Use Caution When Modifying Options and Performance Awards

We all know that modifications to equity awards have consequences. At the moment, however, modifying outstanding stock options and performance awards might have more significant implications than is usually the case.

Section 162(m) and the TCJA

By now, I’m sure you know that the Tax Cuts and Jobs Act significantly expands the scope of Section 162(m), including eliminating the exception for performance-based compensation. Thus, under the new Section 162(m), all stock options and performance awards are subject to the $1 million deduction limitation that applies to compensation paid to covered employees.

The Grandfather Provision

In expanding the scope of Section 162(m), however, Congress wrote a very important grandfather provision into the TCJA. This grandfather provision applies to compensation paid under a written binding contract (such as a grant agreement) that was in effect as of November 2, 2017. It exempts these awards from the expanded scope of Section 162(m) provided—and here’s the catch—that they aren’t materially modified after November 2, 2017.

Thus, where options and performance awards granted on or before November 2, 2017 would have been exempt from Section 162(m) before the enactment of the TCJA, these grants could continue to be fully deductible for the remainder of their terms, so long as they meet the conditions of the grandfather provision. Materially modifying these awards could cause the company to lose out on the tax deduction it would otherwise have been entitled to for them.

What Is a Material Modification?

That’s a very good question. The TCJA doesn’t provide any guidance as to what constitutes a material modification. A memo from Davis Polk notes that guidance under the old Section 162(m) regulations defined material modification to include modifications that increase compensation payable under an award or that accelerate or defer payout of an award (see Q19). But until we get additional guidance from the IRS (expected later this year), we don’t know that this is how the IRS will define a material modification for purposes of the grandfather provision.

For now, any proposed modifications to stock options or awards should be reviewed with your advisors in light of this concern. Let’s be careful out there.