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

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.

Conclusion

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.

IRS Issues Guidance on Withholding Changes Made by Tax Reform

In the wake of changes made by the tax reform law (commonly referred to as the Tax Cuts and Jobs Act) to an employer’s withholding obligations, the IRS is working to update its forms and procedures to reflect those changes.  Yesterday, the IRS issued Notice 2018-14 to communicate its progress and provide transition relief in areas that it has not finished updating to reflect the changes in law, including Forms W-4 and application of the withholding rules personal exemptions.

Expiration of Exempt Forms W-4

Employees furnish Form W-4 to employers to claim withholding allowances, or to claim an exemption from income tax withholding.  Forms W-4 that claim an exemption from withholding expire the following year on February 15.  Accordingly, Forms W-4 furnished for 2017 claiming an exemption from withholding on Line 7 will generally expire on February 15, 2018.  In recognition of the fact that a 2018 Form W-4 will likely not be released prior to the expiration of those forms, Notice 2018-14 extends the validity period of 2017 Forms W-4 to February 28, 2018.  Accordingly, employers need not receive a new Form W-4 before February 15, 2017, for employees who have claimed an exemption from withholding nor must they begin withholding on those employees after that date.

Notice 2018-14 also provides specific instructions for how employees should claim an exemption in 2018 using the 2017 Form W-4 (such as striking through 2017 on Line 7 and entering 2018, entering “Exempt 2018” on Line 7, or a substantially similar method) until 30 days after the 2018 Form W-4 is released.  In all cases, the Form W-4 claiming an exemption from withholding must be signed in 2018 to be valid for 2018.  Employees who claim an exemption from withholding for 2018 on a Form 2017 Form W-4 are not required to submit a new Form W-4 for 2018 after the 2018 Form W-4 is released.

Changes in Withholding Allowances

Under the current law, employees must furnish a new Form W-4 to their employers within 10 days of a change in status that reduces the number of withholding allowances to which they are entitled (such as the loss of itemized deductions).  Notice 2018-14 provides that an employee is not required to furnish his or her employer a new Form W-4 reflecting the reduced number of allowances until 30 days after the 2018 Form W-4 is released.

Flat Rate Withholding

As reflected in the revised Notice 1036 (discussed here), employers are not required to implement the changes to the flat withholding rate available for supplemental wages until February 15, 2018, a delay from the otherwise-applicable January 1 effective date for the new rate.  Under the Act, the withholding rates were reduced from 25% and 39.6% to 22% and 37%, respectively.  If an employer withheld at a higher rate for optional flat-rate withholding (25%) on or after January 1, but before February 15, the employer may refund the excess withholding to the employee using the standard rules related to corrections of excess federal income tax withholding, but is not required to do so.  (Notice 2018-14 is silent on correction of overwithholding based on the higher rate for mandatory flat-rate withholding (39.6%), but presumably similar refunds could be made.)

The new 22% rate optional flat-rate withholding on supplemental wages of less than $1 million increases the likelihood that higher-income employees may be significantly underwithheld on bonus and other compensation.  IRS guidance prohibits employers from withholding at any other rate (higher or lower) than the specified rate if the flat-rate method is used.  As a practical matter, it is unclear what enforcement measures, if any, the IRS could take if an employer permitted employees to elect a rate in excess of 22% to avoid underwithholding and the need for estimated tax payments.  In years past, IRS personnel have informally expressed concern that some individuals may attempt to “game the system” by requesting increased rates of flat rate withholding, but this concern seems more hollow when the rate of optional flat withholding – particularly for higher income workers – seems to fall well below applicable income tax rates.

Withholding on Periodic Payments in the Absence of Form W-4P

Prior to amendment by the Act, withholding at the rate applicable to a married individual claiming three withholding allowances was required with respect to periodic payments made under an annuity, IRA, or qualified plan subject to withholding under Code section 3405 if the payee did not provide a Form W-4P.  The Act amended that provision to require withholding at a rate to be determined by the Secretary of the Treasury.  Due to the implementation timeline for changes under the Act, Notice 2018-14 instructs employers to impose withholding in 2018 on such payments at the same rate previously applicable (married individual claiming three withholding allowances).

For additional guidance on these requirements, employers should consult the 2018 IRS Publication 15, which was also released yesterday and is consistent with the relief provided in Notice 2018-14.

IRS Withholding Guidance Expected in January

December 26, 2017 by  
Filed under Employment Taxes

In a news release, the IRS today announced that it anticipates issuing initial withholding guidance to implement the changes under the tax reform bill in January 2018.  Employers and payroll service providers are encouraged to implement the changes in February.  In the release, the IRS indicated that the withholding guidance will work with the existing Forms W-4 that employees have already provided to their employers.  Until guidance is issued, employers and payroll service providers should continue to use the existing 2017 withholding tables and systems.

Fate of Employer Tuition Assistance Programs Hangs in the Balance

On December 2, the Senate passed a version of the Tax Cuts and Jobs Act that differed in key respects from the House bill passed several weeks prior.  Notably, the House bill would eliminate the exclusion of up to $5,250 from an employee’s wages for qualified educational assistance under Code section 127 (discussed here), but the Senate bill would leave the exclusion in place.  While headlines address the more high-profile differences between the bills (e.g., the new corporate tax rate and the repeal of the ACA’s individual mandate), a number of large employers, including a number of our clients, have expressed concern about the fate of tuition assistance programs, as they view it as an important benefit for their employees.  This backlash is unsurprising, given that the Society for Human Resource Management (SHRM) estimates that over 60% of employers offer some form of tuition assistance.

The fate of the tuition assistance exclusion, as well as all other areas in which the House and Senate bills disagree, now rests with the conference committee.  The Senate bill also retains the exclusion for qualified tuition reductions provided by educational institutions that the House bill would eliminate, representing another education benefit that the conference committee will need to address.  The conference committee is tasked with reconciling the differences between the two bills, and it is expected that the process will conclude within the next one to two weeks.  Conference committees are notoriously unpredictable, making it difficult to anticipate the fate of the tuition assistance provision, particularly with many of the details of the final legislation in flux.  Though several major employers, as well as SHRM, have vocalized objections to the House bill’s proposed repeal, public criticism of a possible repeal has not been as strong as some had anticipated, a fact that could influence policymakers.

Educational Benefits that Qualify for Exclusion as Working Condition Fringe Benefits

Notably, neither version of the Bill would affect the ability of employees to exclude education benefits that qualify as working condition fringe benefits from taxable wages under Code section 132(d).  Working condition fringe benefits include any property or services that would have been deductible by an employee as a business expense had the employee paid for it his or herself.  Some employers have questioned whether the suspension of miscellaneous itemized deductions under Code section 67 under the Senate bill and the new Code section 262A that would be added by the House bill disallowing deductions for unreimbursed business expenses would eliminate the exclusion for working condition fringes because the expenses would no longer be deductible under Code section 162 by the employee if the employee had paid them directly.  The House bill directly addresses this by amending Code section 132(d) to specify that it is determined without regard to Code section 262A.  Although the Senate bill is silent, the change to section 67 would not seem to affect working condition fringes as the exclusion is currently applied without regard to the 2% of adjusted gross income floor that section 67 applies under current law.

Many employers offer educational benefits that qualify for exclusion as a working condition fringe benefit because the benefits are limited to education that maintains or improves job skills or meets requirements for the employee to remain in his or her current position.  One example would be a program under which the employer pays for continuing education courses for medical professional, lawyers, and accountants.  Education benefits that qualify as working condition fringes are more flexible than under Code section 127 because there is no dollar limit and a written plan is not required.  Travel and lodging expenses incurred as part of attending courses can also qualify for exclusion.

Senate Tax Reform Legislative Text Clarifies Some Provisions

Earlier today, the Senate Finance Committee released legislative text of its version of the Tax Cuts and Jobs Act.  Up until now, only “conceptual language” had been available.  The text clarifies some of the provisions that we have previously discussed in our posts about the Senate bill (see earlier discussions herehere and here) and includes new information reporting requirements that we have not previously covered:

  • The legislative text would disallow any deduction for meals provided at the convenience of the employer and meals provided in an “employer-operated eating facility.” If the employer chooses to offer food and beverages, they will remain excludable (to the extent currently excludable) from the employee’s income and wages under section 132, but the cost of providing them would not be deductible.  It is somewhat unclear what the effect of the deduction disallowance would be with respect to employer-operated eating facilities that collect sufficient revenue to cover their operating expenses.  Arguably, the provision could result in the employer recognizing revenue for the food and beverages sold to employees in the facility but having no deduction for the costs associated with selling food and beverages.  (Update: Upon further thought, we believe that the employer would not lose the deduction to the extent the employees pay for food and beverages purchased from the employer-operated eating facility because only the value of such food and beverages in excess of the amount paid is excludible from income under Code section 132(e) as a deminis fringe benefit.)  The new total deduction disallowance would be repealed for taxable years beginning after December 31, 2025, provided government revenue exceeds a target during the period 2018 through 2026.  The provision is effective if the cumulative on-budget Federal revenue from all sources for the 2018 through 2026 government fiscal years exceeds $28.387 trillion.
  • As expected, the text would eliminate the exclusion for bicycle commuting reimbursements, but in a surprise, the elimination is only temporary. The bill adds a new Code section 132(f)(8), which suspends the availability of section 132(f)(1)(D) from 2018 through 2025.  The exclusion would become available again in 2026.  This suggests that the Finance Committee’s decision to eliminate this exclusion may be driven more by revenue demands than by policy considerations, as it helps ensure the reconciliation bill meets the revenue target within the budget window.
  • Also as expected, the deduction for moving expenses and the related exclusion for qualified moving expense reimbursement were eliminated, but they too are only temporary suspensions. The bill would eliminate the deduction under Code section 217 and the exclusion under Code section 132(a)(6) (with an exception for active duty military moving pursuant to a military order and incident to a permanent change of station) from 2018 through 2025.  The exclusion would become available again in 2026.  Revenue demands likely also drove this change.
  • As we discussed in an earlier post, the Senate text makes changes to Code section 162(m) eliminating the exceptions for performance-based pay and commissions to the $1,000,000 deduction limitation for executive remuneration. However, unlike the conceptual language released earlier that contemplated an even broader expansion of the definition of “publicly held corporation,” the Senate text adopts a definition identical to the expanded definition in the House tax reform legislation (discussed here).  The Senate text does not include large private corporations as contemplated by the conceptual language.
  • The Senate text would add a new subsection (l) to Code section 272 that, as expected, eliminates the employer’s deduction for any expense, payment, or reimbursement for providing transportation to an employee in connection with travel between the employee’s work and the employee’s residence. This would eliminate the deduction for qualified transportation fringes, including van pool expenses, transit passes, parking, and other amounts excluded from the employee’s income under Code section 132(f).  This would seem likely to reduce the popularity of pre-tax transit programs under which employees elect to forgo taxable compensation in exchange for transit benefits, because the employer loses a deduction for compensation expenses that it would otherwise be entitled to as a result of the employee’s election to receive some of his or her compensation in the form of transit benefits.  The provision, as we speculated in an earlier post, does not carve out transportation reimbursements taxable to the employee.  For example, if an employee lives away from his tax home (i.e., his or her place of principal employment), the bill appears to disallow the compensation deduction if the employer elects to pay the employee for transportation costs between the employee’s residence and the office even though such amount is taxable to the employee.
  • As described in the Finance Committee’s conceptual language, the legislative text would adopt a new Code section 6050X. The language would require government agencies (or entities treated as government agencies) to report to the IRS and taxpayer on a new information return the amount of each settlement agreement or order entered into where the aggregate amount required that the government required or directed to be paid or incurred exceeds a threshold ($600, in the statute, but subject to adjustment by the Treasury).  The return must identify any amounts that are for restitution or remediation of property or correction of noncompliance, which are deductible, unlike fines and penalties paid under the agreement.
  • As also described in the Finance Committee’s conceptual language, the legislative text would also adopt a new Code section 6050Y that would create a new information reporting requirement for certain life insurance contract transactions. This includes: (a) a return filed and furnished by every person who acquires a life insurance contract or any interest in a life insurance contract in a reportable policy sale; (b) a return filed and furnished by each issuer of a life insurance contract upon notice of a transaction reported under (a); and (c) a return filed and furnished by every payor of reportable death benefits.  A reportable policy sale is generally the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured.  A reportable death benefit is an amount paid by reason of death of the insured under a life insurance contract that was transferred in a reportable policy sale.  The buyer must file the return required under (a) with the IRS and furnish copies of the return to the insurance company that issued the contract and the seller.  The insurance company that bears the risk with respect to a life insurance contract that receives a copy of a return required under (a) must file the return required under (b) with the IRS and furnish a copy of the return to the seller.  The payor insurance company   must file the return required under (c) with the IRS and furnish a copy of the return to the payee.  The reporting requirements would apply for reportable death benefits paid and reportable policy sales after December 31, 2017.
  • The Senate text would also adopt a new Code section 6050Z imposing three new information reporting requirements. The first would require taxpayers making research and experimental expenditures (as defined in Code section 174) to file an information return reporting the aggregate amount of such expenditures.  The second would require taxpayers making payments to a foreign person that is a related party (within the meaning of Code section 59A) to report the amount of such payments by type and any amount paid that results in a reduction of gross receipts to the taxpayer.  The third would require taxpayers that receive foreign-derived intangible income to file an information return that includes the aggregate amount of such income, the amount of foreign-derived deduction eligible income (as defined in section 250(b)(4)), and a certification that any foreign-derived deduction eligible income does not relate to the sale of products for any use, consumption, or disposition within the United States.  The text would impose a penalty of $1,000 per day up to $250,000 under Code section 6652(q) for failure to comply with these requirements.  The reporting requirements would be effective for taxable years beginning after December 31, 2024; however, it only takes effect (along with the associated changes to various deduction provisions) provided government revenue exceeds a target during the period 2018 through 2026.  The provision is effective if the cumulative on-budget Federal revenue from all sources for the 2018 through 2026 government fiscal years exceeds $28.387 trillion.

Impact of Tax Cuts and Jobs Act: Part IV – Changes to the Section 162(m) Deduction Limitation for Executive Compensation

November 3, 2017 by  
Filed under Legislation, Tax Reform

Yesterday, the House Ways and Means Committee released the Tax Cuts and Jobs Act (H.R. 1) (the “Bill”), a bill that, if enacted, would represent the most substantial overhaul of the U.S. tax code in decades.  We are releasing a series of posts to highlight the provisions of the Bill affecting the topics pertinent to our readers, where each post will cover a different area of importance.  In Part I of this series, we covered potential changes to employer-provided benefits, and in Part II, we addressed entertainment expenses and other fringe benefits.  In Part III, we discussed the Bill’s potential impact on various retirement provisions.  In this Part IV of the series, we address proposed changes to the deduction limitation for executive compensation under Code section 162(m).

Currently, Code section 162 allows as a deduction 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 with respect to compensation paid to a “covered employee” to $1 million.   However, certain types of compensation—such as qualified performance-based compensation and commissions—are not subject to the deduction limitation.  Covered employees are defined to include the chief executive officer (“CEO”), as of the close of the taxable year and the officers whose compensation is required to be reported to shareholders by reason of being among the three most highly compensated officers for the taxable year (other than the CEO).

Section 3802 of the Bill would amend section 162(m) in three key ways: (1) it would eliminate the exceptions for qualified performance-based pay and commissions; (2) it would extend the deduction disallowance to a broader array of companies; and (3) it would amend the definition of covered employee to more closely align with current SEC disclosure requirements and make covered employee status permanent.

Repeal of Exceptions to Deduction Limitation.  Many public companies pay covered employees primarily in the form of performance-based compensation to avoid the effect of the deduction limitation.  This exception applies to many forms of equity-based compensation— most stock options, stock appreciation rights, restricted stock, and restricted stock units—and many annual and long-term cash incentive compensation plans.  The Bill would repeal Code sections 162(m)(4)(B) and (C), removing the exceptions for performance-based compensation and commissions.  It is unclear whether the repeal of the performance-based pay exception will reverse the trend toward performance-based compensation, given that many shareholders and shareholder advocates believe that performance-based compensation can align shareholder and executive interests.

Expansion of Deduction Limitation to Additional Corporations.  Currently, the deduction limitation applies only to corporations that issue a class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (the “’34 Act”).  The Bill would amend Code section 162(m)(2) to apply the limitation to any corporation that is an issuer under section 3 of the ’34 Act that (1) has a class of securities registered under section 12 of the ’34 Act or (2) is required to file reports under section 15(d) of the ’34 Act.  This would extend the deduction limitation to corporations beyond those with publicly traded equity securities to include those are required to file reports solely because they issue public debt.

Change to the Definition of Covered Employee.  Code section 162(m)(3) defines covered employee to include the CEO (or the individual acting in such capacity) as of the last day of the tax year and the four officers whose compensation is required to be disclosed to shareholders because the officer is one of the four most highly compensated officers for the tax year.  However, because of a change to the cross-referenced section of the ’34 Act, the IRS interpreted the limitation as applying to only the principal executive officer (generally, the CEO) and the three most highly compensated officers other than the CEO and CFO in Notice 2007-49.  Compensation paid to the CFO was not subject to the deduction limitation regardless of how much he or she was paid.

The Bill would amend the definition of covered employee to align it more closely with current SEC disclosure rules.  Under the Bill, covered employees would include employees who, at any time during the tax year, were the principal executive officer or principal financial officer, and the three officers whose compensation is required to be disclosed to shareholders because they are the three most highly compensated officers during the tax year (other than the principal executive officer).  As a result, the deduction limitation could apply to a variable number officers for any given tax year depending upon whether more than one individual serves as either the principal executive officer or principal financial officer during the tax year and whether the principal financial officer is among the three most highly compensated officers during the tax year.

The Bill would also add a third category of covered employee: individuals who were covered employees of the employer (or any predecessor) for any preceding tax year beginning after December 31, 2016.  Accordingly, the Bill has the effect of making covered-employee status permanent.  Under current law, employees (and former employees) who are no longer officers of the employer as of the last day of the tax year are not covered employees.  As such, the deduction for compensation that is deferred until a date after the employee is no longer a covered employee is not subject to the limitation under Code section 162(m).  The Bill would eliminate this strategy for avoiding the deduction limitation.  Moreover, the Bill specifies that covered-employee remuneration that is includible in the income of, or paid to, someone other than a covered employee, such as a beneficiary of a covered employee after the covered employee’s death, remains subject to the deduction limitation.  Given the changes to the taxation of nonqualified deferred compensation in the Bill (and discussed in Part III of our series), the utility of this strategy for avoiding the deduction limitation would have been greatly reduced even without this amendment.

The amendments to Code section 162(m) would be effective for tax years beginning after December 31, 2017.