The Section 162(m) Grandfather and Material Modifications

Normally, I only post one blog entry during holiday weeks, but in honor of IRS Notice 2018-68, I’m posting two blog entries to celebrate Labor Day Week 2018. Today I discuss what constitutes a material modification.

Who Cares?

As I noted in my blog on Wednesday, compensation that is paid pursuant to a written binding contract that was in place on or before November 2, 2017 is grandfathered from the amendments to Section 162(m) implemented under the Tax Cuts and Jobs Act.*  I noted one rub with this on Wednesday, here’s another: the compensation is grandfathered only so long as the arrangement under which it is paid isn’t materially modified after November 2, 2017.

Which brings us to our next question.

What Is a Material Modification?

Notice 2018-68 defines a material modification as an amendment that increases the compensation payable to the employee. In terms of equity awards, it seems clear that any amendment that increases the number of shares payable under the award or that lowers the price that must be paid for those shares will be considered material, and, thus, will cause the arrangement to become subject to Section 162(m).

What About Acceleration of Vesting?

You might not think of acceleration of vesting as increasing the compensation paid under an award, but the IRS appears to disagree. Notice 2018-68 specifically states that a modification that accelerates payment of compensation is material unless the amount of compensation paid is reduced to reflect the time value of money (which I have never seen done for a stock award). [Update: See also "Section 162(m), Material Modifications, and Acceleration of Vesting," Nov. 13, 2018, for a more recent guidance on this question.]

Even Deferrals?

Maybe. On this topic, Notice 2018-68 says that modifications to defer payment of compensation will not be treated as material, provided that the additional compensation paid as a result of the deferral is based on a reasonable rate of interest or the rate of return on a predetermined actual investment.

Assuming that the company’s stock qualifies as a “predetermined actual investment,” it seems like a deferral would not be considered a material modification. But there aren’t any examples in the notice that make this clear, so check with your tax advisors before assuming this is the case.

Some Good News

On a positive note, the notice provides that amounts paid prior to the material modification are still grandfathered, even though amounts paid after the modification will no longer be exempt from Section 162(m). Also, failure to exercise negative discretion does not result in a material modification (but this may not be all that helpful since awards subject to negative discretion may not be grandfathered at all—see “The Section 162(m) Grandfather and Negative Discretion”). 

_{* Note that compensation that was subject to Section 162(m) pre-TCJA will still be subject to it post-TCJA, even if it might seem like it otherwise qualifies for the grandfather. This shouldn’t come as a surprise to anyone.}