The Case for Negative Discretion in a “Written Binding Contract” for Purposes of Section 162(m)

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February 5, 2018

Code section 162 of the Internal Revenue Code allows companies a deduction of all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.  This includes a deduction for reasonable compensation for personal services actually rendered.  However, Code section 162(m) limits the deduction of any publicly held corporation to $1 million with respect to compensation paid to a “covered employee,” subject to certain exceptions.  Section 13601 of Public Law 115-67, better known as the Tax Cuts and Jobs Act (the “Act”), amended Code section 162(m) in three critical ways:

  1. Prior to amendment, Code section 162(m) contained exceptions to the $1 million deduction limitation for qualified performance-based compensation and commissions.  Both of those exceptions were eliminated.
  2. Prior to amendment, each of the chief executive officer and the three highest-paid officers of the corporation other than the chief executive officer and the chief financial officer was a covered employee for purposes of Code section 162(m). The law modified the definition of “covered employee” to increase the number of individuals deemed to be “covered employees.”  Under the new definition, any individual who served as the principal executive officer or principal financial officer at any time during the taxable year and the three highest paid officers during the taxable years other than those individuals whose compensation is required to be disclosed to shareholders will be a covered employee for the taxable year.  In addition, any individual who qualified as a covered employee for any taxable year beginning after December 31, 2016, will remain a covered employee for all future taxable years.
  3. Prior to amendment, a corporation was a “publicly held corporation” only if it had a class of stock that was publicly traded. The law expanded the definition of “publicly held corporation,” to include any issuer required to file reports under Section 15(d) of the Securities Exchange Act of 1934, which generally includes companies that issued public equity or debt securities not listed on a U.S. exchange.

These changes are generally effective for taxable years beginning after December 31, 2017.  However, Section 13601(e)(2) of the Act provides transition relief for “written binding contracts.”  Practitioners have raised concerns about how this transition rule applies to compensation arrangements that include “negative discretion”—or the right of a company to pay less than the amount that would otherwise be paid under the terms of a plan.  Some have questioned whether an arrangement that includes negative discretion constitutes a “written binding contract” for purposes of the transition relief.

This commentary argues that compensation agreements with negative discretion should be treated as “written binding contracts,” and that as a result, the transition relief provided under Section 13601(e)(2) of Public Law 115-67 should apply.

What is a “written binding contract” for purposes of the transition relief?

Section 13601(e)(2) of Public Law 115-67 provides that the changes made by Section 13601 do not apply to remuneration provided pursuant to a “written binding contract” that (1) was in effect on November 2, 2017, and (2) was not modified in any material respect on or after that date.  The most critical inquiry, then, is whether a particular contract constitutes a “written binding contract,” such that deductions for payments under it are treated as grandfathered.

Application of 1993 Transition Rule

The transition rule is drawn from the transition rule included in Code section 162(m)(4)(D) when section 162(m) was adopted in 1993.  Although the Internal Revenue Service (“IRS”) has not released guidance on the meaning of a “written binding contract” under Section 13601(e)(2) of the Act, it issued Treasury Regulations interpreting the earlier transition rule in Code section 162(m)(4)(D).

In Treasury Regulation § 1.162-27(h)(1)(i), the IRS interpreted the “written binding contract” requirement to mean that, under applicable state law, the corporation must be obligated to pay the compensation if the employee performs services.  Further, a written binding contract that is renewed is treated as a new contract as of the date of the renewal.  If a contract could be terminated by the employer without the consent of the employee, the contract is treated as a new contract as of the date on which the termination would be effective if the employer terminated the contract.  Under Treasury Regulation § 1.162-27(h)(1)(ii), if a plan or arrangement constitutes a written binding contract, payments under the plan or arrangement may be considered grandfathered even if the employee was not a participant in the plan at the time that the contract was required to be in effect, provided that the employee was either an employee of the corporation that maintained the plan or arrangement on such date, or had a right to participate in the plan or arrangement under a written binding contract as of that date.

The Joint Explanatory Statement released by the conference committee mirrors the language of the Treasury Regulation and provides the following example of how the transition rule of Section 13601 of the Act is intended to work:

Suppose a covered employee was hired by XYZ Corporation on October 2, 2017 and one of the terms of the written employment contract is that the executive is eligible to participate in the ‘XYZ Corporation Executive Deferred Compensation Plan’ in accordance with the terms of the plan. Assume further that the terms of the plan provide for participation after 6 months of employment, amounts payable under the plan are not subject to discretion, and the corporation does not have the right to amend materially the plan or terminate the plan (except on a prospective basis before any services are performed with respect to the applicable period for which such compensation is to be paid). Provided that the other conditions of the binding contract exception are met (e.g., the plan itself is in writing), payments under the plan are grandfathered, even though the employee was not actually a participant in the plan on November 2, 2017.

The fact that a plan was in existence on November 2, 2017 is not by itself sufficient to qualify the plan for the exception for binding written contracts.

Some conclusions can be drawn from this example.  It is clear that an employee need not have actually earned a benefit under a plan or even been eligible to participate in a plan as of November 2, 2017, for payments under the plan to be grandfathered.  It appears to be enough that the employee was (1) an employee and (2) contractually entitled to participate in the plan as of November 2, 2017.

This is similar to the requirement in the existing Treasury Regulations for the 1993 transition rule, except that the test in the Joint Explanatory Statement is more clearly conjunctive.  However, the example is ultimately frustrating in that it is not clear what kind of deferred compensation plan the conference committee was discussing in the example and whether certain facts present in the example are necessary for an arrangement to be grandfathered.  Of particular concern for purposes of analyzing an agreement in which the employer retains negative discretion is the statement that under the plan, “the corporation does not have the right to amend materially the plan or terminate the plan (except on a prospective basis before any services are performed with respect to the applicable period for which such compensation is to be paid).”

This statement causes concern because negative discretion could be interpreted as the right to amend materially the plan retroactively on a unilateral basis.  Many stock option awards limit the right of the company to terminate or amend the plan in a manner that is detrimental to the value of preexisting awards.  Accordingly, there is little doubt that such an award should be treated as a written binding contract whether or not the award was vested as of November 2, 2017.  The Treasury Regulations and the example in the Joint Explanatory Statement both permit a plan to require that an employee perform services after the grandfather date to be entitled to a payment.  Consequently, it follows that the mere requirement of future services before payment should not alone operate to make an agreement anything other than a binding contract.

Unlike stock options plans, many written annual bonus, performance share unit, and other types of performance-based compensation plans allow the compensation committee to reduce, based on subjective factors, the award otherwise determined based on the attainment of objective performance goals.  Treasury Regulations explicitly permit this practice in performance-based compensation plans by stating that a performance goal is not discretionary merely because the compensation committee is permitted to reduce or eliminate the compensation that was due upon the attainment of the performance goal.  In Treasury Regulations § 1.162-27(e)(2)(vii), Example 8, a corporation’s bonus plan, under which certain employees receive a certain percentage of a bonus pool if certain pre-established performance goals are met, is treated as qualified performance-based compensation even if the compensation committee ultimately reduces the percentage paid to a certain employee, so long as it does not result in a corresponding increase to another employee’s share.

The concern regarding these “negative discretion” arrangements is that the corporation may not be viewed as obligated to pay the amount due under the plan if the corporation has a unilateral right to reduce the amount payable.  In other words, the unilateral ability of the company to reduce the award renders the award less than a written binding contract, as the company would not have an obligation under state law to pay any amount.

However, the example in the Joint Explanatory Statement provides at least some support for interpreting the transition rule broadly enough to permit negative discretion.  In the example, the executive will not be eligible to earn any benefit under the deferred compensation plan until April 2, 2018.  The employer in the example may unilaterally terminate the plan or amend the plan until April 2, 2018.  Accordingly, as of November 2, 2017, the executive in the example has no right to any benefit under the deferred compensation plan.  Yet, the mere existence of a right to participate in the deferred compensation plan as of November 2, 2017, is sufficient for payments under the plan to be treated as grandfathered.  Negative discretion could be analyzed in much the same way.  In other words, the executive’s legal right to have a bonus awarded under an annual bonus plan or other performance-based compensation plan could be sufficient for the award to be treated as grandfathered, even when the amount of the award will not be fixed until a later date.

Moreover, the IRS has not historically taken the position that any negative discretion has the effect of making an agreement nonbinding—at least with respect to a certain amount of negative discretion.  In one IRS field service advice and corresponding chief counsel advice, the IRS ruled on the application of the 1993 transition rule to a bonus plan that permitted negative discretion. Although this guidance is dated and the IRS may reach a different conclusion if the same issue were to be presented today, we nonetheless believe the guidance presents a technical path to reaching what we believe should be the appropriate conclusion regarding the scope of the transition relief in the Act.

In Field Service Advice 199926030 and Chief Counsel Advice 199926030, the IRS addressed two performance pay plans that permitted the employer to adjust the bonus award beyond the objective operation of a formula in the plan.  One plan provided discretion to unilaterally adjust individual awards, based on subjective factors, upward or downward with a range of 80% to 120% of the total “guideline bonus opportunity,” which was tied to predetermined company performance measures. In the second plan, the employer could unilaterally “increase or decrease performance criteria, targets, [and] payment schedules” in its sole discretion based on extraordinary circumstances not anticipated at the time the award was granted.  In considering whether awards under the plans were written binding contracts, the IRS did not take issue with either the positive or the negative discretion permitted under the agreement.  Instead, the IRS found that both plans constituted written binding contracts, despite the discretion provided to the employer.  Moreover, the IRS did not limit the application of the transition rule to the 80% minimum set forth in the first plan—Code section 162(m) was held not to apply to the full amount of the award ultimately given to the employee.

The IRS’s analysis in the field service advice and chief counsel advice combined with the lack of IRS guidance to the contrary suggest that the IRS has historically considered an agreement to be a written binding contract so long as the corporation is obligated to honor the terms of the agreement.  In other words, the fact that the exact amount awarded under an agreement is subject to discretion does not necessarily undermine the status of the agreement as a written binding contract.  The IRS’s analysis in Field Service Advice 199926030 recognizes this by determining that under state law, the employee’s reliance on the contract may have the effect of making a contract binding upon the employer even in an at-will employment relationship.

State law, in at least some jurisdictions, supports the IRS’s analysis and also provides support for the position than a written contract is binding even if the employer has discretion to determine the amount of the bonus paid.  In other contexts, courts in California have held that a contract is unenforceable only if the presence of discretion renders the contract lacking in consideration.  See, e.g., Auto. Vending Co. v. Wisdom, 182 Cal. App. 2d 354 (Cal. Ct. App. 1960).  That a party to a contract reserves the power of varying the price does not render the contract unenforceable if the power to vary the price is subject to implied limitations.  E.g., id. (citing 1 Corbin on Contracts § 98).  Courts are “prone” to imply limitations on discretion when necessary to avoid rendering the consideration under a contract illusory.  See e.g., Third Story Music, Inc. v. Waits, 41 Cal. App. 4th 798 (Cal. Ct. App. 1995) (citing 1 Corbin on Contracts, supra, § 1.17 and 2 Corbin on Contracts § 5.28).

Although various courts have reached different conclusions, a number of courts have held that when a party to a contract is permitted to vary the price to be paid, a duty is imposed to exercise that discretion in good faith and in accordance with fair dealing, particularly if no other consideration is paid under the contract.  See, e.g., Perdue v. Crocker Nat’l Bank, 702 P.2d 503 (Cal. 1985); Wolf v. Walt Disney Pictures and Television, 76 Cal. Rptr. 3d 585 (Cal. Ct. App. 2008).  Courts in other states have reached similar conclusions.  See, e.g. Wilson v. Amerada Hess Corp., 773 A.2d 1121 (N.J. 2001) (citing Steven J. Burton, “Breach of Contract and the Common Law Duty to Perform in Good Faith,” 94 Harv. L. Rev. 369 (1980)) (“decisions concerning price that are deferred to the discretion of one of the parties must be made in good faith”); Furrer v. Sw. Or. Cmty. Coll., 103 P.3d 118 (Or. 2004) (citing Wyss v. Inskeep, 699 P.2d 1161 (Or. 1985)) (“Wyss therefore stands for the proposition that, when an employment contract vests an employer with discretion in conferring a particular employment benefit, that discretion must be exercised in good faith.  Stated differently, even if the employer’s discretion extends to denying the benefit, its decision to do so must be made in good faith.”).

In the event that a performance-based compensation agreement has other consideration beside the payment that is subject to discretion, the discretion would not generally render the contract unenforceable under state law.  If the agreement does not have other consideration—such as performance-based award that provides only the bonus subject to the employer’s discretion—at least some courts have relied on the implied covenants of good faith and fair dealing to avoid rendering a contract illusory and to protect the reasonable expectations of the parties.  Indeed, in considering the application of the covenants to a bonus plan under which the employer retained “sole discretion” to terminate or amend the plan “for any . . . reason that [it] determines,” the Seventh Circuit, applying Illinois law, held that the employer’s discretion was limited by the implied covenants and the reasonable expectations of the parties.  Wilson v. Career Educ. Corp., 729 F.3d 665 (7th Cir. 2013).  Ultimately, the employee in that case was unable to demonstrate that the employer exercised its discretion in bad faith, but that does not change the conclusion that the contract itself was binding.  Wilson v. Career Educ. Corp., 844 F.3d 686 (7th Cir. 2016).  The plain language of the transition rule does not require that the specific amount of remuneration paid be fixed under the contract, only that the remuneration be paid under a written binding contract.  Case law demonstrates that the mere presence of discretion to determine the amount of remuneration does not generally render a written contract nonbinding even if the covenant of good faith and fair dealing do not serve as implied limitations on the exercise of the discretion.

More recently, the IRS has also recognized that negative discretion does not render an agreement unenforceable against an employer.  The IRS has recognized in the context of Code section 409A that the presence of negative discretion in a compensation arrangement may lack “substantive significance” such that an amount may not be subject to a substantial risk of forfeiture even if the service recipient retains the right to reduce or eliminate the compensation.  Treas. Reg. § 1.409A-1(b)(1).  The question of whether discretion lacks substantive significance is based on the facts and circumstances, although the examples in the regulations focus on the control or influence of the service provider over or on the service recipient.  It is worth noting that the discussion in the regulations is focused on whether an amount is subject to a substantial risk of forfeiture.  The example in the Joint Explanatory Statement makes clear, however, that an amount may be subject to a substantial risk of forfeiture and still be considered paid under a binding written contract.  Moreover, the initial transition rule in the Senate Finance Chairman’s Mark included a requirement that the compensation be no longer subject to a substantial risk of forfeiture as of December 31, 2016.  That requirement was removed in a later modification to the Chairman’s Mark.  Because the standard of whether an amount is paid under a written binding contract is a lesser standard than finding an amount is not subject to a substantial risk of forfeiture, we do not think the presence of negative discretion precludes a determining than agreement is a written binding contract even if it was sufficient to result in an amount being treated as subject to a substantial risk of forfeiture.

Public Policy Considerations

Sound policy reasons also justify interpreting the transition rule broadly enough to permit negative discretion. First, from a policy perspective, it seems odd that an agreement to pay $X upon the attainment of an objective performance goal would be treated differently than an agreement to pay up to $X upon the attainment of the same goal.  Neither presents a significant opportunity for the corporation to circumvent the Code section 162(m) limitation.  Both arrangements specify a pre-determined maximum amount of performance-based compensation so as to prevent a corporation from seeking to deduct other amounts by treating the amounts as paid under the grandfathered arrangement.  The prohibition on material modifications—and the existing Treasury Regulations interpreting that prohibition for purposes of the 1993 transition rule—are sufficient to prevent any potential abuse.  The limited guidance issued with respect to the 1993 transition rule provides support for applying the transition rule in Section 13601(e)(2) of the Act to allow for negative discretion.

Second, negative discretion is a common feature across many types of executive compensation agreements.  The Treasury Regulations governing what constitutes qualified performance-based pay specifically permit negative discretion, and including negative discretion represents sound corporate governance, as it provides corporations with a mechanism for adjusting performance-based compensation to reflect individual performance in a way that objective performance goals often cannot.  Given the broad adoption of negative discretion in various executive compensation arrangements, Congress should be presumed to have known that many performance-based pay plans include negative discretion.  It seems unlikely Congress would have intended to exclude such a large number of performance-based plans from the provided relief without an explicit discussion of that decision in the conference report.  Sound public policy dictates that the transition rule should not be interpreted in a way that would exclude from its scope a large number of the very arrangements that the rule was primarily designed to grandfather.

Finally, the transition rule should protect employers’ reasonable expectations by shielding pre-existing arrangements that satisfy the requirements for performance-based compensation from the expanded deduction disallowance.  In response to administrative guidance and Congressional prodding, corporations adopted performance-based pay plans to preserve the deductibility of the compensation paid to senior executives.  Unlike the 1993 rule, where a pre-existing agreement that was not grandfathered could always be replaced with a new compensation arrangement that satisfied the requirements for performance-based compensation and ensured future deductibility, corporations that relied on existing law to structure their arrangements as deductible have little recourse if such agreements are beyond the scope of the transition rule under Section 13601 of the Act.  Replacing existing plans with new plans would simply ensure that the compensation paid under the replacement plan is not deductible.


Many companies have been left scrambling to address the effect of the Code section 162(m) changes for purposes of their financial reporting obligations with respect to deferred tax assets.  That is complicated by the uncertainty regarding how broadly the IRS will interpret the transition relief provided in the new law.  The IRS should interpret the language of the transition relief in light of its purpose and in a manner that protects the reasonable expectations of corporations.  Compensation arrangements adopted with the understanding that the payments under them would be deductible should be within the scope of the transition rule.  Ultimately, Treasury or the IRS should quickly issue guidance clarifying that the presence of negative discretion does not preclude an agreement from being treated as a written binding contract.