162(m) Proposed Regulations: Six Lessons and a Handful of Planning Opportunities
Background
Section 162(m) of the Internal Revenue Code of 1986, as amended (162(m)) limits to $1 million the amount that certain “publicly held corporations” (PHCs) can deduct per year for compensation paid to certain “covered employees.” The Tax Cuts and Jobs Act of 2017 (TCJA) amended 162(m) to expand its application effective for tax years beginning on and after January 1, 2018. In December 2019, the IRS published proposed regulations to further interpret and implement the TCJA’s changes to 162(m).
The TCJA changes to 162(m) were intended to raise tax revenues as a partial offset to other changes made by the TCJA, such as the reduction in the corporate tax rate. The proposed regulations, in general, seek to implement 162(m) in a way that will maximize those tax revenues. This TS Alert explores six key lessons from the proposed regulations and several planning opportunities that PHCs may want to consider going forward.
Lesson 1: 162(m) Will Apply to More Companies
162(m) as in effect before the TCJA (old 162(m)) applied only to companies that had a class of common equity securities that was required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Exchange Act) – e.g., generally companies with common stock traded on a securities exchange like the NYSE or NASDAQ.
Under 162(m) as modified by the TCJA (new 162(m)), PHCs will now include:
- Any company that has any securities (not just common stock) required to be registered under Section 12 of the Exchange Act, and
- Any company that is required to file reports under Section 15(d) of the Exchange Act.
As a result of this change, 162(m) will apply to more companies, including:
- Privately held companies that have publicly traded debt (and, as a result, must file reports under Section 15(d) of the Exchange Act); and
- Certain foreign private issuers – i.e., if (i) the foreign private issuer has securities, such as American Depositary Receipts (ADRs), that are required to be registered under Section 12 of the Exchange Act or (ii) the foreign private issuer is otherwise required to file reports under Section 15(d) of the Exchange.
A company may be a PHC even if the company is not otherwise required to disclose executive compensation under the Exchange Act.
Status as a PHC for a tax year is determined as of the last day of that tax year. The PHC also includes all of the company’s affiliated subsidiary or parent corporations under Section 1504 of the Internal Revenue Code (which generally requires at least 80% common ownership). The proposed regulations include complicated rules for allocating compensation paid to covered employees by members of the affiliated group.
The proposed regulations also clarify that an affiliated group could include multiple PHCs, each of which is separately subject to new 162(m). For example, if a parent company with publicly traded securities has a wholly owned subsidiary with publicly traded debt, the proposed regulations treat the parent and the subsidiary as separate PHCs for purposes of new 162(m). Each PHC in this case must separately identify its covered employees, and this could result in more covered employees subject to new 162(m) (see Lesson 2 below).
Planning Opportunity – Designating Officers in Controlled Groups with Multiple PHCs
For affiliated groups with multiple PHCs within the group (such as a parent with listed securities and a subsidiary with publicly-traded debt), care should be taken in appointing officers in order to minimize the impact of new 162(m). For example, it may be advantageous under new 162(m) to have the chief executive officer (CEO) and chief financial officer (CFO) of the parent PHC also be the CEO and CFO of the subsidiary PHC.
Lesson 2: 162(m) Will Apply to More Employees
Old 162(m) limited the covered employees to the company’s year-end:
- CEO; and
- top three other highest-paid executive officers whose compensation was required to be reported in the company’s annual proxy statement.
As interpreted by the U.S. Treasury and IRS, old 162(m) did not apply to the company’s CFO. Also, an individual who terminated employment before the end of the tax year could not be a covered employee for that tax year (or any future year while not employed by the PHC). As a result, payments of severance or deferred compensation generally were not subject to the $1 million deduction limit under old 162(m).
New 162(m) significantly expands the definition of covered employee to include the following individuals:
- anyone who served during the year as the CEO—i.e., not just the year-end CEO;
- anyone who served during the year as the CFO—i.e., no exclusion for the CFO;
- the three other highest paid other executive officers of the PHC (excluding the CEO or CFO), regardless of whether the individual is in service at the end of the year and regardless of whether the individual’s compensation must be disclosed per Exchange Act rules; and
- any individual determined to be a covered employee for any prior tax year beginning after December 31, 2016. For a company with a calendar year tax year, the covered employees subject to this rule for 2017 are those determined under old 162(m) (i.e., the 2017 year-end CEO and top three other highest paid year-end executive officers excluding the CFO).
The last rule above in particular significantly expands the covered employee definition. This rule means “ once a covered employee, always a covered employee,” even for tax years after termination of employment. This rule means that severance and deferred compensation payments will not escape new 162(m), including payments made to beneficiaries after the death of a covered employee.
The proposed regulations clarify that individuals in the “top three officers” category must also be “executive officers” within the meaning of Rule 3b-7 under the Exchange Act. This rule generally defines “executive officers” as officers who perform a “policy making function” for the public company. The rule does not define “policy making function.” As a practical matter, the determination of a company’s executive officers is made by the company’s board based on the company’s specific facts and circumstances, and ordinarily the board’s judgment will be respected.
Planning Opportunity – Identifying Executive Officers
PHCs may want to take a fresh look at who they identify as their executive officers under the Exchange Act. If the facts and circumstances support it, the board may want to consider approving a more limited list of executive officers. Fewer executive officers could mean fewer covered employees subject to new 162(m), especially given the “once a covered employee, always a covered employee” rule.
The proposed regulations also require that the covered employees of certain “predecessor corporations” remain covered employees of their successor corporation(s). For example, if a PHC acquires another PHC, the individuals treated as covered employees of the acquired company will be treated as covered employees of the acquiring company. Similar rules apply for public company spin-offs and similar transactions. Additional special rules apply if a company ceases to be a PHC and then, within three years, again becomes a PHC or is acquired by a PHC.
Planning Opportunity – Public Company Acquisitions
In public company transactions, care should be taken to make sure that all covered employees of the target company (including former employees still owed compensation) are properly identified as covered employees. Payments to those individuals under change in control agreements will likely be subject to new 162(m) (unless grandfathered – see Lesson 5 below), and the potential cost of lost tax deductions may need to be considered in evaluating the transaction.
Lesson 3: 162(m) Will Apply to More Compensation
The 162(m) deduction limit applies to all compensation paid to a covered employee during a year, and includes compensation paid by any members of the PHC’s affiliated group.
Under old 162(m), certain commissions and compensation that qualified as “performance-based compensation” were not subject to the 162(m) deduction limit. The “performance-based compensation” exception, in particular, drove compensation design at many public companies and often greatly limited the impact of 162(m). The TCJA eliminated the exceptions for commissions and performance-based compensation, and the proposed regulations confirm that outcome.
Planning Opportunity – Removing Old 162(m) Limits
Companies with incentive plans designed to meet the performance-based compensation exception under old 162(m) should take a fresh look at those plans. The performance-based compensation exception placed limits on incentive arrangements – such as requiring shareholder-approved individual award limits and limitations on company discretion in determining performance results. Because new 162(m) provides no tax benefit to plans that include those limits, plans can be re-designed to remove the old 162(m)-driven limits, providing the company with greater incentive plan design flexibility. But no changes should be made that might impact certain 162(m) grandfathered amounts (see Lesson 5 below). Companies will also want to consider how removing old 162(m) limits will be viewed by their shareholder in light of their voting policies or the voting polices of certain proxy advisory firms (like ISS and Glass Lewis).
The “once a covered employee, always a covered employee” rule also has important implications as to what counts as compensation that is subject to new 162(m). For example, if a covered employee retires but continues to serve the PHC as a non-employee director or consultant, the proposed regulations confirm that compensation received for those non-employee services remain subject to the 162(m) deduction limit.
In addition, various categories of compensation payable to a covered employee after termination of employment will now be subject to the deduction limit under new 162(m) unless covered by the grandfather rule (see Lesson 5 below), including:
- Severance payments;
- Post-employment vesting of equity awards or post-employment exercise of nonqualified stock options; and
- Post-employment payments of nonqualified deferred compensation or supplemental retirement.
Planning Opportunity – Deferred Compensation
Spreading payments over more years may be beneficial under new 162(m). Each tax year will have a new $1 million bucket of deductible compensation. For example, if an executive would have received $3 million in taxable payments in the year after termination of employment, $2 million of those payments would not be tax deductible due to new 162(m). But if those payments were evenly spread as $1 million per year over three years, the entire amount would be deductible.
This type of deferral strategy may create complexities, however. Compliance with other tax rules such as Section 409A of the Internal Revenue Code (“409A”) would need to be considered. Also, deferring compensation can potentially result in greater lost tax deductions under new 162(m) depending on the facts, such as: (i) if otherwise deductible compensation is deferred and later paid in a lump sum with other accumulated deferrals such that the 162(m) deduction limit applies, or (ii) as the result of earnings on the deferred compensation.
Planning Opportunity – Equity Compensation
New 162(m) could impact equity award design. Stock options under old 162(m) were considered “performance-based compensation.” As a result, amounts realized at exercise were generally deductible. In fact, old 162(m) was often considered to have encouraged the rapid growth in use of stock options during the 1990s. Under new 162(m), the opposite may be true. Income from nonqualified stock options realized upon exercise could be quite large, especially given the long option term (often 10 years). Lost tax deductions for other equity vehicles such as restricted stock will likely be less than for options. New 162(m) may therefore tend to discourage use of stock options in favor of other equity vehicles like restricted stock.
Lesson 4: New Public Companies Will Not Have Transition Relief
Under old 162(m), a company that became public generally had a 3-year period before the 162(m) deduction limit became fully applicable. This transition relief allowed new public companies to conform plans to meet the old 162(m) performance-based compensation exception.
The IRS considered whether to continue this transition relief under new 162(m). Ultimately, though, the proposed regulations do not provide that relief. As a result, a new public company will be fully subject to the 162(m) deduction limit for the first tax year in which it becomes a PHC. This result if adopted in the final regulations may increase the short-term costs to a company going public, although it is not clear that those costs will create a measurable chilling effect on IPOs.
Lesson 5: Grandfather Rules Are Clarified but Still Require Legal Judgments
The TCJA includes certain “grandfather rules” that preserve old 162(m) in limited cases. In particular, compensation that is paid under a “written binding contract” that was in effect as of November 2, 2017 and that is not “materially modified” after that date remains subject to old 162(m).
These grandfather rules can preserve the deductibility of compensation paid in 2018 or later under certain plans and agreements that were in effect as of November 2, 2017, such as certain employment agreements, severance plans, equity awards, and deferred compensation plans. Whether any of those arrangements qualify as “written binding contracts” is determined under applicable state law principles, and will therefore require a legal judgment. These judgments can be especially dependent on the facts and applicable law if the arrangement includes any company discretion that would permit reductions in the compensation or termination of the arrangement.
These grandfather rules were initially discussed by the IRS in Notice 2018-68. The proposed regulations generally incorporate the concepts and approaches to applying the 162(m) grandfather rules as described in that Notice. But the proposed regulations include a number of additional examples intended to further clarify application of the grandfather rules. For example, the proposed regulations clarify that an arrangement may still be grandfathered even if compensation under the arrangement in some cases could be reduced because of a compensation recovery/clawback policy.
The ability to grandfather nonqualified deferred compensation benefits accrued as of November 2, 2017 can be especially valuable. Those benefits are often payable only after termination of employment. Under old 162(m), those post-employment payments would not be subject to the 162(m) deduction limit. The proposed regulations include rules and examples intended to clarify how the grandfathered portion of nonqualified deferred compensation benefits is determined. For account balance plans, the amount grandfathered will likely be limited to the balance as of November 2, 2017, although in some cases depending on plan design some or all of the earnings credited on the November 2, 2017 balance could be grandfathered. For non-account balance/defined benefit plans, the proposed regulations generally provide that only the amount of the benefit accrued for compensation and service as of November 2, 2017 is grandfathered.
Planning Opportunity – Identifying and Tracking Grandfathered Amounts
Grandfathered arrangements should be clearly identified and tracked so that they are not inadvertently materially modified. For companies with nonqualified deferred compensation plans, the grandfathered amounts will need to be carefully calculated. For defined contribution plans, companies may want to consult with any third party recordkeepers to make sure they can properly track and apply grandfathered amounts. For defined benefit plans, identifying the grandfathered amount may require help from the actuaries.
The proposed regulations helpfully provide that accelerated vesting and payment of an unvested award that is otherwise grandfathered is not considered a material modification of the award, as long as the payment amount is appropriately discounted to reflect the time value of money. For equity awards that have their vesting accelerated, no discount in value is required since the value is based on the underlying shares.
Lesson 6: The Interplay Between 409A Payment Rules And 162(m) Are Clarified
Under 409A, a company is permitted to delay making a payment that would otherwise not be deductible under 162(m) until such time that it can be deductible. This 409A rule was written when old 162(m) applied, and contemplated that at some point in time, such as following termination of employment, the 162(m) deduction limit would cease to apply to the individual.
Because of the “once a covered employee, always a covered employee” rule, payments may have to be spread out over many years after termination of employment for the amounts to be deductible under new 162(m), and in some cases may never be deductible. Given the 162(m) change, the IRS will permit companies to apply the 409A rule only to 162(m) grandfathered amounts, so that non-grandfathered amounts do not have to be further deferred. The IRS expects to update its regulations under 409A to further clarify this rule.
Planning Opportunity – 409A Plans With Express 162(m) Deferral Requirements
For plans that expressly required deferral of payments based on 162(m) deductibility, the IRS has stated that companies may amend those plans to limit the required deferrals only to any 162(m) grandfathered amounts. Such an amendment will not be treated as violating 409A or resulting in a material modification that eliminates the 162(m) grandfather status. Any such plan amendment, however, must be completed by no later than December 31, 2020.
Effective Dates
The proposed regulations generally become effective once finalized. There is a public comment period open through a public hearing date scheduled for March 9, 2020. Companies may rely in good faith on the proposed regulations until they are finalized.
Certain of the rules in the proposed regulations will be considered effective from September 10, 2018, the date that Notice 2018-68 was published. These rules include the definition of covered employee and the grandfather rules. The IRS believes that the proposed regulations do not substantially change the rules as first published in that Notice.
Companies that had an IPO before the proposed regulations were published may still rely on the 3-year IPO transition rule in the regulations under old 162(m). Companies going public after the proposed regulations were published, however, may no longer use that transition rule.
The Benefits and Executive Compensation team at Troutman will continue to monitor the development of these rules.