Now that we have had a couple of weeks to digest the IRS’s guidance in Notice 2018-68 on the Tax Cuts and Jobs Act’s (TCJA’s) amendments to Code Section 162(m), it’s a good time to take a closer look at the “grandfathering” rule. As a reminder, the TCJA (i) eliminated the “performance-based compensation” exception to Section 162(m)’s $1 million limit on the deductibility of covered employee compensation, (ii) expanded and made permanent the group of covered employees, and (iii) broadened the scope of the “publicly held corporations” that are subject to the deduction limit.
Grandfathering of Arrangements with “Negative Discretion”
As described in our recent alert, the grandfathering rule shields compensation from the new Section 162(m) to the extent that it is required to be paid pursuant to a written binding contract in effect on November 2, 2017, as determined under applicable law (e.g., state contract law or employment law). Grandfathering protection is lost if the contract is materially modified (generally, an increase in the amount payable) or renewed (other than where the renewal is at the sole discretion of the employee).
The requirement that a taxpayer look to “applicable law” to determine whether grandfathering applies can create uncertainty. Ironically, this problem is particularly acute for arrangements intended to be qualified as “performance-based compensation” under the former Section 162(m) because they were often designed to give the compensation committee “negative discretion” to reduce the amount payable if the performance goals were met, as expressly permitted under the prior 162(m) regulations. For instance, a critical design feature of “umbrella plans,” which were commonly used by companies to avail themselves of the former Section 162(m) performance-based compensation exception, provides the compensation committee with wide latitude to reduce the compensation payable if the 162(m) performance goal is met.
A company’s past practice of paying performance-based equity or cash bonus awards at a particular level, or of not exercising negative discretion, may suffice to obligate a corporation to pay at least a certain amount of compensation under applicable state law. However, it will take a significant amount of legal research and analysis to reach any such conclusion, particularly if a company’s covered employees reside in multiple states or if the governing law provisions in their compensation arrangements may be ignored under applicable law. Therefore, the grandfathering rule is difficult to rely on for arrangements with negative discretion and companies are likely to abandon it, at least when it comes to calculating their deferred tax assets for purposes of their financial reporting. It remains to be seen whether companies will be willing or able to take a more aggressive tax return position on the deductibility of such amounts under the grandfathering rule (including in view of IRS rules relating to disclosure of discrepancies between a company’s tax return position and its financial reporting).
Identifying Grandfathered Arrangements
Against this troublesome background, it is worth reiterating a silver lining of the grandfathering rule, which is that it applies to all of the TCJA’s amendments to Section 162(m). In other words, if a particular item of compensation being paid to a particular employee is subject to the $1 million deduction limit of Section 162(m) solely because of the amendments made by the TCJA, then it is at least eligible for grandfathering relief.
In determining whether grandfathering applies to a particular compensation item to be paid to a particular person, a step-by-step approach is useful:
Step 1 – Would the employee have been a covered employee prior to the TCJA amendments?
- If “Yes” – Not eligible for grandfathering unless it’s qualified performance-based compensation.
- If “No” – Eligible for grandfathering.
Step 2 – Determine the grandfathered (deductible) amount, i.e., the amount required to be paid as of November 2, 2017 pursuant to a written binding contract under applicable law.
Step 3 – Consider whether any material modification or contract renewal may have ended the grandfathering relief.
By applying this test, companies may find that compensation under a variety of arrangements is eligible for grandfathering, to the extent required to be paid as of November 2, 2017. Examples include:
- Time-based RSUs, stock options or similar awards held by the CFO
- Deferred compensation amounts being paid at or after termination to a CEO or other covered employee who departs before the last day of the tax year
- Amounts payable to a covered employee of a corporation that was not a “publicly held corporation” subject to 162(m) under prior law (e.g., all amounts payable to covered employees at foreign private issuers)
- Payments to a former covered employee at a time when the employee is no longer in such status (e.g., a third highest compensated employee is the tenth highest compensated employee at the time of payment)
As we head towards year-end and compensation planning and proxy reporting season, companies would be well-advised to take a full inventory of their compensation arrangements that may qualify for grandfathering relief, both for purposes of their tax return position and financial reporting, and to avoid inadvertent modification of such arrangements in a way that could jeopardize any available grandfathering.