IRS Widens Scope of Section 162(m) Deduction Limit

Section 162(m) of the Internal Revenue Code (the “Code”) caps at $1 million a year a public corporation’s tax deduction for compensation paid to each of certain executive officers. As originally implemented, the regulations included certain generous exemptions, including the critical and often used exemption for performance-based compensation. The 2017 Tax Cuts and Jobs Act (the “TCJA”) largely eliminated these exemptions and significantly expanded the coverage of Section 162(m), effective for tax years beginning after December 31, 2017. Last summer’s IRS Notice 2018-68 (the “Notice”) (discussed in detail in a previous Morrison & Foerster alert) provided guidance on the definition of covered employee and the application of the grandfather rule to arrangements in effect on November 2, 2017. This week’s proposed regulations (the “Proposed Regulations”) largely affirm the guidance in the Notice but also expand the coverage of Section 162(m) and its potential disallowance of deductibility of compensation.

Key Takeaways

• Expansion of covered entities. “Publicly held corporations” are now broadly defined to include publicly traded partnerships that are taxable as corporations, and the Proposed Regulations provide detailed guidance and examples regarding the treatment of affiliated groups of parent and subsidiary corporations, S-corporations and foreign private issuers.
• Shift in position for publicly held corporations that hold operating partnership interests (e.g., in Up-C and UPREIT structures). In a significant shift from the position taken by the IRS in prior private letter rulings, the Proposed Regulations provide that if a publicly held corporation is a partner in a partnership, Section 162(m) applies to the corporation’s distributive share of the partnership’s deduction for compensation paid by the partnership for services performed for it by a covered employee of the corporation.
• Expansion of “covered employee”. The Proposed Regulations confirm the broad definition in the Notice of a “covered employee,” which is now a life-long status not only for the public corporation employer but for any public successor corporation, which must treat the predecessor’s covered employees as its own additional covered employees.
• Expansion of covered compensation. Compensation subject to Section 162(m) is broadly defined and includes amounts paid for services to covered employees outside of their capacity as executive officers, including services in a non-employee capacity such as fees for post-employment service on the corporation’s board of directors.
• Elimination of IPO transition relief. The Proposed Regulations repeal the transition relief that was previously available to newly public corporations.
• Confirmation of Notice approach to grandfather rule. The Proposed Regulations adopt the Notice’s interpretations of the grandfather rule and its definition of a “written binding contract”.

Background

Section 162(m) disallows a deduction by a “publicly held corporation” for compensation paid to a “covered employee” to the extent the compensation for the taxable year exceeds $1 million. The TCJA significantly expanded the reach of Section 162(m) by, among other things, amending the definition of “covered employee” and eliminating the exemptions for commission and performance-based compensation. The Notice’s guidance on the TCJA’s changes to Section 162(m) has been largely affirmed by the Proposed Regulations, including regarding compensation arrangements in effect on November 2, 2017 that may be grandfathered under Section 162(m).

The regulations generally are effective for taxable years beginning on or after December 20, 2019 (i.e., the date the final regulations were published in the Federal Register). There are, however, several special effective dates proposed to apply to specific parts of the regulations, some retroactive and some effective later than the general effective date.

Proposed Regulations Clarify the TCJA and Expand 162(m) Coverage

Expanded Definition of a “Publicly Held Corporation”

The TCJA broadly defined a “publicly held corporation” as any corporation that issues securities 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 provide guidance on the extent to which this definition expands the reach of Section 162(m). Specifically, whereas Section 162(m) was previously limited to issuers with common equity listed under Section 12 of the Exchange Act, the amended definition of publicly held corporation expands Section 162(m) to include foreign private issuers with US-listed ADRs, issuers (including subsidiaries of public companies and S corporations) with debt registered under Section 15(d), and publicly traded partnerships that are taxable as corporations. The Proposed Regulations also provide detailed guidance and examples regarding the treatment of affiliated groups of parent and subsidiary corporations and partnership interests.

Shift in Position for Compensation Paid by Partnerships (e.g., in Up-C and UPREIT structures)

With publicly held corporations that use the Up-C or UPREIT structure (in which the publicly held corporation holds an interest in a lower-tier operating partnership), much of the compensation paid to executive officers typically relates to services the executive officer provides to the operating partnership, rather than the public company. Between 2006 and 2008, the IRS issued four private letter rulings addressing the applicability of Section 162(m) to compensation paid by an operating partnership to a covered employee of a publicly held corporation, ruling that Section 162(m) does not apply to the corporation’s distributive share of the partnership’s deduction for compensation paid by the partnership for services performed for the partnership by a covered employee of the corporation. Consistent with these rulings, many publicly traded corporations using the Up-C or UPREIT structure have taken the position that compensation expense for services performed for the operating partnership is not subject to the Section 162(m) deduction limit when the operating partnership is a regarded entity for tax purposes.

In a dramatic shift in the IRS’s position that could significantly affect publicly held corporations using these structures, the Proposed Regulations provide that Section 162(m) applies to the corporation’s distributive share of the partnership’s deduction for compensation paid by the partnership for services performed for the partnership by a covered employee of the corporation.

This new rule is effective for deductions attributable to compensation that otherwise would be deductible for a taxable year ending on or after December 20, 2019. The proposed regulations establish a special grandfather rule for these arrangements under which the new rule will not apply to compensation paid pursuant to a written binding contract in effect on December 20, 2019 that is not materially modified thereafter.

Expanded Definition of “Covered Employee”

The Proposed Regulations adopt the positions in the Notice and confirm that the term “covered employee” includes any employee who is among the three highest compensated executive officers for the taxable year (other than the CEO and CFO), regardless of whether the employee is serving at the end of the taxable year, whether the employee’s compensation is required to be disclosed under SEC rules, and whether the employee continues to serve as an executive officer. The Proposed Regulations also go further in detailing the continued coverage of covered employees of predecessor corporations. In this regard, a covered employee remains covered if the corporation becomes private and again becomes public within a three year period, if the covered employee is transferred to a subsidiary that is spun off, or if the company is reorganized or party to a corporate transaction. In short, covered employee status follows the covered employee to a new corporate employer for whom the number of covered employees will multiply.  

A discussion of the implications of the modification to the definition of a “covered employee” for smaller reporting and emerging growth companies and companies involved in mergers and acquisitions is covered in this Morrison & Foerster alert.

Expansion of Applicable Employee Remuneration

All forms of compensation are subject to the Section 162(m) deduction limit for the life of a covered employee and beyond. The Proposed Regulations provide that all compensation, whether reported on Form W-2 or Form 1099, is subject to the deduction limit if paid to a person who was a covered employee of the corporation or any predecessor corporation. As such, the expanded reach of the Section 162(m) deduction limit applies not only to payments during service as a “covered employee” but also to retirement payments, payments to a covered employee who terminated employment and returns to provide services as an independent contractor or a non-employee director, and compensation paid to a deceased covered employee’s heirs. The Proposed Regulations also provide that Section 162(m) applies to a corporate partner’s distributive share of a partnership’s compensation expense deduction attributable to compensation paid for services provided by the corporation’s covered employees.

Repeal of the IPO Transition Rule

The pre-TCJA regulations provided generous relief to newly publicly held corporations following an IPO. It was not clear from the TCJA or Notice whether this relief remained available. Unfortunately, the Proposed Regulations shut the door on this relief:  Section 162(m) immediately applies to any corporation that IPOs on or after December 20, 2019. A corporation that became public before December 20, 2019 can continue to rely on the pre-TCJA transition rules.

The Grandfather Rule

Legally Binding Right Interpreted under Applicable Law

The Proposed Regulations reject commenter suggestions to use a GAAP accrual concept to determine grandfathered amounts and instead affirm the Notice guidance that exempts compensation payable under a written binding contract in effect on November 2, 2017 that is not thereafter materially modified. The Proposed Regulations confirm that a written binding contract is a contract under which the corporation is obligated to pay under applicable law (for example, state contract law) if the employee performs services or satisfies applicable vesting conditions. The Proposed Regulations further confirm the Notice guidance that negative discretion is problematic, but clarify that a conditional right to claw back or reduce compensation does not ungrandfather the compensation unless and until the condition permitting exercise of the right is satisfied.

Each Element of Grandfathered Compensation Must Be Analyzed Separately

The Proposed Regulations clarify that a material modification is determined on a contract-by-contract basis such that, if amounts are paid to a covered employee under more than one written binding contract, a material modification of one of the contracts does not automatically result in a material modification of the other contracts. The Proposed Regulations also address applicability of the grandfathering rule to severance entitlements, stating that severance payments under an otherwise grandfathered agreement that are paid to a covered employee may be grandfathered, but only if the amount of severance is based on compensation elements the employer is obligated to pay under the contract. For example, if the amount of severance is based on final base salary, the severance 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 in effect on November 2, 2017.  The Proposed Regulations further clarify that if an employee remains employed as of November 2, 2017 and receives pay increases after that date that increase the severance entitlement, only the amount the corporation would have been required to pay if the employee had been terminated as of November 2, 2017 is grandfathered.

Not All Changes Are Material Modifications

As a small consolation, the Proposed Regulations provide that, for all forms of compensation, a modification to a grandfathered contract that allows for acceleration of compensation or that causes a lapse of a substantial risk of forfeiture is not considered a material modification.

Modification of 409A Arrangements by December 31, 2020

In the preamble to the Proposed Regulations, the IRS announced that it intends to modify the regulations under Section 409A of the Code to address concerns regarding the ability to amend nonqualified deferred compensation plans to account for the new Section 162(m) rules. Specifically, Section 409A permits deferred compensation to be further deferred until the time that the compensation is deductible under Section 162(m), but requires that the deferral election comply with Section 409A’s subsequent deferral rules and, where elected by the employer, apply to all scheduled payments of the deferred compensation. In light of the expansion of covered employee status, potentially in perpetuity, these deferred amounts might never be payable. Therefore, the Proposed Regulations allow an employer to amend the deferral to apply only to the grandfathered payments, and to remove the deferral for non-grandfathered payments. The Proposed Regulations further provide that this amendment, which must be made no later than December 31, 2020, will not be treated as a material modification of the grandfathered payments for purposes of Section 162(m) or be treated as an impermissible acceleration of the non-grandfathered payments under Section 409A, provided that the amounts are paid by December 31, 2020. Moreover, the Proposed Regulations permit employers to defer grandfathered amounts without delaying payment of non-grandfathered amounts without the delay being treated as a subsequent deferral election under Section 409A or a material modification under Section 162(m), provided that the deferral election is made no later than December 31, 2020.

Effective Dates

The Proposed Regulations generally are effective for taxable years beginning on or after the date on which final regulations are published; however, taxpayers may rely on the Proposed Regulations before that date, provided that they are relied on consistently and in their entirety. Certain provisions, however, have earlier effective dates, including the definition of covered employee, the inclusion of a corporation’s allocable share of partnership deductions, and the elimination of the pre-IPO transition relief, each of which are effective on December 20, 2019. The comment period for raising additional Section 162(m) issues before the Proposed Regulations become final runs until February 18, 2020.