IRS defines covered employees and grandfathered employment contracts under Sec. 162(m)

By Sally P. Schreiber, J.D.

In Notice 2018-68, the IRS issued guidance on Sec. 162(m), as amended by P.L. 115-97, the law known as the Tax Cuts and Jobs Act. As amended, Sec. 162(m) disallows a deduction by any publicly held corporation for employee remuneration paid to any covered employee to the extent that the employee's remuneration for the tax year exceeds $1 million.

The amendments changed the definition of covered employees, broadened which publicly held corporations are subject to the law, and eliminated the exception from the $1 million limit for remuneration payable on a commission basis and qualified performance-based compensation. The amendments generally apply to tax years beginning after Dec. 31, 2017, but under a grandfather rule, they do not apply to remuneration paid under a written binding contract that was in effect on Nov. 2, 2017, and was not modified in any material respect on or after that date. The notice provides guidance on the definition of a "covered employee" and the operation of the grandfather rule, including how to determine whether a contract is a written binding contract and whether a contract has been materially modified. Both are illustrated with a number of examples. The IRS says it plans to issue regulations interpreting Sec. 162(m) generally but issued this interim guidance at stakeholders' request.

Covered employee

A covered employee includes any employee who is the principal executive officer (PEO) or principal financial officer (PFO) of the publicly held corporation at any time during the tax year or was an individual acting in that capacity (Sec. 162(m)(3)(A)) and any employee whose total compensation for the tax year is required to be reported to shareholders under the Securities Exchange Act of 1934 because that employee is among the three highest-compensated officers for the tax year (other than the PEO or PFO, or an individual acting in that capacity) (Sec. 162(m)(3)(B)). The IRS rejected suggestions that to be a covered employee under Sec. 162(m)(3)(B), the employee must have been an executive officer as of the end of the tax year, providing instead that an employee can be a covered employee under Sec. 162(m)(3)(B) if he or she is an executive officer at any time during the year.

The rules also deem employees to be covered employees if they were so in 2017 under the old version of Sec. 162(m). Thus, although the amended Sec. 162(m) applies beginning in 2018 generally, those employees who were covered employees under the old definition in 2017 remain covered employees under the new rules.

Grandfather rule: Remuneration under written binding contract

Written binding contract: Remuneration is payable under a written binding contract that was in effect on Nov. 2, 2017, only to the extent that the corporation is obligated under applicable law (e.g., state contract law) to pay the remuneration under the contract if the employee performs services or satisfies the required vesting conditions. Therefore, the amendments apply to any amount of remuneration that exceeds the amount of remuneration that the applicable law obligates a corporation to pay under such a contract.

The amendments also apply to a contract that is renewed after Nov. 2, 2017. If the corporation may cancel or terminate the contract without the employee's consent, that contract is treated as renewed as of the date that any such termination or cancellation, if made, would be effective. There are also rules for contracts that may be canceled or terminated by both parties.

Material modification: A material modification occurs if a contract is amended to increase the amount of compensation paid to the employee. If a written binding contract is materially modified, it is treated as a new contract entered into as of the date of the material modification. A modification of the contract that accelerates the payment of compensation is a material modification, unless the accelerated payment is discounted to reasonably reflect the time value of money. If a modification defers the payment of compensation, any compensation paid or to be paid that is in excess of the amount originally payable to the employee under the contract is not treated as a material modification if the additional amount is based on either a reasonable rate of interest or a predetermined actual investment. The adoption of a supplemental contract or agreement that provides increased compensation or the payment of additional compensation under certain facts and circumstances will also be a material modification.

The IRS asked that written comments on the notice be sent by Nov. 9, 2018.

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