The Internal Revenue Service on Tuesday issued initial guidance on changes to the deductibility of executive compensation that were included in the Tax Cuts and Jobs Act

Those in the executive compensation field had been eagerly awaiting word from the IRS, given that the legislation left many questions about how to apply its compensation provisions.

However, the guidance “doesn’t really address a lot of the meaty issues,” says Andrew Liazos, leader of the executive compensation group for law firm McDermott Will & Emery.

It’s expected that regulations eventually will be proposed to fill the gaps, but “that will take awhile,” laments Liazos, who posted a summary analysis of the guidance on Thursday. “Look how long it took to get this notice.”

Under Section 162(m) of the Internal Revenue Code, companies can claim a maximum $1 million tax deduction on compensation paid to a “covered employee,” which until now has included the CEO and the three other most highly paid executives other than the CFO. Under the new law, covered employees include the CEO, CFO, and the three top-earning executives.

Until now, performance-based pay was exempt from the $1 million limitation. That exemption, part of the Tax Reform Act of 1986, had driven many companies to cap executive salaries at $1 million and provide any additional pay under performance programs.

But the Tax Cuts and Jobs Act eliminated that exception, making performance-based executive compensation also subject to the $1 million deductibility limit.

Kindly Grandfather?

A big unanswered question was how the new rule would apply to compensation arrangements that were established before the TCJA was passed but covered a future period.

The IRS notice gave at least partial answer to that by providing for grandfathering. The TCJA changes to Section 162(m) include a grandfather clause. The new rule will not apply to compensation paid under a “written binding contract” in effect on Nov. 2, 2017, provided the contract is not “materially modified” after that date.

The guidance provides that a material modification occurs when a contract is amended to increase the amount of compensation payable to the employee.

All of that seems clear enough. But as is typically the case with both executive compensation agreements and contract law, the devil is in the details.

Andrew Liazos, McDermott Will & Emery

Notably, the guidance does not address how the law might apply to contracts that provide a board’s compensation committee with “negative discretion” — i.e., the ability to award bonus pay that’s lower than stipulated in the contract, even when performance targets are met. Almost all bonus compensation arrangements in the United States include such a provision, Liazos notes.

That’s thorny because, in general, compensation is treated as paid under a written binding contract only to the extent the company is “obligated under law” to pay it if the employee performs specified services or satisfies vesting conditions, Liazos notes.

Indeed, the IRS guidance provides an example of a contract that requires a payment of at least $400,000, but the compensation committee exercises positive discretion and awards the employee $500,000. The extra $100,000 is then subject to the $1 million tax-deductibility limit, because the company wasn’t obligated to pay it.

Sound fair? In fact, there’s a big problem. “Virtually no contracts have that kind of minimum payment,” Liazos says. “If the bonus for reaching the target is, say, $1.5 million, but there’s language that the amount the executive receives could be less than that, it suggests that the compensation committee could decide to pay a bonus of zero.”

Therefore, under a literal reading of the law and the IRS guidance, it’s feasible that under most contracts, the way they’re currently structured, no bonus amounts would be considered tax-deductible.

What Makes for Material Change?

Also remaining unanswered is what compensation increases constitute material modifications to written binding contracts.

The guidance points out three actions that will not be treated as increasing compensation:

  • An accelerated payment that is discounted for the time value of money
  • A deferred payment that includes earnings based on a reasonable rate of interest or a predetermined actual investment
  • The payment of increased or additional compensation that is equal to or less than a reasonable cost of living increase

“That leaves out everything else that could be changed within these contracts,” Liazos says. “And while an annual bonus is a one-year issue, and long-term incentive payments are typically three-year cycles, deferred compensation agreements might run for a decade or more. I can assure you that there will be lots of amendments to those plans in the next 10 years.”

In many cases, he adds, employees other than top executives might be participants in deferred compensation programs.

“You might have 10% of your work force in these plans,” Liazos says. “So we’ve been telling clients, we don’t know what’s going to be considered a material modification, and putting in a provision that says any change made to the plan won’t apply to the executive officers unless we explicitly say otherwise. That way you won’t inadvertently modify the plan in a way that will cause you to lose a big tax deduction.”

The good news is that most equity awards, such as stock options and  stock appreciation rights, “likely should be OK, absent some unusual circumstances,” according to Liazos. In most cases they are written binding contracts that don’t provide for the exercise of discretion.

Meanwhile, CFOs have a professional interest in the IRS guidance beyond their own compensation.

Most corporate tax directors likely took positions early this year about what level of tax deductibility they expected based on the language in the TCJA. “In many cases, it’s not unreasonable to assume that they took positions that were more aggressive than what’s listed in this IRS notice,” Liazos says.

Specifically, the CFO and the tax director have to determine whether negative discretion was applied to executive pay and, if so, the impact that could have on tax deductibility.

“There may be deferred tax assets on the balance sheet that they’ll now have to write down in light of the guidance,” says Liazos.

He cautions that it’s important for a board of directors to be kept fully informed on any additional compensation costs the company may bear as a result of the changes to IRS Section 162(m). It’s likewise important for the board to consider the impact of the extra costs, and to document that they did so.

“There will surely be plaintiffs’ lawyers filing strike lawsuits, saying shareholders are bearing outrageous costs that the board didn’t even consider,” Liazos says. “My advice to companies is simple: You know there are people trolling for these lawsuits. Protect yourself and make sure you have a record that the board and its committees considered these costs.”

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