By Pension and Benefits Editorial Staff
The IRS has issued guidance on amendments made to Code Sec. 162(m) by the Tax Cuts and Jobs Act (P.L. 115-97). This initial guidance focuses the amended rules for identifying covered employees and the operation of the grandfather rule, including when a contract will be considered materially modified so that it is no longer grandfathered. Code Sec. 162(m)disallows the deduction by any publicly held corporation for certain employee compensation paid to any covered employee to the extent that the remuneration for the taxable year exceeds $1 million.
Background on limitation on excessive employee compensation. Effective for tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act (P.L. 115-97) modified the definitions of “covered employee,” “applicable employee remuneration,” and “publicly held corporation” for purposes of the limitation on the deduction for excessive employee compensation paid by publicly held corporations.
Covered employee. A covered employee is any employee of the corporation who:
- is the principal executive officer (PEO ) (or an individual acting in such capacity) at any time during the tax year;
- is the principal financial officer (PFO) (or an individual acting in such capacity) at any time during the tax year;
- is among the three highest compensated officers for the tax year (other than the PEO or the PFO) whose total compensation for the tax year must be reported to shareholders under the Securities Exchange Act of 1934; or
- was a covered employee of the corporation (or any predecessor) for any prior tax year beginning on or after January 1, 2017.
Applicable employee compensation (remuneration). For tax years beginning after 2017, compensation includes any cash and noncash benefits paid for services, including commissions and performance-based compensation.
Grandfather rule. A transition rule applies to compensation provided pursuant to a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date.
Amended definition of covered employee. As stated above, under the amended law, a covered employee is the PEO, the PFO, or one of the three other highest compensated executives. The IRS clarifies that there is no requirement that an employee must an executive officer at the end of the tax year to be a covered employee. The definition applies regardless of whether the executive officer is serving at the end of the publicly held corporation's tax year. Furthermore, an employee of a publicly held corporation whose compensation is not required to be disclosed under the applicable Securities and Exchange Commission (SEC) rules can be a covered employee for purposes of Code Sec. 162(m).
The IRS is requesting comments on the application of the SEC executive compensation disclosure rules for instances where a publicly held corporation's tax year and last completed fiscal year do not end on the same date. Until additional guidance is issued, taxpayers in that specific circumstance should use a good faith interpretation of the statute and this guidance to determine the three most highly compensated employees.
The IRS provides examples that address the covered employee rules, including how their application may differ from the application of the SEC's executive compensation disclosure requirements.
Written binding contract. The amendments made by P.L. 115-97 to Code Sec. 162(m) do not apply to any compensation paid under a written binding contract that is effect on November 2, 2017 and is not materially modified after that date. In order for the IRS to consider a contract binding, the publicly held company must be obligated to pay the compensation if the employee performs services or satisfies the applicable vesting conditions in the contract. Thus, the amendments to Code Sec. 162(m) apply to any amount of compensation that exceeds the amount required to be paid to an executive under a binding contract.
Amendments to Code Sec. 162(m) also apply to a written binding contract that is renewed after November 2, 2017. If the terms of the contract allow for termination or cancellation of the contract without the employee's consent after November 2, 2017, the contract is treated as renewed as of the date that the termination, if made, would be effective. However, if the company will remain legally obligated by the terms of a contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed if the employee exercises the discretion to keep the company bound to the contract. In addition, a contract is not treated as terminable or cancelable if it can be canceled only by terminating the employment relationship. Furthermore, a contract is not treated as renewed if upon termination of the contract the employment relationship continues but would no longer be covered by the contract. Note that if the employment continues after such termination, payments are not grandfathered and are subject to the amended Code Sec. 162(m).
If a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017 to an employee will not be subject to the amended Code Sec. 162(m) even if the employee was not eligible to participate in the plan or arrangement as of November 2, 2017. However, the new rules will apply to any compensation plan unless the employee was already employed on November 2, 2017 by the company, or the employee had the right to participate in the plan or under a written binding contract as of that date.
Material modification. Material modifications include an increase the amount of compensation payable to the employee. If a contract is modified to accelerate the payment of compensation, it is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Material modifications may also include modifications that defer compensation under certain circumstances. In addition, supplemental contracts or agreements may materially modify the existing contract. The IRS provides several examples to illustrate when such contracts are modified.
Reliance. The Act's amendments to Code Sec. 162(m) apply to taxable years beginning on or after January 1, 2018. The IRS anticipates that further guidance on the Act's amendments will be issued in proposed regulations that will incorporate this initial guidance. The IRS notes that any future guidance, including regulations, that addresses the definition of covered employees by broadening the definition, or the definition of a written binding contract by restricting the application of the definition, would apply prospectively only.
Source: IRS Notice 2018-68.
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