Now that Congress has passed tax reform, and President Trump is poised to sign the bill into law, companies will need to contend with the repeal of the performance-based exception under Code section 162(m) in place for payments made beginning in 2018. What remains a bit of a mystery is how companies should interpret the transition rule, first included by the Senate, and now part of the Conference Committee agreement (H.R.1, the Tax Cuts and Jobs Act). While it seems, on its face, to be a reasonable rule that would avoid a 2017 year-end scramble to ensure deductibility of existing agreements, the legislative history makes us wonder about its usefulness.
The text of the transition rule in section 13601(e)(2) of H.R. 1 provides an exception:
(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.
You’ll note this is the same transition rule as appeared in the Senate bill, and we previously expressed our concerns about its applicability for compensation earned during 2017 and earlier and paid during 2018 in “Did the Senate tax reform bill “fix” the 162(m) performance-based compensation transition rule?”, Executive Pay Matters, November 28, 2017. In essence, our concern is based on the fact that nobody is guaranteed a payment under many programs because the compensation committee has the discretion to reduce the amount of the bonus after November 2, 2017, so that perhaps no “written binding contract” exists on that date.
Our concerns are heightened, however, because of the legislative history: the Conference Committee added a description of the impact of the transition rule. The first part of the explanation begins with promise:
The conference agreement follows the Senate amendment. For purposes of the transition rule, compensation paid pursuant to a plan qualifies for this exception provided that the right to participate in the plan is part of a written binding contract with the covered employee in effect on November 2, 2017.
This suggests that the test is not whether or not a covered employee is guaranteed a payment under the plan, but merely that they have a right to a payment under the plan as of this date. Thus, even if the compensation committee can reduce the actual payment, the right to a payment does exist on November 2, 2017.
The explanation then continues:
For example, 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.
This is not really the example we had hoped for to address treatment of 2017 bonus plans or long-term incentive plans (LTIPs) whose measurement cycles conclude at the end of 2017. But it is not entirely clear what types of plans the example references. In the world of 162(m), there are many deferred compensation plans that provide that amounts not currently deductible because they don’t meet the performance-based exception, would have payment deferred until the recipient is no longer a covered employee, mostly in the year after the person retired.
It is equally plausible that this example would apply to a traditional supplemental executive pension that would make payments to a “covered employee” after retirement. Under existing rules, if those programs make payments after retirement, those payments would be exempt from 162(m) after those individuals are no longer “covered employees.”
For both these programs, absent the transition rule, a payment would be made to a person that still remains a covered employee, under the new rule that states “once a covered employee, always a covered employee,” even in post-retirement.
The example continues:
Assume further that the terms of the plan provide for participation after six months of employment, amounts payable under the plan are not subject to discretion,[emphasis added] 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.
Depending on the type of deferred compensation program a company has in place, this example raises the question of whether deferrals or accruals made in future years (e.g. 2018, 2019, and so on) will continue to be subject to this transition rule. Hopefully, we will get guidance from Treasury and the Internal Revenue Service some time during 2018 to help clarify their interpretations.
More troubling for the 2017 annual bonus, is the language that says a condition of meeting the transition rule is that “amounts payable under the plan are not subject to discretion.” We can’t be certain if the drafters were thinking about the 2017 annual bonus or LTIP plans whose measurement cycles conclude at the end of 2017, but since those plans are often subject to discretionary adjustments until the time the compensation committee verifies that goals have been obtained, we find this language very unsettling.
If that phrase isn’t concerning enough, the following sentence is cause for more worry:
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.
We admit that we don’t really understand the statement’s context, but we don’t think it will help companies feel more confident that they meet the transition rule.
What companies should do now
Although it’s a challenge to make sense of this rule, we are concerned enough about its meaning to advise companies to work with their tax advisors and get their opinions on how they can maximize their 162(m) deduction for amounts earned in 2017 and earlier. We’re concerned because most companies will pay out amounts attributable to these plans in 2018, the first year during which payments of performance-based compensation will not be deductible.
To assure that the deduction can be taken for 2017, there are mechanical questions that companies need to work through with their tax advisors. Many companies are seeking to fix all or a portion of their entire bonus pools before the end of the taxable year under the rules of Code section 461, to take a tax deduction in that year, even though they are permitted to pay the bonus within two and a half months after year-end. And many companies already are focused on sustaining that deduction for 2017, when their effective tax rate is higher than it is likely to be during 2018, so that the value of the tax deduction also will be more valuable.
However, for the portion of 2017 compensation paid to top executives, the compensation committee must certify under Code section 162(m) that results required under the plan have been attained. But many companies currently wait until post-year end to do so, when their audited financials are made available. The technical question to ask your tax advisors is whether meeting Code section 461 for the bonus pool would also fix the obligation to pay bonuses to covered employees. A “yes” should encourage exploration of whether it is okay to meet the certification requirements under 162(m) during 2018. The statute only requires that certification takes place before the payment is made, so that a post year-end certification would be possible while sustaining tax deductibility under 162(m).
If that does not work for your tax advisors, the alternative is to consider that the compensation committee would certify at least some portion of the performance-based compensation attributable to 2017 and prior years before year-end. This may be considered a less aggressive tax position to take, but is not without its challenges to get done before year-end. The only silver lining for 2017 is that the last day the markets are open is on Friday, December 29, allowing the weekend to assess performance before Sunday evening at midnight.
Steve Seelig, Puneet Arora and William Kalten are regulatory advisors specializing in executive compensation in Willis Towers Watson’s Research and Innovation Center. Email email@example.com, firstname.lastname@example.org, William.email@example.com or firstname.lastname@example.org.