
Under the TCJA, an otherwise grandfathered amount loses its grandfathered status if there is a material modification of the written binding contract on or after November 2, 2017. Drawing heavily from the 1995 Regulations, Notice 2018-68 addressed a number of material modification issues. The proposed regulations retained all the rules from Notice 2018-68. One issue Notice 2018-68 did not address, however, was whether acceleration of vesting would be considered a material modification. Under the proposed regulations, the acceleration of vesting was not treated as a material modification.
Notice 2018-68 also did not address how to identify the grandfathered amount when compensation is paid in a series of payments rather than as a lump sum. Under the proposed regulations, the grandfathered amount would be recovered first, and non-grandfathered amounts would be recognized only after the grandfathered amount was fully recovered.
The final regulations generally retain the rules from the proposed regulations, but those rules are expressed using fewer illustrative examples and more operative rules. In addition, there are four key changes to the proposed rules.
First, the final regulations have a different rule for clawbacks. As the Preamble explains, "After further consideration, the Treasury Department and the IRS recognize that the corporation's right to recover compensation is a contractual right that is separate from the corporation's binding obligation under the contract (as of November 2, 2017) to pay the compensation. Accordingly, these final regulations provide that the corporation's right to recover compensation does not affect the determination of the amount of compensation the corporation has a written binding contract to pay under applicable law as of November 2, 2017, whether or not the corporation exercises its discretion to recover any compensation in the event the condition arises in the future."
Second, the final regulations include a new rule under which the grandfathered amount is not required to be reduced for losses after November 2, 2017. Tracking grandfathered amounts is simpler under this rule because it is unnecessary to distinguish investment gains and losses from new plan benefits if the value of the grandfathered benefit falls after November 2, 2017.
Third, the final regulations require the grandfathered amount to be determined on a plan-by-plan basis. Thus, for example, if a participant's grandfathered benefit under one plan is forfeited, the grandfathered amount does not become available under another plan — the grandfathered amount associated with the forfeited compensation is simply lost.
Finally, the final regulations add a rule that extending the exercise period for a grandfathered stock option or stock appreciation right is not a material modification and does not cause a loss of grandfathering, provided that the extension complies with Treas. Reg. Section 1.409A-1(b)(5)(v)(C)(1). A common example is an employer allowing a stock option to be exercised for a short time after an employee separates from service, even though the original terms of the stock option called for the exercise period to end upon separation from service.
Although the final regulations generally apply to tax years beginning on or after the regulations are finalized, there are special applicability dates for certain rules. Where relevant, the special applicability date for each newly proposed rule is identified in the discussion above along with the description of the rule. In addition, the rules contained in Notice 2018-68, nearly all of which were retained in both the proposed and final regulations without substantive changes, apply to tax years beginning on or after September 10, 2018.
The following chart summarizes the final applicability dates:
Tax year for calendar-year taxpayers
Notice 2018-68 rules for covered employees and grandfathering
Tax years ending on or after September 10, 2018
Identifying three highest compensated executive officers when tax year is different from fiscal year
Tax years ending on or after December 20, 2019
Distributive share of partnership compensation deduction
For compensation paid after December 18, 2020
2020 (for compensation paid December 19-31, 2020 that is not grandfathered)
IPO transition rule repealed
Corporation becomes publicly held after December 20, 2019
Depends on transaction date
Predecessor corporation rules for identifying covered employees
Transactions on or after date of publication in the Federal Register
Depends on transaction date
Public to private to public 36-month cooling off period
Corporation becomes publicly held again on or after date of publication in the Federal Register
Depends on date corporation becomes publicly held again
All other rules
Tax years beginning on or after date of publication in the Federal Register
Taxpayers likely will be disappointed by the modest changes to the proposed rules. Commenters had suggested numerous changes that would have narrowed the scope of IRC Section 162(m), thereby allowing taxpayers greater compensation deductions. Nearly all those suggestions were rejected.
The most important change in the final regulations is the additional transition relief for a publicly held corporation's distributive share of a partnership's compensation deductions. As proposed, this rule would have applied retroactively once the final regulations were published. The proposed regulations were published in the Federal Register on December 20, 2019, and this rule 162 m limitation and stock options proposed to apply to tax years ending on or after that date (2019 in the case of a calendar year taxpayer). This put some taxpayers in an awkward position, because they had to file tax returns without knowing whether this rule would be included in the final regulations and applied retroactively as proposed. In many cases, however, this was a moot point, thanks to the special grandfather rule for amounts paid pursuant to a written binding contract in effect on December 20, 2019. Thus, many taxpayers had been expecting 2020 to be the first year the new partnership rule would have any practical effect. The additional transition relief for amounts paid on or before December 18, 2020, likely will allow those taxpayers to avoid applying the partnership rule for one more year. In many cases, this will mean one more year of avoiding the $1 million deduction limit entirely.
Other favorable changes in the final regulations were more modest. These changes include the simplified approach for calculating grandfathered amounts subject to pre-TCJA rules, making it unnecessary to track losses on amounts deferred as of November 2, 2017; the more reasonable approach to clawbacks; and the clarification that extending the exercise period for a grandfathered stock option or stock appreciation right is not a material modification and does not result in a loss of grandfathering.
If there is a silver lining for tax professionals, it is that the final rules are by and large familiar. Indeed, some of the most important rules in the final regulations were carried forward from Notice 2018-68, which was released more than two years ago.
1 Notice 2007-49. With regard to smaller reporting companies (and emerging growth companies), the SEC rules allow for reduced disclosure, generally consisting of three individuals: the CEO and the two highest-compensated officers other than the CEO. The IRS confirmed in CCA 201543003 that the CFO would be considered a "covered employee" subject to IRC Section 162(m) if the CFO's compensation is required to be disclosed as one of the two highest-compensated officers.
2 PLR 200837024, PLR 200727008, PLR 200725014 and PLR 200614002. Since 2010 this has been an issue on which the IRS will not issue rulings, but taxpayers and their advisors have come to their own views based upon the statutory and regulatory rules in effect.
Tax reform legislation expanded the one-million-dollar annual deduction limitation applied to certain compensation paid to top executives of publicly held companies. The result? More disallowed compensation deductions for more companies and on more employees, a higher financial statement cost of compensation, and more work to account properly for the new tax effects in financial statements issued under generally accepted 162 m limitation and stock options principles.
How did tax reform affect the deductibility of, and income tax accounting for, compensation paid to top executives of public companies?
Answer: Previously, Section 162(m) of the Internal Revenue Code imposed a one-million-dollar annual limit on deductible compensation paid to each of up to four top executives employed at year-end by publicly held companies. Commissions and incentive pay meeting certain performance-based criteria could escape limitation. HR 1, commonly known as the Tax Cuts and Jobs Act (TCJA), expanded the application of the one-million-dollar limit to more companies, to more employees, for longer time periods, and to more types of compensation. For financial reporting purposes, to record the correct tax effect on accrued compensation expense, more analysis is needed to determine if that expense will ever be deductible in tax returns. What once were temporary differences that created deferred tax assets now may be permanently nondeductible book-to-tax differences.
Major Changes to Section 162(m)
These changes generally are effective for compensation deductible in tax years beginning after December 31, 2017:
- Companies. Section 162(m) previously applied to corporations issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act). Changes made by the TCJA now encompass issuers of any type of publicly traded security, including debt, as well as certain broker dealers and all foreign companies publicly traded through American depository receipts that north texas vs utah state basketball U.S. federal tax returns.
- Employees. Immediately prior to the TCJA, Section 162(m) covered only four employees—the principal executive officer (PEO) at the close of the taxable year and the three most highly compensated officers for the taxable year other than the PEO or the principal financial officer (PFO), all as defined in reference to the Exchange Act. Now, covered employees are those who were the PEO or PFO at any time during the year as well as those whose compensation must be reported in the company’s proxy statement (or would be required if the company had to file a proxy statement) because they were the three most highly compensated officers other than the PEO or PFO.
- Time period. Prior to the TCJA, compensation was subject to limitation only if it was deductible in a year in which an individual was a covered employee as of the last day of the tax year. The TCJA takes a “once a covered employee, always a covered employee” approach, extending the limitation to compensation paid to the employee, even after death, if he or she had been a covered employee of the taxpayer (or any predecessor) for any tax year beginning after December 31, 2016. Thus, the opportunity is lost to avoid the limitation by deferring payment of compensation until after an executive retires, and the number of covered executives will grow over time.
- Types of compensation. The TCJA removed the exception for commission payments and compensation meeting certain performance-based criteria. Now, all compensation will be subject to the one-million-dollar deduction limitation except qualified retirement plan payments and amounts excludable from the recipient’s gross income (such as employer-provided health benefits and miscellaneous fringe benefits). Amounts paid pursuant to a written binding contract in effect on November 2, 2017, and not materially modified on or after that date 162 m limitation and stock options not subject to limitation if they would not have been limited prior to the TCJA. Until further guidance is provided, considerable uncertainty exists about exactly what contracts would be grandfathered under this transition clause.
What Tax Accounting Analysis Is Required Under GAAP?
Prior to the TCJA, to record the proper tax effect, companies that paid different types of Section 162(m)-limited compensation to their covered executives had to determine an order of priority in applying the annual one-million-dollar limit to that compensation, particularly if some compensation was expensed for financial statement purposes in years before it potentially would be deductible in tax returns. This commonly occurred when a company granted restricted stock that did not meet the performance-based criteria in addition to paying cash salary. For example, assume a calendar-year company that on December 31, 2015, granted to its PEO a restricted stock award that would vest on December 31, 2017. The grant-date fair value was $1.6 million. The company would expense $800,000 of this amount in 2016 and in 2017. In addition, the company peoples trust credit union phone number to pay and expense $1.2 million of cash salary to the PEO in each of 2016 and 2017. Absent Section 162(m), the company would expect to deduct $1.2 million in 2016 and $2.8 million in 2017 but could deduct only one million dollars each year due to Section 162(m). In practice, companies 162 m limitation and stock options this situation would adopt (or have adopted) and apply consistently from year to year one of three accounting policies for determining which items were not deductible:
- Cash first. This policy applies the one-million-dollar limit first to cash compensation deductible in each year. Thus $200,000 of the $1.2 million salary expense would be permanently nondeductible in each year. The entire stock award would be permanently nondeductible, since there is no limit left for it to use in 2017. The $800,000 of book expense each year would be treated as permanently nondeductible, instead of as a temporary difference creating a deferred tax asset.
- Stock first. This policy applies the limit first to any stock compensation expected to be deductible in the year. Since no stock compensation vests in 2016, that year’s entire limit is applied to the 2016 cash salary, leaving $200,000 of it as permanently nondeductible. The 2017 stock award vest would use the entire 2017 limit before any 2017 cash salary. Thus, the $800,000 expensed in 2016 ultimately would be deductible, and in 2016 it would be treated as a temporary difference creating a deferred tax asset. In 2017, $200,000 of the stock award’s additional $800,000 expense would be deductible, and thus it would be treated as a temporary difference until the vest date, with the remaining $600,000 treated as permanently nondeductible. Alternatively, the company could have taken the approach that 62.5 percent ($1 million of $1.6 million), or $500,000 of each year’s $800,000 stock award expense, was deductible. Either way, the entire 2017 cash salary would be permanently nondeductible.
- Pro rata. This policy allocates the one-million-dollar limit between both types of compensation expected to be deductible in a given year. As with the other two approaches, the entire 2016 limit is allocated to the 2016 cash salary, as no stock compensation is scheduled to vest then. The 2017 limit divided by the entire $2.8 million potentially deductible in 2017 ($1.2 million cash salary plus $1.6 million restricted stock vesting) equals 35.7 percent. Thus, 35.7 percent of the 2017 cash salary, and 35.7 percent of the $800,000 stock compensation expense in each of 2016 and 2017, would be treated as deductible.
A company should update its analysis at the end of each period for any changes in expected compensation expense. For example, if the number of restricted shares to vest depended upon meeting certain performance targets (albeit still not qualifying as performance-based for tax purposes), the company would update the amount of total compensation expense for changed expectations regarding target achievement. However, the analysis should always use the per-share grant-date fair value, ignoring any changes in market value that might affect the ultimate deduction amount. Changes to the potential tax deduction caused by market value changes would be dealt with discretely only in the quarter of actual settlement of a stock-based award.
After the TCJA, these same principles should guide accounting for the tax effects of executive compensation, and companies should continue to apply consistently any policies already adopted. However, changes initiated by the TCJA will add considerable complexity to scheduling the expected ultimate resolution of all compensation.
Prior to the TCJA, stock options typically met the performance-based criteria and thus were not a factor 162 m limitation and stock options the analysis described here. Now, unless grandfathered into prior treatment, deductibility of the expense of nonqualified stock options (NSOs) must be analyzed for limitation. For example, assume that on January 1, 2018, the PEO was granted non-grandfathered NSOs that had a grant-date fair value of $500,000, vested in two years, and expired on the earlier of January 1, 2030, or thirty days after the PEO terminated employment. The company would expense $250,000 in each of 2018 and 2019 and must determine whether to treat this expense as a temporary deductible difference or as permanently nondeductible, following any of the above policies already adopted. The most challenging aspect may be estimating when the NSOs might be exercised, thus creating the potential deduction event. Companies should consider using the same exercise assumptions employed when computing the fair value of the options at grant date.
Prior to the TCJA, supplemental employee retirement plans (SERPs) and compensation deferred under other nonqualified plans escaped the Section 162(m) limitation, because payouts typically occurred (and were deductible) after the executive was no longer a covered employee. Now, unless grandfathered, these payments will be subject to the limitation. Expected payout schedules will have to be created and analyzed to determine if amounts currently expensed for these plan obligations are temporary deductible differences or permanently nondeductible.
Annual cash bonuses often escaped limitation prior to the TCJA, either because they met the performance-based criteria or the executive deferred the payment to post-employment via a nonqualified plan. Again, unless grandfathered, these payments now will be subject to limitation. If a company’s bonus plan does not meet the criteria for deduction in the year of accrual (but does in the following year when paid), companies should follow a consistent policy for ordering the use of the one-million-dollar limit between current-year cash salary and prior-year bonus paid and deductible in the current year.
How Might the New Rules Change Executive Compensation Plans and Behaviors?
Lost tax deductions are unlikely to drive companies to pay their top executives less, given the competition to attract and retain top talent and the lower value of any tax deduction at the new twenty-one-percent corporate tax rate. However, the new rules might spur other behavioral changes. For example:
- Companies will have more flexibility in setting the criteria to use for performance-based compensation, because staying within the parameters for deductibility is no longer relevant. One item in particular, a company’s discretion to increase an award, precluded qualification for the pre-TCJA Section 162(m) performance-based exception. This feature now might appear more often.
- The mix of base versus incentive pay might change, because performance criteria no longer drive deductibility.
- Executives who previously agreed to defer portions of their compensation to nonqualified plans so the company could retain a deduction might see future deferrals as no longer necessary. Alternatively, pressure might increase to defer but elect payout over time versus taking a lump sum payment upon termination, thereby increasing the number of one-million-dollar annual limitations to support deductibility.
- Companies might be reluctant to modify older plans so as to save grandfathered deductions of future compensation payments.
If and how companies will revise compensation packages remains to be seen. It likely will take time for tax professionals to refine the new tax accounting analysis necessitated by the TCJA’s changes to Section 162(m), especially in light of the uncertainty noted earlier about applying the grandfathering provision to existing compensation arrangements. One thing is certain, however: there is increased cost, in terms of time and tax dollars, for paying executives the big bucks.
Sheryl VanderBaan, CPA, is a tax partner at Crowe LLP, one of the largest public accounting, consulting, and technology firms in the United States. Julie Collins, CPA, is a senior manager in the Crowe assurance professional practice
Section 162(m) Compliance Alert - Do You Need to Seek Shareholder Approval of Your Incentive Plan in 2014?
Annual Reminder - If the corporation’s equity or annual incentive plan was last approved by shareholders in 2009, the plan(s) must be submitted to shareholders for re-approval in 2014 in order to ensure that future awards qualify as performance-based compensation under Section 162(m).
Compensation paid by a publicly-traded corporation to its CEO and three other highest compensated officers (other than the Principal Financial Officer) is generally not deductible to the extent it exceeds $1,000,000 per year. This limitation, however, does not apply to qualified performance-based compensation that complies with the requirements of Section 162(m).
There are numerous conditions that must be satisfied for awards to be considered performance-based compensation. Recent IRS audit activity in this area continues to reveal a number of common failures, including: (i) making mid-year changes to performance goals; (ii) making adjustments to the performance goals that were not pre-determined (e.g., adjusting for subsequent events); (iii) failing to obtain shareholder re-approval of the plan; (iv) paying awards out upon retirement or an involuntary termination regardless of whether the performance goals were satisfied; (v) using performance measures that are not included in the shareholder approved plan; (vi) paying out the compensation before the compensation committee certifies in writing that the performance goals were obtained; and (vii) issuing stock options in excess of plan limits.
In an effort to assist employers in their compliance efforts, set forth below are a few action items that employer’s should consider in order to enhance compliance.
What Can Employers Do to Enhance Compliance With Section 162(m)?
Shareholder Re-Approval of 2009 Plans: Where a plan allows the compensation committee to establish the performance goals and targets from year to year (as many plans commonly do), Section 162(m) requires that the performance goals be disclosed and re-approved by shareholders every five years. If the corporation’s equity or annual incentive plan was last approved by shareholders in 2009, the plan(s) must be submitted to the shareholders for re-approval in 2014 in order to ensure that future awards qualify as performance-based compensation under Section 162(m).
Review Proxy Disclosures: Plaintiffs’ attorneys continue to bring derivative suits against corporations and their boards challenging the corporation’s compliance with Section 162(m). The lawsuits allege, among other claims, that (i) the corporation failed to comply with the procedural requirements of Section 162(m), and (ii) the corporation’s proxy contained false and misleading statements by failing to disclose that awards violated the terms of the plan and/or did not qualify as performance-based compensation. Corporations should carefully review their proxy disclosures to ensure that they do not suggest or imply that the corporation’s plan and awards will qualify as performance-based compensation under Section 162(m). The use of language such as “may comply” or “is intended to comply” may protect the corporation from allegations of false or misleading statements in the proxy materials. Additionally, disclosures for shareholder approval or re-approval of a plan should be rigorously reviewed to ensure that they are drafted in compliance with the requirements of Section 162(m).
Update/Establish Grant Procedures: Several recent targets of derivative suits contain Section 162(m) claims involving the issuance of equity or incentive awards in excess of the plan’s specified limits. In several cases where the plan’s limits were exceeded, the Company and the executive agreed to rescind the grants that exceeded the limit in order to avoid the costs and distraction of litigation. Therefore, corporations should establish and/or update grant procedures to ensure that awards are made in compliance with the plan’s terms and that award limits are properly monitored.
Appoint a Section 162(m) Compliance Administrator: In light of the technical nature of Section 162(m), corporations should consider designating a compliance administrator in the corporation’s tax or legal department to assume overall responsibility for monitoring compliance with Section 162(m) and the corporation’s established grant procedures. The compliance administrator should be authorized to attend compensation committee meetings, and otherwise be given access to the corporation’s compensation, tax and legal advisors as necessary to carry out his or her responsibilities.
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