The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, which was signed in December 2017, made significant changes to Sec. 162(m), which limits a public company's annual compensation deduction to $1 million for each covered employee. The changes expand the covered employees and public companies subject to the deduction limit and repeal the exclusions for qualified performance-based compensation and commissions. The new rules are effective for tax years beginning after Dec. 31, 2017, but the TCJA also provides a grandfather rule that generally exempts from the changes compensation payable under a written binding contract in effect on Nov. 2, 2017, and not modified in any material respect on or after that date.
Under the pre-TCJA rules, many public companies relied on the exclusion for qualified performance-based compensation to minimize or avoid exposure to the $1 million limit. To the extent a covered employee's compensation met the requirements to be treated as qualified performance-based compensation, the performance compensation did not have to be taken into account when applying the $1 million limitation. Because of its prevalence before the TCJA changes, many companies have been focusing on how they can preserve the performance-based compensation exclusion through the grandfather rule, but companies should consider a number of other situations when applying the grandfather rule.
Grandfather rule: How it works
To the extent the grandfather rule applies, compensation that would not otherwise be deductible under the TCJA changes may be deductible in certain situations. Grandfathered amounts are not subject to any of the TCJA changes. The first step is to determine the extent to which, if any, a covered employee's compensation is grandfathered. If so, then the second step is to apply the pre-TCJA rules to the grandfathered compensation, which may allow the compensation to be excluded from the $1 million deduction limit.
The determination of whether an item of compensation, particularly performance-based compensation, is grandfathered (i.e., the first step) has received a lot of attention from companies since the changes were first enacted. In addition, in August 2018, the IRS issued Notice 2018-68, which provides guidance on the grandfather rule as well as the expanded definition of covered employees. Although there are still a lot of open issues in determining grandfather status, this discussion focuses on the second step — applying the pre-TCJA rules to grandfathered compensation — to demonstrate the potential application of the grandfather rule to situations other than performance-based compensation that companies may not have been focusing on since the changes were first enacted.
Grandfathered CFO compensation
Before the enactment of the TCJA, CFOs were not treated as covered employees subject to the $1 million deduction limit. Pre-TCJA rules defined the group of covered employees to include only four individuals for each tax year — the CEO (or an individual serving in such a role) and the company's three highest-paid officers, other than the CEO and CFO, as of the last day of the tax year. As such, the grandfathered compensation of a CFO is not subject to the $1 million deduction limit because it is treated as paid to a noncovered employee. For this purpose, a CFO's grandfathered compensation may include base salary, supplemental executive retirement benefits, severance payments, certain fringe benefits, and other forms of compensation — but only to the extent those amounts meet the requirements to be treated as grandfathered compensation.
In this regard, Notice 2018-68 includes an example where a company and its CFO entered into an account balance plan as part of a nonqualified deferred compensation arrangement. Under the plan's terms, the company is required to pay the CFO the account balance in 2019, provided the CFO continues to serve in his or her role through Dec. 31, 2018. The plan also allows for company discretion to unilaterally reduce or eliminate the amount of future credits to the account balance; but the plan provides further that the company may not deprive a participating employee of any benefit accrued before the date of any such amendment.
On Dec. 31 of each tax year from 2016 to 2018, the company is required to credit $100,000 to the CFO's account, with earnings on each principal amount credited to the account on each subsequent Dec. 31. In tax year 2019, the company pays the CFO $350,000 (including earnings) from the account balance. Notice 2018-68 provides that the account balance plan constitutes a written binding contract in effect on Nov. 2, 2017, to pay $100,000 of remuneration that the company credited to the CFO's account balance as of Dec. 31, 2016. The IRS concluded that, under this fact pattern, $250,000 of the $350,000 account balance is subject to the $1 million annual limit under the amended Sec. 162(m) rules (the $350,000 payment in 2019 less the $100,000 credited as of Dec. 31, 2016). However, the IRS concluded that the remaining $100,000 was grandfathered under the pre-TCJA rules because the $100,000 credited as of Dec. 31, 2016, was accrued under a written binding contract on Nov. 2, 2017, and the provisions of the arrangement did not allow the company to unilaterally reduce amounts accrued prior to any amendment of the plan. Under the pre-TCJA rules, the CFO was not a covered employee, and therefore, $100,000 of the $350,000 payment in tax year 2019 is excluded from the $1 million annual deduction limit.
As noted, the TCJA expanded the group of covered employees to include anyone who served as the CEO or CFO, or acted as such, at any point during the tax year (not just as of the last day of each tax year). The three highest-paid officers other than the CEO and CFO continue to be covered employees (but that determination takes into account even employees who were not employed as of the last day of the tax year). It also includes an employee who was formerly a covered employee of the company for any prior tax year beginning after Dec. 31, 2016 (even after he or she terminates employment). Thus, there can be more than five covered employees after the 2017 tax year — under the new rules, once a covered employee, always a covered employee. Thus, any person serving as the CFO for any portion of a tax year beginning after Dec. 31, 2017, would be considered a covered employee under the TCJA changes, and all nongrandfathered compensation would need to be taken into account for purposes of applying the $1 million deduction cap for tax years beginning after Dec. 31, 2017.
Grandfathered compensation paid after termination of employment
Under the pre-TCJA rules, covered employees were determined as of the last day of each tax year. Under that approach, employees who terminated employment or were no longer the CEO or the next three highest-compensated officers (other than the CEO or CFO) before the last day of the tax year were not considered covered employees subject to the $1 million deduction limit for that tax year. Under these rules, grandfathered compensation payable to an individual who is not a covered employee under the pre-TCJA rules because he or she is not employed as of the last day of the tax year would not be subject to the annual $1 million limit. Thus, for example, grandfathered severance pay or nonqualified deferred compensation benefits payable to a covered employee would not be subject to the $1 million deduction cap to the extent the grandfathered compensation is paid after the employee terminates employment.
Grandfathered commissions
Under the pre-TCJA rules, commissions are excluded from the $1 million deduction limit. Regs. Sec. 1.162-27(d) provides that commissions must be paid solely on account of income generated directly by the individual performance of the individual to whom the compensation is paid. Compensation paid on account of broader performance standards, such as income produced by a business unit of the corporation, does not qualify as compensation paid on a commission basis. Thus, to the extent commissions are grandfathered, the commissions do not have to be taken into account in applying the $1 million deduction limit.
Rules are complex
In summary, the Sec. 162(m) grandfather rule provides multiple opportunities outside of the exemption for performance-based compensation. However, the pre-TCJA rules and the guidance under Notice 2018-68 are complex, with many open issues. Companies should carefully review their existing arrangements to identify grandfathered compensation and determine the extent, if any, to which those amounts may be excluded under the pre-TCJA rules in applying the $1 million cap for tax years beginning after Dec. 31, 2017.
EditorNotes
Greg Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington..
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
