On December 18, 2020, the Internal Revenue Service (IRS) released final regulations (the “Final Regulations”) under Section 162(m) of the Internal Revenue Code, as amended by the Tax Cuts and Jobs Act of 2017 (“TCJA”). Section 162(m) generally limits the deductibility of compensation paid in any tax year to “covered employees” of a publicly held corporation to $1 million.
The TCJA made several significant amendments to Code Section 162(m) including eliminating the qualified performance based compensation exception and expanding the scope of Section 162(m)’s coverage.
The Final Regulations retain the basic approach of the proposed regulations issued in 2019 (the “Proposed Regulations”), with certain clarifications and changes noted below. (see here for study discussing the Proposed Regulations).
Publicly Held Corporation.
Consistent with the Proposed Regulations, the Final Regulations provide that, for ease of administration, a corporation is a publicly held corporation if, as of the last day of its taxable year, its securities are required to be registered under section 12 of the Securities Exchange Act of 1934 (the “Exchange Act”) or it is required to file reports under section 15(d) of the Exchange Act. The Final Regulations clarify that compensation paid by a non-publicly held member of an affiliated group to a covered employee of two or more members of the affiliated group will be prorated for purposes of allocating the deduction among the publicly held members of which the employee is a covered employee.
Distributive Share of Partnership Deduction.
The Final Regulations clarify that a publicly held corporation holding a partnership interest must aggregate its distributive partnership share of any compensation payments with any other allowable deduction. The Proposed Regulations had provided that this rule applied to any deduction for a taxable year ending on or after December 20, 2019 with an exclusion for any compensation paid pursuant to a written binding contract in effect on December 20, 2019 and not materially modified after such date. The Final Regulations extend the effective date to apply only to compensation paid by the partnership after December 18, 2020 provided that such payments are made pursuant to written binding contract in effect on December 19, 2019 that is not materially modified thereafter.
Post-IPO Relief Eliminated.
The Proposed Regulations eliminated the exemption from the $1 million deduction limit for compensation paid by publicly held corporations following the initial public offering for a limited period of time after the corporation became publicly held. The Final Regulations retain the elimination of that special transition relief and clarify that a subsidiary may rely on the transition relief if it became a separate publicly held corporation on or before December 20, 2019.
Grandfather Rule- Negative Discretion.
The Final Regulations do not extend grandfathered protection (i.e., exemption for compensation payable pursuant to written binding contract in effect on November 2, 2017) to arrangements that include the employer’s ability to reduce the amount payable pursuant to its reservation of negative discretion. As an example, if an employer had a right to discontinue contributions to an account balance plan on November 2, 2017, or a later date, then the grandfathered protection only applies to the account balance as of the date such contributions could have been discontinued.
Grandfathered Arrangements Subject to Clawback or Forfeiture.
For purposes of the grandfather rule, the Proposed Regulations provided that if a corporation is obligated or has discretion to recover compensation (i.e., clawback) solely upon the future occurrence of a condition that is outside of the corporation’s control, the recovery right will be disregarded for purposes of determining the grandfathered amount. However, the Proposed Regulations provided that if that condition occurs, only the amount of compensation the corporation is required to pay under applicable law would remain grandfathered. Recognizing that a corporation’s right to recover compensation is a contractual right that is separate from the corporation’s binding obligation under the contract, the Final Regulations modified this rule to provide that the corporation’s recovery right does not affect the determination of the grandfathered amount, regardless of whether the corporation exercises its discretion to recover any compensation in the event the condition arises.
No Material Modification to Extended Stock Rights if 409A Rule Followed.
Under the Final Regulations, compensation that would be recognized upon the exercise of a grandfathered stock option or stock appreciation right will not lose its grandfathered status if the option’s or right’s exercise period is extended in compliance with Section 409A of the Internal Revenue Code.
The Final Regulations are generally applicable to tax years beginning on or after December 30, 2020. Taxpayers can apply the Final Regulations to any tax year beginning after December 31, 2017 if applied in their entirety in a consistent manner to such tax year and all subsequent tax years. The Final Regulations provide special effective dates for certain provisions including determining predecessor corporations, and determining whether a written binding contract exists with respect to account balance plans.