A small change in the Chairman’s Mark of the Senate’s version of the “Tax Cuts and Jobs Act” might save companies a lot of work before the end of 2017 as they seek to deduct performance-based compensation under 162(m). The proposed repeal of that rule is still on tap in both the bill passed by the full House last week, and in the Senate version that still needs approval by the full chamber. But the Senate version now includes the following provision:
(2) EXCEPTION FOR BINDING CONTRACTS. — The amendments made by this section shall not apply to remuneration which is pursuant to a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date.
This is a change from a prior version of the Senate Chairman’s Mark that included a third prong, which made the transition rule applicable only when “the right of the covered employee was no longer subject to a substantial risk of forfeiture on or before December 31, 2016.” Removing that requirement may broaden this transition rule’s application to far more existing performance-based compensation, depending on how the rule is interpreted. If the changes to 162(m) are enacted and include the Senate’s transition rule, companies might not need to act before the end of 2017 to assure a deduction on much of their existing performance-based compensation. However, if the transition rule does not apply (or is not included in the final legislation), companies might need to act quickly, in consultation with their tax advisors, to determine if, and how much, of this pay can be ascribed to the 2017 tax year because it may no longer be deductible if paid in years thereafter.
For example, consider a company with a 2017 annual bonus program that meets the requirements of 162(m) using an umbrella plan. Under this structure, if the umbrella plan goals are met, the plan would be fully funded at a level above what is expected to be paid out and then the compensation committee would employ permissible “negative discretion” to reduce the amount that would be paid to the disqualified employees under the plan. Or consider another example where performance shares under a three-year cycle concluding at the end of 2017 would otherwise become vested as of the anniversary of the grant date, which often takes place the following February. The number of performance shares that vest once the performance period ends can be reduced by the compensation committee, again using negative discretion.
The straightforward issue in each case is whether a “written binding contract” is in place as of November 2, 2017, even though compensation payments can still be reduced by discretion. The plan exists, and as a legal matter the company is required to measure performance under that plan, so it can be argued that this obligation to do so meets the standard. However, the compensation committee, in administering this arguably binding plan, can reduce or eliminate payments, raising the question of whether there is really a binding contract.
If you’re not a tax lawyer, this might appear to be hair splitting, but it is important and central to understanding the scope of the transition rule.
As a potential reference point, we reread the existing 162(m) regulations, and found an interesting section dealing with the 1993 transition to the then new regime under 162(m). Under the general transition rule of section 1.162–27(h)(1)(i), the regulations state:
“(i) The deduction limit of paragraph (b) of this section does not apply to any compensation payable under a written binding contract that was in effect on February 17, 1993. The preceding sentence does not apply unless, under applicable state law, the corporation is obligated to pay the compensation if the employee performs services.”[emphasis added]
Is the corporation “obligated to pay the compensation,” where it retains discretion to reduce or potentially eliminate it? The answer is not clear.
Subparagraph (ii) section 1.162–27(h)(1) then articulates a rule that addresses the question of which participants would be covered under the “written binding contract,” and then goes on to suggest a more lenient rule may apply to our examples:
“(ii) If a compensation plan or arrangement meets the requirements of paragraph (h)(1)(i) of this section, the compensation paid to an employee pursuant to the plan or arrangement will not be subject to the deduction limit of paragraph (b) of this section even though the employee was not eligible to participate in the plan as of February 17, 1993. However, the preceding sentence does not apply unless the employee was employed on February 17, 1993, by the corporation that maintained the plan or arrangement, or the employee had the right to participate in the plan or arrangement under a written binding contract as of that date. [emphasis added]
The notion is that the test under the Senate’s version of the transition rule is merely focused on whether participants “had the right to participate in the plan or arrangement” as of November 2, and not whether they actually are paid under the plan after the compensation committee exercises its discretion.
Let’s hope that if this provision becomes law it includes the transition rule that is currently only in the Senate bill, and that we will get more legislative history or quickly get regulatory guidance on how this transition rule would be applied. In the meantime, companies still need to do their homework on this question and determine – based on their own circumstances – whether action would be required in 2017 to preserve deductions under 162(m) should the provision be enacted.
This is but one of many areas of the tax reform proposals that could inform year-end activities and compensation decisions to be made in 2018. Toward that end, on December 5, we will be hosting the fourth webcast in our series: Addressing New Directions in U.S. Policy, which examines legislative and regulatory changes in process, and how employers can prepare. Please invite your clients and prospects to register now. Willis Towers Watson colleagues are also welcome to join this complementary hour-long webcast.
Steve Seelig, Puneet Arora and William Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email firstname.lastname@example.org, email@example.com, William.firstname.lastname@example.org or email@example.com.