On August 21, 2018, the Internal Revenue Service (the "IRS") issued Notice 2018-68 (the "Notice"), offering initial guidance on changes made to Section 162(m) of the Internal Revenue Code (the "Code") by the Tax Cuts and Jobs Act (the "Act"). The Notice provides guidance relating to the Act's expansion of the definition of "covered employee" and the operation of the grandfather rule under the Act.
Companies can no longer simply look to the summary compensation table to identify covered employees. Smaller reporting companies and emerging growth companies are treated the same as larger reporting companies. Clauses in plans that allow a company to reduce or eliminate payments (commonly referred to as "negative discretion" clauses) will likely take the plans outside the scope of the grandfather rule to the extent of the company's discretion to reduce or eliminate such payments. In corporate transactions, compensation paid under non-grandfathered arrangements to target company executives will be subject to Code Section 162(m) for the pre-closing short tax year, regardless of whether compensation for the short tax year is required to be disclosed under the rules of the Securities and Exchange Commission (the "SEC"). Companies should be careful to avoid inadvertent material modifications that could limit the deductibility of otherwise grandfathered compensation. Background
Code Section 162(m) disallows a deduction by publicly held corporations for compensation paid to a "covered employee" to the extent the compensation for the taxable year exceeds $1,000,000. As discussed in a previous Morrison & Foerster alert, the Act significantly expanded the reach of Code Section 162(m) by, among other things, amending the definition of "covered employee" and eliminating the exemptions for commission- and performance-based compensation. The Act contained a transition rule making the Act's changes to Code Section 162(m) inapplicable to written binding contracts that were in effect on November 2, 2017, provided they are not materially modified after that date (commonly referred to as the "grandfather rule"). Other than with respect to grandfathered amounts, the Act's changes to Code Section 162(m) apply to taxable years beginning on or after January 1, 2018.
Definition of Covered Employee
Before the Act, the definition of "covered employee" was limited to the chief executive officer ("CEO") and the corporation's four other most highly compensated executive officers whose compensation was required to be reported in the corporation's summary compensation table. Notably, before the Act, the definition of "covered employee" did not pick up chief financial officers ("CFOs") or anyone who was not serving as an executive officer on the last day of the tax year.
The Act significantly expanded the coverage of Code Section 162(m) by amending the definition of covered employee to include individuals who, at any time during the year, serve as the CEO or CFO, and to provide that any officer who was a "covered employee" of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016 will remain a covered employee in future tax years. The Act also added flush language to the covered employee definition that provides that the term "covered employee" includes an employee who would have been one of the three most highly compensated employees whose compensation is required to be reported under SEC rules if such reporting were required. Many practitioners believed this flush language was added simply to address the expansion of the coverage of Code Section 162(m) to include certain issuers that are not required to disclose compensation of their top executive...