To corporations hoping for a holiday reprieve from the IRS’s narrow interpretation of the grandfathering rules included in the Tax Cut and Jobs Act (“TCJA”) amendment of section 162(m), the IRS has said “Bah… Humbug!” To those foreign private issuers, publicly traded partnerships, and issuers of public debt hoping for relief from the expanded definition of publicly held corporation, the IRS has said the same. On December 16, the IRS released proposed regulations addressing the changes made to section 162(m) of the Internal Revenue Code as part of TCJA, which are certain to disappoint many taxpayers. The regulations also address the definitions of covered employee and “predecessor of a publicly held corporation,” as well as, the treatment of amounts paid by a partnership in which a publicly held corporation is a partner and director compensation. The regulations are generally proposed to apply to compensation that is otherwise deductible for taxable years beginning on or after December 20, 2019, the date of expected publication in the Federal Register.
Continuing the trend from Notice 2018-68, the IRS has held fast to its narrow interpretation of the grandfather provision included in section 162(m). Section 162(m) limits the deduction of any publicly held corporation to $1 million with respect to compensation paid to a “covered employee,” subject to certain exceptions. Prior to its TCJA amendment, section 162(m)(4) contained an exception to the $1 million limitation for qualified performance-based pay. Section 13601 of the TCJA eliminated the exception for qualified performance-based pay effective for taxable years beginning after December 31, 2017. However, section 13601 of the TCJA provides transition relief for amounts paid pursuant to “written binding contracts” that were in effect as of November 2, 2017, and that are not materially modified after that date.
In Notice 2018-68, the IRS took the position that “[r]emuneration is payable under a written binding contract that was in effect on November 2, 2017, only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.” In a series of examples, the IRS concluded that a reservation of discretion to reduce the amount payable under a performance award would result in the award not being grandfathered. This interpretation was particularly troubling given that many employers included so-called negative discretion in their plans, but never exercised it. The examples also illustrated the IRS’s position that future accruals under nonqualified plans in place on November 2, 2017, including earnings on pre-existing deferrals, were generally not grandfathered, even if the executive was already a participant in the plan.
In the proposed regulations, the IRS doubles down on these positions, rejecting arguments from commenters that the interpretation in the notice was unduly narrow. Plans with negative discretion generally would not be grandfathered under the proposed regulations, although the IRS acknowledges that payments could be grandfathered if applicable law prevented the discretion from being exercised. The proposed regulations continue to treat earnings on grandfathered amounts that accrue after November 2, 2017, as not grandfathered unless applicable law obligates such earnings to be paid. Similarly, benefits under a nonqualified nonaccount balance plan are grandfathered only as to the benefit earned based on service and compensation as of November 2, 2017. A similar rule applies to severance benefits, so that only the amount of severance based on compensation elements that the employer is obligated to pay under a contract are considered grandfathered. For example, if severance is based on final average pay the payment is grandfathered only if the corporation is obligated to pay both the base salary and the severance under applicable law pursuant to a written binding contract that was in effect on November 2, 2017. Only amounts that the corporation would have been obligated to pay if the employee had been terminated on November 2, 2017, are grandfathered. If a severance obligation is based on two or more components, some of which are discretionary, each part must be considered separately to determine whether, under applicable law, the corporation is obligated to pay both portions. As a result, many written severance arrangements that corporations may have believed to have been grandfathered may not be grandfathered, at least in part. Accordingly, employers will have to carefully track such earnings and benefit accruals for purpose of applying the disallowance.
In one bit of good news, the proposed regulations would not treat the acceleration of a vesting event as a material modification unless the payment of an amount was also accelerated without reduction for the time value of money. The proposed regulations adopt this approach with respect to an award of property (including stock options with an exercise price at least equal to the fair market value on the date of grant), even if the acceleration of vesting may result in an earlier payment date. This addresses practitioners’ concerns that for awards not settled in property, accelerated vesting could be interpreted as an increase in the amount payable under a contract. According to the preamble to the proposed regulations, the IRS determined that given the limited scope of the grandfathering rule as interpreted by the IRS and its diminishing applicability over time, it was not necessary to consider a change in the vesting schedule as having independent value.
Another helpful provision in the proposed regulations provides that the corporation’s right to recover a payment is disregarded for purposes of determining the grandfathered portion of the payment, when the compensation is subject to a potential clawback based on the future occurrence of a condition objectively outside of the corporation’s control.
Two other provisions may also ease administration of the grandfathering provisions going forward. First, the proposed regulations treat payments under a nonqualified deferred compensation plan or arrangement, including both grandfathered and non-grandfathered amounts, as grandfathered until the entire grandfathered amount is paid. For example, if a plan provides for $100,000 payments in each of three years and $120,000 is grandfathered under the plan, the first payment of $100,000 is grandfathered in its entirety and $20,000 of the second payment is grandfathered. This will shorten the period over which employers must track grandfathered compensation compared to an approach that would treat a portion of each payment as grandfathered (40% in the above example).
Second, the preamble to the proposed regulations announces that the Treasury Department intends to modify the regulations under section 409A to address practitioner concerns. Under section 409A, payments under a nonqualified deferred compensation plan may, in certain circumstances, be further deferred (either at the election of the service recipient or by mandatory plan language) until such time as the payment would be deductible. If the delay is at the discretion of the service recipient, the service recipient must generally delay payment of all scheduled payments until such time as section 162(m) would no longer limit the deduction; otherwise, the delay must satisfy the rules for subsequent deferral elections. Because section 162(m), as amended by TCJA, continues to apply to covered employees in perpetuity, these provisions could result in amounts becoming payable over very long periods, or in some cases, not at all. The preamble to the proposed regulations addresses this concern by permitting service recipients to elect a payment delay of grandfathered amounts without delaying the payment of non-grandfathered amounts without the delay being treated as a subsequent deferral election. Similarly, if a plan or arrangement mandates the delay of payments until such time as the deduction is not limited by section 162(m), the plan may be amended no later than December 31, 2020, to remove the required delay. If a corporation would have been required to make payments before December 31, 2020, as a result of the plan amendment, the payments must be made no later than December 31, 2020. Critically, an amendment adopting this change will not be treated as an impermissible acceleration under section 409A or a material modification under section 162(m).
Foreign Private Issuers, Publicly Traded Partnerships, Publicly Traded Subsidiaries
The proposed regulations define a publicly held corporation as any corporation that issues securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or that is required to file reports under section 15(d) of the Exchange Act. The proposed regulations look to the last day of a corporation’s taxable year to determine whether it is publicly held under this definition.
In the proposed regulations, Treasury declined to exclude foreign private issuers from the reach of section 162(m). Accordingly, a foreign private issuer that is required to register its securities under section 12 of the Exchange Act or to file reports under section 15(d) of the Exchange Act is a publicly held corporation, even if it is not required to file a summary compensation table.
Similarly, an S corporation that issues securities required to be registered under section 12(b) of the Exchange Act or that is required to file reports under section 15(d) of the Exchange Act (for example, because it issues publicly traded debt) is a publicly held corporation for purposes of the deduction limitation. A publicly traded partnerships that is treated as a corporation under section 7704 of the Code is a publicly held corporation for purposes of section 162(m) if its securities are required to be registered under section 12 of the Exchange Act or it is required to file reports under section 15(d) of the Exchange Act. If a publicly traded partnership is not treated as a corporation under a provision of the Code (such as the gross income requirement of section 7704(c)(2)), it is not a publicly held corporation.
Affiliated groups are much more likely to have more than one corporation considered to be “publicly held” for purposes of section 162(m), due to the statute’s broadened definition of a publicly held corporation as one required to file reports under section 15(d) of the Exchange Act. As under the prior regulations, the definition of a publicly traded corporation includes an affiliated group of corporations. However, previously an affiliated group did not include any member of the group that was itself a publicly held corporation. The proposed regulations generally retain the existing rule, but expand the definition of affiliated group to include a privately held parent corporation and its publicly held corporation subsidiary. If an affiliated group contains more than one publicly held corporation, each publicly held corporation will have its own group of covered employees with respect to whom the deduction limitation applies. The proposed regulations provide guidance regarding the determination of the amount disallowed if a covered employee is paid compensation by more than one publicly held corporation within an affiliated group.
Under the proposed regulations, if a privately held corporation owns a disregarded entity that is required to file reports under section 15(d) of the Exchange Act or has issued securities that are required to be registered under section 12(b) of the Exchange Act, the privately held corporation is treated as the issuer of the securities and thus is a publicly held corporation. A similar rule exists with regard to QSubs. The preamble indicates that if a corporation forms a partnership with a minority partner to circumvent this rule regarding the treatment of disregarded entities, the corporation could nonetheless be treated as a publicly held corporation under the anti-abuse rule in Subchapter K.
Covered Employee Definition
The proposed regulations take a broad approach to addressing some of the outstanding questions regarding the expansion of the definition of a “covered employee.” The definition would typically apply to any taxable year ending on or after September 10, 2018.
Although the proposed regulations provide that only an “executive officer” as defined under SEC regulations may qualify as a covered employee, the regulations treat an officer of a partnership in which a publicly held corporation owns an interest as an executive officer, if the officer performs a policy making function for the corporation. Similarly, the principal executive officer, principal financial officer, or executive officer of a disregarded entity is not generally treated as a covered employee of the disregarded entity’s corporate owner. However, if the officer performs policy making functions for the corporate owner during the taxable year, he or she is treated as an executive officer of the corporate owner.
Particularly troubling is the proposed regulations’ approach to addressing the statutory language providing that a covered employee includes a covered employee of a predecessor corporation. The approach in the proposed regulations will serve as a potential trap for the unwary. Key takeaways are:
- A publicly held corporation is its own predecessor if it becomes privately held and then again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held.
- Similarly, a publicly held corporation that becomes privately held and then is acquired by another privately held corporation is a predecessor if the acquiring corporation subsequently becomes publicly held within the 36-month period described above. A similar rule applies for asset acquisitions
- A publicly held corporation that is acquired by another publicly held corporation in a stock acquisition or that is the transferor corporation in a tax-free reorganization under section 368(a)(1) is a predecessor of the acquiring corporation.
- A publicly held corporation that becomes a member of an affiliated group is a predecessor of the affiliated group.
- A publicly held corporation 80% of the operating assets of which another publicly held corporation acquired is a predecessor of the acquiring corporation. In this case, acquisitions made within 12 months must generally be aggregated for purposes of determining whether the 80% threshold has been met. This rule only applies to covered employees of the target corporation who are hired within the 24-month period beginning 12 months before and ending 12 months after the acquisition.
- A publicly held corporation that distributes or exchanges the shares of a controlled corporation in a section 355(a)(1) transaction is a predecessor of the controlled corporation if the controlled corporation is a publicly held corporation. This rule applies only to covered employees of the distributing corporation if the controlled corporation (or by an affiliate of the controlled corporation that received shares of the controlled corporation as a shareholder of the distributing corporation) within the 24-month period beginning 12 months before and ending 12 months after the distribution.
These rules will require the careful monitoring of covered employee lists, as in some cases, an officer of a publicly held corporation who is not a covered employee may become a covered employee if he or she was a covered employee of a company that is acquired by his employer. Similarly, because of the approach taken in the proposed regulations with respect to director’s fees (discussed below), director’s fees paid to a non-employee director may become subject to the deduction limitation if the company for which he or she serves on the board of directors acquires a corporation of which he or she was a covered employee. This would appear to be true even with respect to amounts earned before the acquisition but deferred until after the acquisition. The definition of a predecessor of a publicly held corporation in the proposed rules would generally apply to corporate transactions for which all events necessary for the transaction occur on or after December 20, 2019.
Applicable Employee Remuneration
Continuing the “Bah… Humbug” theme, the proposed regulations reverse the position taken in four private letter rulings issued by the IRS between 2007 and 2008. In those rulings, the IRS held that a corporate partner’s distributive share of a partnership’s deduction for remuneration paid by the partnership for services performed for the partnership by a covered employee of the corporate partner was not subject to the section 162(m) limitation. The proposed regulations rely on the pre-TCJA statutory language to provide that a corporate partner would be required to take into account its distributive share of the partnership’s deduction for compensation paid to the publicly held corporation’s covered employee and aggregate that amount with other compensation paid directly to the employee in determining the allowed deduction under section 162(m). The proposed regulations provide a transition rule under which compensation paid pursuant to a written binding contract in effect on December 20, 2019, that is not materially modified after that date, would not be subject to the newly announced rule. As discussed above, however, the IRS takes a narrow view of what constitutes a written binding contract.
In another provision that may surprise some practitioners, the proposed regulations determine that amounts paid to covered employees for services other than in their capacity as executive officers is also subject to the deduction limitation. Accordingly, amounts paid to former executives under independent contractor arrangements or for service as a non-employee director would be subject to the deduction limitation.
Given the proposed effective date of some of the provisions of the proposed regulations, taxpayers should review their approach to section 162(m) compliance for consistency with the proposed regulations and consider filing comments with the IRS if they believe a different approach is justified.