On Tuesday, August 21, the IRS issuedon the changes to Section 162(m) of the IRS code included in the 2017 Tax Cuts and Jobs Act. The Guidance addressed two important 162(m) topics:
- The Transition Rule; and.
- Identifying covered employees.
The Transition Rule and Negative Discretion: The Tax Cuts and Jobs Act included a transition rule which grandfathered qualifying compensation (i.e., performance-based) compensation payable pursuant to a valid binding contract in effect on November 2, 2017 as deductible, rather than non-deductible under the rules of the revised Section 162(m). The language of the Act also stated that, to qualify for the grandfathered status, the contract could not be materially modified after November 2, 2017. The language raised many questions as to how certain actions, like the valid exercise of negative discretion, would impact the grandfathered status of the compensation amount. The IRS’s Guidance addresses the issue of negative discretion directly.
The Guidance reaffirms the need for a company to be legally bound by written contract to pay an amount prior to November 2, 2017 which was not materially modified to qualify for the grandfathered status. Accordingly, the Guidance can be interpreted as stating that the ability of a compensation committee to exercise negative discretion negates the legal obligation to pay the award and renders applicable compensation ineligible for grandfathered status.
The Guidance provided an example which addressed the exercise of negative discretion. In the example, a company’s CEO had a bonus plan under which the CEO would receive $1.5 million upon the achievement of a performance goal. The award would have been deemed “qualified performance-based compensation” under old 162(m) and was contractually in place prior to November 2, 2017. Notably, the compensation committee possessed the ability to exercise negative discretion to reduce the amount of the award downwards to “no less than $400,000”. In the example, the compensation committee exercised discretion to reduce the amount of the CEO’s award to $500,000. According to the Guidance, in this scenario, $400,000 of the CEO’s $500,000 is grandfathered under the Transition Rule and deductible by the company while the remaining $100,000 is not grandfathered and subject to taxation.
The rationale, according to the Guidance, is that the $400,000 floor created a legally binding obligation to pay $400,000 thus that compensation was grandfathered. However, for amounts over $400,000, the company’s ability to exercise negative discretion refuted the legal obligation to pay. It follows, therefore, that merely having the ability to exercise negative discretion to reduce an award renders that award unable to qualify for grandfather status for amounts over a “floor amount” (the $400,000 limit in the example). Applicable state law could create an entitlement to pay an amount which would be subject to the grandfather clause.
The view discussed by the Center is still emerging but has been echoedin law firm and consulting firm memos. Over the immediate period, the Center will work to confirm that the interpretation discussed above is indeed the intended impact of the IRS’s Guidance.