Getting Ready to Comply with the New Section 162(m)

As I’m sure my readers know by now, the Tax Cuts and Jobs Act, signed into law late last year, significantly expands the scope of Section 162(m). Most importantly, the exception for performance-based compensation was eliminated and the employees covered by 162(m) were expanded.

The TCJA includes a grandfather provision that exempts compensation paid pursuant to a contract in effect on or before November 2, 2017, provided the company is legally obligated to pay the compensation if the vesting conditions are satisfied and the contract isn’t materially modified after this date.

Who Cares?

Well, you probably should. It’s important to know which compensation arrangements are grandfathered, for the following reasons:

• Accounting: Because the tax savings a company realizes for stock awards impact how the awards are accounted for, grandfathered arrangements will be accounted for differently than arrangements for which the company will not be entitled to a tax deduction. This will impact the deferred tax assets recorded for awards as well as the company’s tax expense forecasts.
• Material Modifications: It’s also important to know which awards are grandfathered so you can make sure they aren’t materially modified.
• Tax: And, of course, you need to know which awards are grandfathered so the company can be sure to claim the tax deduction it is entitled to with respect to them.

Not Just for 2018

Because equity awards typically vest and pay out over several years, the need to know which awards are grandfathered extends beyond 2018, possibly for many years into the future.  Stock options that are grandfathered could be outstanding for up to ten years.

For this reason, you might want to consider identifying which awards are grandfathered in the recordkeeping system you use to administer your stock plan.

Equity Awards and the Grandfather Provision

Only those compensation arrangements that would not have been subject to Section 162(m) before the TCJA can be grandfathered. Here’s a run-down of how this applies to equity awards in general:

Stock options/SARs: Prior to the TCJA, stock options (both NQSOs and ISOs) and SARs were considered to be inherently performance-based and had to meet only a few minimal requirements to be exempt from the 162(m) limitation. Thus, it’s likely that many options and SARs granted on or before November 2, 2017 will be grandfathered.

Restricted stock/RSUs: Prior to the TCJA, service-based restricted stock and RSUs were not considered performance based and thus were subject to 162(m). So restricted stock and RSUs granted prior to November 2, 2017 generally won’t be grandfathered, except for awards granted to newly covered employees or by newly covered companies. For example, prior to the TJCA, the CFO wasn’t a covered employee. This means that restricted stock and units awards granted to the CFO on or before November 2, 2017 could be grandfathered.

Performance awards: Performance awards usually were exempt from 162(m) before the TCJA, so theoretically, they are eligible for grandfathering if granted prior to November 2, 2017. As a practical matter, however, many performance awards may not be considered legally binding because it is common for the award agreements to grant the board discretion to reduce the payment under the award. Awards that weren’t legally binding as of November 2, 2107 aren’t grandfathered (more on this in a future blog entry).

ESPPs: Most ESPPs that offer a discount were already subject to 162(m) before the TCJA and thus won’t be eligible for grandfathering. Here again, however, shares purchased by newly covered employees or at newly covered companies may still be eligible for grandfathering in offerings that commenced on or before November 2, 2017 (assuming the offering constitutes a legally binding obligation on the part of the of company and the employee’s right to participate isn’t materially modified). ESPPs that don’t offer a discount also don’t generally result in a tax deduction for the company, so it doesn’t matter whether they are grandfathered.

These are general guidelines; the determination of whether an award is grandfathered depends on the specific facts and circumstances of each award. In some cases, a legal opinion may be necessary to establish deductibility, making it even more important to keep track of which awards are grandfathered and which aren’t.

Need to know more? Be sure to tune in for our webcast “Navigating Equity Plan and Award Changes After the TCJA and IRS Notice 2018-68,” which will be held next Wednesday, October 24. The panel features two IRS representatives, including the primary author of IRS Notice 2018-68.

- Barbara