Companies have a little more clarity from the Internal Revenue Service about how to interpret provisions under tax reform affecting executive compensation.

On Dec. 20, the Treasury Department and the IRS published long-awaited proposed regulations under Section 162(m) of the Internal Revenue Code, clarifying and expanding upon the new framework for the deductibility of executive compensation by public companies introduced by the Tax Cuts and Jobs Act (TCJA). The massive tax law enacted at the end of 2017 provided, among other things, new rules governing the deductibility of compensation paid to top executives of publicly held companies. The IRS previously issued Notice 2018-68 to provide “initial guidance” on Section 162(m) of the Internal Revenue Code as amended by the TCJA.

First, some background: Under the TCJA, the $1 million deduction cap that already existed under Section 162(m) was expanded to include additional “covered employees,” including the CEO and CFO, even after they are separated from the company. It also expanded the definition of “public company” that would be affected by the provisions to include other securities registrants, such as foreign private issuers and private companies with certain registered debt offerings.

The tax law also removed the “qualified performance-based” exception applied to the $1 million deductibility limit, meaning even performance-based pay would be subject to the deduction cap. Companies have long used performance-based arrangements like bonuses or stock options as part of their executive compensation packages, in part because of the way tax rules have been structured historically.

Proposed regs

The proposed regulations issued by the IRS last week provide additional clarity as to which companies, employees, and compensation are covered by the new Section 162(m) regime, particularly in the context of mergers and acquisitions and newly public companies. Those definitions are, for the most part, consistent with the initial guidance issued by the IRS in Notice 2018-68.

The proposed regulations also address “written binding contracts” and “material modifications” to those contracts and set forth several examples to illustrate how guidance would be interpreted under various facts and circumstances.

At a high level, the proposed regulations address the following aspects of Section 162(m):

  • What constitutes a “publicly held corporation”;
  • Who qualifies as a “covered employee”;
  • What is “compensation” for purposes of the $1 million annual limit on deductibility imposed by Section 162(m);
  • What constitutes a “written binding contract” as of Nov. 2, 2017, that may be grandfathered under the old Section 162(m) rules; and
  • How and when are grandfathered arrangements materially modified such that they become subject to the new Section 162(m) rules.

The IRS is inviting further public comment on other aspects of Section 162(m) amendments, asking for input by Feb. 18, 2020.