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IRS Explains New Limits on Executive Compensation Deduction

Companies hoping to sidestep the new limits on the executive compensation deduction may be disappointed with new guidance from the IRS, which restricts the grandfather rules and confirms the expanded scope of covered executives. Notice 2018-68 narrowly construes whether pre-2018 contracts qualify for the binding contract exemption. The Notice also clarifies that covered employees are those that served as an executive officer at any time during the tax year.

New Limits for 2018

The Tax Cuts and Jobs Act (TCJA) expanded the $1 million deduction limit for compensation paid to officers of large publicly-held corporations by applying it to the five top executives, including the principal executive officer (PEO), the principal financial officer (PFO), and the three other, highest paid employees. It also removed the exemption for commissions and performance-based compensation, such as stock options, cash bonuses, and some deferred compensation, which now are subject to the $1 million deduction cap.

Covered Employees not Limited to Proxy Disclosures

Executive officers of publicly-held corporations can be covered employees even when disclosure of their compensation is not required under the SEC rules, the IRS states in the Notice. Thus, an employee need not hold his or her position as of the end of the corporation’s taxable year or need not be listed in the proxy disclosure materials to be considered a “covered employee.” Despite the fact that the IRS received numerous requests to exempt employees who did not hold their positions at the end of the year, the IRS Notice includes as a “covered employee” anyone who meets the definition at any time during the year.

Example:

Facts: Assume Z Corporation has a fiscal year ending December 31 for SEC reporting purposes. Corporation Z is a calendar year taxpayer and a publicly held corporation. For 2018, Employee A served as the sole PEO of Corporation Z and Employees B and C both served as the PFO of Corporation Z at different times during the year. Employees D, E, and F were the first, second, and third most highly compensated executive officers of Corporation Z for 2018 other than the PEO and PFO, and all three retired before the end of 2018. Employees G, H, and I were Corporation Z’s fourth, fifth, and sixth highest compensated executive officers for 2018, and all three were serving at the end of 2018.

Conclusion:  Because Employee A served as the PEO during 2018, Employee A is a covered employee. Because Employees B and C served as the PFO during 2018, Employees B and C are covered employees. Even though the SEC rules require Corporation Z to also disclose the compensation of Employees D, E, G, H, and I for 2018, Corporation Z’s covered employees for 2018 are Employees D, E, and F, because these are the three highest compensated executive officers other than the PEO and PFO for 2018. Note that Employee F would not have to be disclosed under the SEC rules but is a covered employee under the IRS executive compensation rules.

Determining Grandfathered Status

The TCJA rules grandfather in compensation provided under a written binding contract that was in effect on November 2, 2017, if the contract is not modified in any material way on or after that date. Overall, the IRS Notice applies this rule narrowly, making it difficult to avoid the deduction cap under the binding contract rule. One bright spot is that renewals of binding contracts continue to be exempt from the deduction cap. For example, if the terms of a contract provide that it will be automatically renewed or extended as of a certain date unless either the corporation or the employee provides notice of termination of the contract at least 30 days before that date, the contract is treated as renewed as of the date that termination would be effective.

Grandfathered status will be lost for if there are material amendments to the contract, such as substantially increasing a certain type of compensation, accelerating compensation, or providing a different type of compensation. A supplemental payment that represents a “reasonable cost-of-living increase” however, will not be considered a material change. The IRS offers examples of these types of changes and their effect on the deduction cap.

The failure to exercise negative discretion under a contract does not result in the material modification of that contract. However, only the amount of incentive compensation that is required to be paid under state law or under the compensation agreement is protected from the deduction cap. An IRS example explains that, if the agreement provides up to $1.5 million in incentive compensation with negative discretion to reduce the award to $400,000, then only the $400,000 will be exempt from the deduction cap.

Other examples illustrate that if the plan allows the company to amend the plan to freeze or reduce contributions in the future, then only the portion of the benefit that is protected from change and that has accrued as of 11/2/2017 is grandfathered.

Review Covered Execs Now

The Notice provides many other clarifications which are important to understand. Companies subject to executive compensation limits should review compensation agreements put in place before November 2, 2017, in light of these clarifications to determine which employees are covered and which contracts are binding. Contact your Frazier & Deeter tax professional to help you with this analysis and to determine how best to handle executive compensation in the future given the new deduction rules.

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