Final Section 162(m) Regulations

Late last year, the IRS issued final regulations under Section 162(m). Here’s what you need to know about them.

What the Heck?

A quick refresher for those of you who only vaguely recollect something about Section 162(m) changing: Section 162(m) limits the tax deduction public companies can claim for compensation paid to specified employees to $1 million per employee. As it was originally adopted in 1993, performance-based compensation, including stock options and performance-based equity awards were exempt from the limitation. This caused companies to start loading up executives with stock options, which turned out to be a huge windfall for executives, but that is a story for another blog entry.

Back in 2017 (you remember 2017—back when masks were for Halloween and we went to parties), Congress passed The Tax Cuts and Jobs Act, which significantly expanded the scope of Section 162(m) by both increasing the number of employees covered under the provision and eliminating the exception for performance-based compensation.

The Grandfather Provision

When it expanded the scope of Section 162(m), the TCJA carved out a loophole: compensation arrangements already in effect when the bill was first introduced into Congress (November 2, 2017) would be grandfathered, provided they meet the following conditions:

• The compensation would have been exempt from the limitation under the pre-TCJA Section 162(m).
• The arrangement is a written, legally binding contract. This means that if the employee performs the services required under the contract, the company is legally bound to pay out the compensation.
• The arrangement is not materially modified after November 2, 2017.

The Subsequent Guidance

There are always a host of implementation and interpretive questions with any new law and the amended Section 162(m) is no exception. The IRS initially issued Notice 2018-68 to address some of these concerns and then issued proposed regulations in late 2019. Two key questions addressed in Notice 2018-68 and the proposed regulations are:

• What constitutes a legally, binding contract? For example, if the board has discretion to reduce payments under a contract even if the vesting conditions are achieved (referred to as “negative discretion” and common in performance awards), is the contract legally binding? What if the board can choose to claw back the compensation in certain circumstances?
• What is a material modification?

Now we have the final word on the above two questions and many others.

What Isn’t New in the Final Regulations?

For the most part, the final regulations simply adopt the proposed regulations with very few changes. Here are some of the key parts of the proposed regulations that relate to equity compensation that were not changed in the final regulations:

• Covered employees include the CEO, CFO, and the three highest paid employees, regardless of whether these individuals are employed by the company at the end of the year and regardless of whether their compensation is subject to disclosure for proxy statement purposes. In addition, once an employee is covered, all future compensation they receive from the company is subject to the deduction limit, regardless of whether they are employed by the company at the time the compensation is paid.
• Covered employees of companies that are acquired or spun off remain covered employees in the acquirer or spun-off entity. The rules here are very complicated and likely apply in circumstances that you wouldn’t expect.
• A contract is legally binding if it is enforceable under applicable law. If a contract includes negative discretion you look to the laws of the governing jurisdiction to determine if the contract is considered binding.  
• A material modification is one that increases the amount of compensation payable to the employee. Acceleration of vesting of a stock option or SAR is not a material modification.
• The transition period for privately held companies is eliminated for any companies that go public after December 20, 2019. Companies that go public after this date are immediately subject to the deduction limitation.

What Is New in the Final Regulations?

Well, not much that relates to stock compensation, but there are a couple of bits of good news:

• Exercise Period Extensions: Extending the time to exercise a stock option after termination of employment is not a material modification.
• Clawbacks: The proposed regulations provided that the mere inclusion of a clawback provision did not prevent a compensatory arrangement from being legally binding but if the clawback were triggered, the portion of compensation recovered would no longer be grandfathered (because the company was no longer legally obligated to pay that compensation). The final regulations view the recoupment of compensation under a clawback provision as a separate event, apart from the original contract. As a result, even compensation that is clawed back can still be grandfathered.

More Information

For a discussion of the final regs, listen to the NASPP webinar “What’s Next for Equity Compensation in 2021?”  See also memos by RSM US, Skadden Arps, Ropes & Gray, and Akin Gump.