On Friday, December 18, the IRS released final regulations under section 162(m) implementing the statutory changes made in 2017 by the Tax Cuts and Jobs Act. Section 162(m), as amended, generally limits the deduction for compensation (also referred to as applicable employee remuneration) paid to the a publicly held corporation’s principal executive officer (“PEO”), principal financial officer (“PFO”), and its three highest-paid executive officers other than the PEO and PFO. The final regulations are largely unchanged from the proposed regulations released almost exactly one year earlier. (See earlier coverage.) The IRS did make a small number of changes in response to taxpayer comments, but declined to make changes in a number of areas.
Affiliated Groups. The final regulations clarify that compensation paid by a non-publicly held corporation that is a member of an affiliates group which contains a publicly held corporation, to an employee who is a covered employee of two or more other members of the affiliated group, is prorated for purposes of the determining the deduction disallowance among the members that are publicly held corporations of which the employee is a covered employee.
Special Applicability Dates. Like the proposed regulations, the final regulations contain a number of special applicability dates. Most of them are the same as in the proposed regulations.
The provisions defining a predecessor corporation of a publicly held corporation apply to corporate transactions that occur on or after the date the final regulations are published in the Federal Register. If a corporate transaction occurs before the date the final regulations are published in the Federal Register, then taxpayers may apply either the definition of predecessor of a publicly held corporation under the final regulations or a reasonable good faith interpretation of the term “predecessor” in with respect to such transaction.
However, with respect to any of the following corporate transactions occurring after December 20, 2019, and before the date the final regulations are published in the Federal Register, excluding target corporations from the definition of the term “predecessor” is not a reasonable good faith interpretation of the statute:
- a publicly held target corporation the stock or assets of which are acquired by another publicly held corporation in a transaction to which Section 381(a) applies, and
- a publicly held target corporation, at least 80% of the total voting power of the stock of which, and at least 80% of the total value of the stock of which, are acquired by a publicly held acquiring corporation (including an affiliated group).
The preamble states that no inference is intended regarding whether the treatment of a target corporation as other than a “predecessor” in any other situation is a reasonable good faith interpretation of the statute.
Under the proposed regulations, a corporation that was not a publicly held corporation but then became a publicly held corporation on or before December 20, 2019, may rely on the transition relief provided in Treasury Regulation § 1.162-27(f)(1) until the earliest of the events provided in § 1.162-27(f)(2). As a result, amounts paid under compensation plan or agreement that existed when the corporation was not publicly held until the plan or agreement expires or is materially modified; all of the stock and other compensation allocated under the plan has been issues; or the first shareholder meeting at which directors are elected that occurs after the close of the third calendar year following the calendar year in which the initial public offering occurs or, in the case of a privately held corporation that becomes publicly held without an initial public offering, the first calendar year following the calendar year in which the corporation becomes publicly held. IN a bit of good news, the final regulations clarify that a subsidiary corporation that is a member of an affiliated group may rely on the transition relief provided in Treasury Regulation § 1.162-27(f)(4) if it became a separate publicly held corporation on or before December 20, 2019.
The final regulations also delay the special applicability date for the provision defining compensation to include a corporations distributive share of a partnership’s deduction for compensation expense. The proposed regulations would have applied the change to any deduction for compensation paid by a partnership that is otherwise allowable for a taxable year ending on or after December 20, 2019, unless it was paid under a written binding contract that was in effect on that date. The final regulations apply the rule only to compensation paid after December 18, 2020, but does not apply to amounts paid after December 18, 2020, provided that the amounts are paid pursuant to a written binding contract that was in effect on December 20, 2019, and that was not materially modified after that date.
Material Modifications. The final regulations incorporate a rule from Section 409A permitting the extension of stock options and SARs to excluded such extensions from the definition of material modification for purposes of the grandfather. Under the final regulations, if compensation attributable to the exercise of a non-statutory stock option or a SAR is grandfathered and the exercise period of the option or SAR is extended, then all compensation attributable to the exercise of the option or the SAR is grandfathered if the extension complies with Treasury Regulation § 1.409A-1(b)(5)(v)(C)(1). In general, this will not treat an extension as a material modification if at the time of the extension, the exercise price is greater than the underlying stock’s fair market value and the exercise period is extended to a date no later than the earlier of the latest date upon which the stock right could have expired by its original terms or the 10th anniversary of the original date of grant.
Section 409A Coordination. The IRS did not provide any further relief to address arrangements that defer payments until they are deductible. Prior to the amendment of Section 162(m) in 2017, some deferred compensation plans mandated that payments be delayed until the payment would be deductible. This typically delayed payments until an individual was no longer a covered employee, either because the individual was no longer among the top-paid group or because the individual terminated employment. However, Section 162(m) was amended to make covered employee status permanent. Thus, a payment that was subject to a delay might never become payable. To address situation, the proposed regulations indicated that the IRS intended to amend the 409A regulations to permit a plan or arrangement that mandates the delay of payments until such time as the deduction is not limited by section 162(m) to be amended no later than December 31, 2020, to remove the required delay. If a corporation would have been required to make payments before December 31, 2020, as a result of the plan amendment, the payments must be made no later than December 31, 2020. The final regulations do not provide an extension of these deadlines.
Negative Discretion. Despite multiple requests from taxpayers, the IRS also refused to extend the protection for grandfathered compensation arrangements to arrangements that include a so-called negative discretion clause to reduce the amount payable under the objective formula. The IRS did acknowledge, however, that if the employer reserves negative discretion under an agreement but that the company is unable to exercise that discretion under applicable law (including state law), the arrangement may nonetheless be grandfathered.
Other Requested Changes. The IRS declined make a number of other changes requested by taxpayers. Like the proposed regulations, the final regulations do not exclude amounts paid for services rendered as an independent contractor from the scope of the limitation. Similarly, the IRS declined to excluded payments made post-termination or post-death based on a distinction between the language of Section 4960 (which included a parenthetical referencing former employees) and section 162(m) (which contains no such parenthetical).
After the IRS delivered a “lump of coal” with the proposed regulations last year, it seems safe to say that the final regulations are not likely to make many taxpayers who are concerned about Section 162(m) inclined to put the IRS on the “nice list” in 2020.