8/22/18

Client Alert: Bad News for Employers! New IRS Guidance Regarding Expanded 162(m) Rules

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We previously wrote about the changes to 162(m) under the “Tax Cuts and Jobs Act” which significantly expanded the $1,000,000 deduction cap on compensation paid by publicly traded companies to certain executive officers. On August 21, 2018, the IRS released Notice 2018-68 providing the first official glimpse of their interpretation of the changes to 162(m).  It is mostly bad news for employers.

Which employees are subject to the deduction limitation?

The guidance reflects that the new 162(m) deduction limit may apply to a different list than the proxy disclosure rules.  In general, the test will be applied without requiring the individual to be employed on the last day of the fiscal year or be listed in the proxy materials.  The 162(m) status is determined the same way whether the company is a smaller reporting company or a larger company subject to the full disclosure rules.  The interpretation is best illustrated with an example:

Role/Compensation

Proxy Reporting

162(m) status

CEO  at any time during the year (whether or not employed at year end)

Reported

Covered

CFO at any time during the year (whether or not employed at year end)

Reported

Covered

HCE1 (highest ranked by pay non-CEO/CFO of all executive officers, terminated during year)

Reported

Covered

HCE2 (second highest ranked by pay of all executive officers, terminated during year)

Reported

Covered

HCE3 (third highest ranked by pay of all executive officers, terminated during year)

Not reported

Covered

HCE4 (fourth highest paid non-CEO/CFO executive officer overall, highest who was employed on the last day of the fiscal year)

Reported

Not covered

HCE5 (fifth highest paid non-CEO/CFO executive officer overall, second highest who was employed on the last day of the fiscal year)

Reported

Not covered

HCE6 (sixth highest paid non-CEO/CFO executive officer overall, third highest who was employed on the last day of the fiscal year)

Reported

Not covered

If the company has a short-fiscal year, the list of covered employees could be determined twice for one 12 month period (once for each short fiscal year).

What compensation is grandfathered (subject to transition relief)?

Compensation that would have been exempt under prior law remains deductible if it is payable pursuant to a written binding contract which was in effect on November 2, 2017 and which was not modified in any material respect on or after such date. This is referred to as grandfathering and/or transition relief. The IRS proposes to define this exception very narrowly:

Companies subject to the deduction limitation should act now: (1) to confirm that the list of individuals that they have identified as subject to the deduction limitation comply with this methodology, (2) to determine what portion, if any, of current compensation arrangements would be able to be grandfathered, and (3) consider methods to maximize the deductibility of current and future compensation. The grandfathering analysis will be very nuanced with minor changes in the facts or plan provisions changing the deduction status.

If you have questions or want assistance evaluating the impact of this interpretation on your compensation programs, contact your Vorys relationship attorney.