Application of grandfathering rules under Sec. 162(m) to severance plan payments

Editor: Alexander J. Brosseau, CPA

The changes to Sec. 162(m) made by Section 13601 of the Tax Cuts and Jobs Act (TCJA), P.L. 115–97, may feel like a distant memory, but the transition rules that were included with those changes — what the IRS refers to as “the grandfathering rules” — are as relevant as ever. As Congress has continued to expand the scope of the deduction limit under Sec. 162(m), public companies and their advisers are taking a closer look at the grandfathering rules to identify payments that meet the requirements to be grandfathered and therefore potentially deductible under the rules in effect before the TCJA. This item examines the application of these TCJA grandfathering rules to payments made under severance arrangements.

Background

Sec. 162(m) limits to $1 million the deduction that a publicly held corporation can take for compensation paid to a covered employee in a tax year. This section was added to the Code by the Omnibus Budget Reconciliation Act of 1993, P.L. 103–66, and was effective for tax years beginning on or after Jan. 1, 1994. For well over two decades, Sec. 162(m) remained largely unchanged until the TCJA made significant amendments to it. Treasury and the IRS issued proposed regulations implementing the TCJA changes on Dec. 20, 2019 (REG–122180–18), and published final regulations on Dec. 30, 2020 (T.D. 9932). Subsequent changes were made by the American Rescue Plan Act of 2021, P.L. 117–2, and H.R. 1, P.L. 119–21, the law commonly referred to as the One Big Beautiful Bill Act.

The TCJA changes included, among others:

• An expansion of the definition of the term “publicly held corporation” to include (1) a corporation with any class of securities that is required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) and (2) a corporation that is required to file reports under Section 15(d) of the Exchange Act, which had the effect of bringing foreign private issuers, publicly traded partnerships, and certain issuers of publicly traded debt, among others, within the scope of Sec. 162(m);
• An expansion of the definition of “covered employee,” primarily to include the principal financial officer (PFO) of a publicly held corporation and any individual who was a covered employee of the corporation (or any predecessor) in any preceding year beginning after Dec. 31, 2016;
• Elimination of certain exceptions for performance-based compensation and commissions; and
• Elimination of an exception for amounts paid under a transition rule for companies that become newly publicly held.

As a result of these changes, many compensation payments that were fully deductible under the pre–TCJA rules became subject to the $1 million limit. For example, compensation paid to the PFO of a publicly held corporation before the TCJA changes became effective was generally deductible, subject to the ordinary, necessary, and reasonable requirements of Sec. 162(a)(1), because the PFO was not a covered employee under the pre–TCJA rules. After the TCJA changes, however, the deduction for this compensation became subject to the limitation under Sec. 162(m). This item highlights the benefit of applying the grandfathering rules to severance arrangements and applying the Sec. 162(m) deduction rules in effect prior to the TCJA.

Grandfathering rule: Retaining pre-TCJA deduction benefits

The amendments to Sec. 162(m) made by the TCJA generally apply to tax years beginning after Dec. 31, 2017, subject to certain exceptions set out in the regulations. However, compensation payable under a written binding contract in effect on Nov. 2, 2017, that is not materially modified after that date is “grandfathered.” Nov. 2, 2017, was the date on which the legislative text that included the proposed changes to Sec. 162(m) was first made public.

The grandfathering rules can apply to a wide range of compensation types, including salary, bonuses, equity compensation, deferred compensation, post–retirement compensation, and severance. Grandfathered amounts are not subject to the statutory changes made by the TCJA or to the regulations implementing the TCJA changes. Instead, they are subject to the rules in effect before the changes made by the TCJA.

If a written binding contract is renewed after Nov. 2, 2017, amounts payable under the contract cease to be grandfathered. In the case of a written binding contract that is terminable or cancelable by the corporation after Nov. 2, 2017, the contract is treated as renewed, and thus compensation payable under the contract would no longer be grandfathered on the earliest date that the termination or cancellation could be effective. Generally, in the case of contracts that automatically renew unless either the corporation or the employee provides notice of termination, the contract is treated as renewed on the date a termination would have been effective if notice of termination had been given. However, if the corporation remains legally obligated under a contract beyond a certain date at the sole discretion of the employee, the contract is not treated as renewed as of that date if the employee exercises the discretion to keep the corporation bound by the contract. A contract is not treated as terminable or cancelable if terminating or canceling the contract requires terminating the employment relationship.

In further articulating the grandfathering rule, the regulations provide that “[c]ompensation is a grandfathered amount only to the extent that as of November 2, 2017, the corporation was and remains obligated under applicable law (for example, state contract law) to pay the compensation under the contract if the employee performs services or satisfies the applicable vesting conditions” (Regs. Sec. 1.162–33(g)(1)(i)).

Material modifications

If a written binding contract is materially modified after Nov. 2, 2017, the payments under the contract are no longer grandfathered. A material modification occurs when a contract is amended to increase the amount of compensation payable to the employee. If a written binding contract is materially modified, it is treated as a new contract that is entered into as of the date of the material modification. Amounts received before the material modification remain grandfathered, but amounts received after the material modification are subject to the post–TCJA rules.

If a written binding contract is amended or a new agreement is entered into to provide for increased or additional compensation, the amendment or new agreement will be treated as a material modification of the written binding contract if the facts and circumstances demonstrate that the additional compensation is based on substantially the same elements or conditions as the compensation that would otherwise be paid pursuant to the original written binding contract. However, a material modification of a written binding contract does not occur if the additional compensation is equal to or less than a reasonable cost–of–living increase. Likewise, the failure to exercise negative discretion under a contract is not a material modification, and the modification of a contract to remove a substantial risk of forfeiture is not a material modification.

Application of the rules to severance payments

The regulations do not include special rules for severance arrangements, nor do they specifically address what would qualify as a material modification for severance arrangements. However, they do include a series of examples that apply the general grandfathering rules to severance agreements (Regs. Secs. 1.162–33(g)(3)(i)–(v)). A close inspection of these examples provides insight on the view that the IRS appears to have on the application of these rules to certain types of severance arrangements.

Example (1) is straightforward. On Oct. 2, 2017, Corporation X enters into a three–year employment agreement with Employee A to serve as the PFO with an annual salary of $2 million beginning on Jan. 1, 2018. Employee A serves as the PFO of Corporation X for the 2017 through 2020 tax years. The agreement renews automatically at the end of the initial three–year term for additional one–year periods unless it is terminated by Corporation X. Termination of the employment agreement does not require termination of Employee A’s employment.

The regulations conclude in Example (1) that Employee A’s annual $2 million salary will be grandfathered because it is payable under a written binding contract that was in effect on Nov. 2, 2017. Employee A would not be a covered employee for the years 2018 through 2020 because Employee A is the PFO, and PFOs were not covered employees under the pre–TCJA rules. Because Employee A was not a covered employee under the pre–TCJA rules, Sec. 162(m)(1) would not limit Corporation A’s deduction for the payment of A’s annual salary for the 2018 through 2020 years. The regulations note that the employment agreement would be treated as renewed on Jan. 1, 2021, unless it is previously terminated, and that the post–TCJA rules would apply to the deduction of any payments made under the employment agreement on or after that date.

The facts in Example (2) are the same as the facts in Example (1) except the employment agreement also provides that Corporation X must pay severance to Employee A if it terminates the employment relationship without cause during the term of the employment agreement. The amount of the severance is equal to two times Employee A’s annual salary, plus two times any discretionary bonus paid within the 24 months preceding the termination. In this example, Corporation X does not pay a discretionary bonus to Employee A during the term of the employment agreement.

The regulations conclude in Example (2) that if Corporation X terminates Employee A’s employment during the initial term of the agreement (i.e., before Jan. 1, 2021) and pays Employee A $4 million in severance, the $4 million severance payment will be grandfathered because it is payable under a written binding contract that was in effect on Nov. 2, 2017. As a result, the deduction of that payment will be governed by the pre–TCJA rules under Sec. 162(m)(1), and, under those rules, Corporation A’s deduction for the severance payment would not be limited. The regulations again note that the employment agreement would be treated as renewed on Jan. 1, 2021, unless previously terminated, and that the post–TCJA rules would apply to the deduction of any payments made under the employment agreement, including for severance, on or after that date.

A further variation is presented in Example (3), which highlights the treatment of a discretionary bonus that is included as part of a severance formula under the grandfathering rules. In Example (3), the facts are the same as Example (2), except that Corporation X pays two discretionary bonuses to Employee A during the initial term of the employment agreement — one in the amount of $100,000 on Oct. 31, 2017 (before the Nov. 2, 2017, grandfathering date), and the other in the amount of $600,000 on May 14, 2018 (after the Nov. 2, 2017, grandfathering date). Employee A is terminated without cause on April 30, 2019, and on May 1, 2019, is paid $5.4 million, which is equal to the sum of two times Employee A’s $2 million annual salary, plus two times Employee A’s discretionary bonus of $100,000, plus two times Employee A’s discretionary bonus of $600,000.

The regulations conclude that only $4.2 million of the $5.4 million payment is grandfathered. The $4.2 million represents the amount that is two times the $2 million annual salary and two times the $100,000 discretionary bonus. The portion of the payment that is based on two times the $600,000 discretionary bonus is not grandfathered. The regulations explain that this is because the Oct. 2, 2017, employment agreement was not a written binding contract to pay the $600,000 discretionary bonus. That is, as of Nov. 2, 2017, Corporation X was not obligated under applicable law to make the $600,000 discretionary bonus payment.

This conclusion is not necessarily obvious under the generally applicable grandfathering rules set out in the regulations. In this case, the Oct. 2, 2017, employment agreement plainly requires Corporation X to pay severance equal to two times Employee A’s annual salary and two times Employee A’s discretionary bonus (if any) paid within the 24 months preceding termination. Both the $100,000 and $600,000 discretionary bonuses were paid within the 24 months preceding termination of employment. Presumably, the employment agreement, which was in effect on Nov. 2, 2017, legally required Corporation X to make a severance payment in the amount of $5.4 million based on Employee A’s annual salary and both discretionary bonuses.

However, the conclusion in this example appears to be based on a broad (and somewhat literal) interpretation of the rule that “[c]ompensation is a grandfathered amount only to the extent that as of November 2, 2017, the corporation was and remains obligated under applicable law … to pay the compensation under the contract if the employee performs services or satisfies the applicable vesting conditions” (Regs. Sec. 1.162–33(g)(1)(i)). Under this view, any payment based on an amount that a corporation was not required to pay as of Nov. 2, 2017, appears not to be grandfathered.

Such an interpretation is consistent with the general policy behind the grandfathering rules. In providing for grandfathering, Congress was concerned that it would be unfair to change the rules to deny a deduction for an amount that a corporation was legally obligated to pay before the date that the public was put on notice that Congress intended to change the Sec. 162(m) rules (i.e., Nov. 2, 2017). If a corporation was required to make a payment as of that date and could not avoid the payment through legal means, fairness arguably dictates that the old rules should apply to that payment. However, if a corporation could lawfully avoid making a payment, the case for grandfathering is considerably weaker.

In Example (3), Corporation X is not legally obligated on Nov. 2, 2017, to make the $1.2 million severance payment or the $600,000 discretionary bonus payment on which the severance payment was based. If the corporation subsequently chooses to make the $600,000 discretionary bonus payment with full knowledge of the changes made to Sec. 162(m), the policy reasons for protecting the corporation from the TCJA changes are far from compelling.

Example (4) addresses discretionary adjustments to salary amounts. In this example, the facts are the same as Example (2), described above, except that the employment agreement provides for discretionary increases in salary. On Jan. 1, 2019, Corporation X increases Employee A’s salary from $2 million per year to $2,050,000 per year, which the example indicates is less than a reasonable cost–of–living adjustment.

The regulations conclude in Example (4) that the Oct. 2, 2017, employment agreement is a written binding contract to pay an annual salary of $2 million and that the $50,000 discretionary increase is not a material modification of that agreement because the increase is less than or equal to a reasonable cost–of–living increase. Thus, the $2 million annual salary is grandfathered because the Oct. 2, 2017, employment agreement was a written binding contract to pay that amount. However, the regulations also conclude that the $50,000 increase is not grandfathered. Although the regulations do not explain why the $50,000 increase is not grandfathered, it appears to be because the increase was not required as of Nov. 2, 2017, under a written binding contract.

For similar reasons, the regulations further conclude in Example (4) that the employment agreement is a written binding contract to pay severance of $4 million and that the $100,000 increase in severance (i.e., two times the $50,000 increase in salary) is not a material modification. The regulations conclude that the $4 million severance payment is grandfathered and that the $100,000 severance payment is not grandfathered. Again, this conclusion appears to be based on the view that compensation is grandfathered only to the extent that a corporation is legally obligated on Nov. 2, 2017, to make the payment and that discretionary amounts paid after that date are not grandfathered.

In Example (5), addressing the application of the grandfathering rules to severance arrangements, the facts are the same as Example (4), except that, on Jan. 1, 2019, Corporation X increases Employee A’s annual salary from $2 million to $3 million. The example indicates that this increase is more than a reasonable cost–of–living increase.

The regulations conclude in Example (5) that, although the employment agreement is a written binding contract to pay Employee A an annual salary of $2 million, the $1 million increase is a material modification of the original agreement because the additional compensation is based on substantially the same elements or conditions as the original salary and the increase exceeds a reasonable cost–of–living increase. Accordingly, no salary paid to Employee A after the date of the material modification (Jan. 1, 2019) is grandfathered.

The regulations further conclude in Example (5) that the additional $2 million payable under the severance arrangement (i.e., two times the $1 million salary increase) is also a material modification and that no amount of severance is grandfathered. Interestingly, the example explains that the increase is a material modification not because the increase in severance is based on substantially the same elements or conditions as the original severance payment and exceeds a reasonable cost–of–living increase but, rather, that the increase in salary on which the additional severance is based exceeds a reasonable cost–of–living increase. This explanation again suggests that the grandfathered status of a severance payment under a severance arrangement like the one described in the examples is based on the grandfathered status of the underlying payment.

A narrow application

Although the examples included in the regulations are relatively simple — and one should be cautious about extrapolating from them too broadly — they appear to reflect a narrow application of the grandfathering rules to severance arrangements. In the case of severance payments determined under a formula that is based on other compensation elements (such as salary or bonus), the regulations appear to look beyond the formula to the underlying payments. The fact that the severance formula is included in a written binding contract that was in effect on Nov. 2, 2017, and that was not materially modified on or after that date is not alone sufficient to grandfather payments made under the severance arrangement. In that situation, the treatment of severance payments as grandfathered or not grandfathered will depend, at least in part, on whether the underlying payments are grandfathered.

Editor

Alexander J. Brosseau, CPA, is a senior manager in the Tax Policy Group of Deloitte Tax LLP’s Washington National Tax office.

For more information about these items, contact Brosseau at abrosseau@deloitte.com.

Contributors are members of or associated with Deloitte Tax LLP.

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