The 2017 Tax Cuts and Jobs Act (TCJA) significantly amended Internal Revenue Code Section 162(m), which generally disallows the deduction of compensation in excess of $1 million paid by a “publicly held corporation” to a “covered employee” in any single taxable year. (Our prior alert on the amendments made by the TCJA generally is available here.) The Internal Revenue Service (IRS) has now released proposed regulations under Section 162(m) (Proposed Regulations) (available here), which address and elaborate on the TCJA changes to Section 162(m), including the expansion of the definitions of “publicly held corporation” and “covered employee”; the elimination of the exception to Section 162(m) for performance-based compensation; and application of the grandfather rule to arrangements in effect on November 2, 2017, which are not materially modified. The Proposed Regulations largely follow guidance previously issued by the IRS in Notice 2018-68 (available here), and generally confirm the IRS approach of interpreting the deduction disallowance provisions broadly.

Grandfathered Arrangements. Whether compensation payable currently is grandfathered, or whether previous or future corporate action destroys grandfather status, are key questions for taxpayers administering pre-November 2, 2017 compensation arrangements. Significant provisions of the Proposed Regulations relevant to the determination of grandfathered treatment include:

• Whether an Arrangement Is Grandfathered Must Be Determined by Reference to Applicable Law. The IRS considered, but ultimately rejected, providing a safe harbor for interpreting the “written binding contract” requirement with reference to GAAP or other external standard. Consistent with prior guidance, the determination of whether a “written binding contract” was in effect on November 2, 2017, must be made in accordance with applicable law (e.g., state contract law), leaving taxpayers with the challenge of determining questions of state or local law that are often unsettled or unclear. 
• Negative Discretion Still Problematic, Unless Local Law Constrains Use. The IRS, citing to the legislative history of the TCJA, confirmed its position that a negative discretion provision permitting the reduction of compensation otherwise payable may result in no grandfather, as the negative discretion could prevent the conclusion that a written binding contract was in effect. However, the IRS noted helpfully in the preamble to the Proposed Regulations that applicable law may not permit the corporation to exercise the negative discretion and that, to such extent, negative discretion is not taken into account. 
• Vesting Acceleration Permitted Under Grandfather. The acceleration of option vesting, as well as accelerated vesting of other forms of compensation, is not considered a material modification that would forfeit the grandfather status of compensation payable under a written binding contract in effect on November 2, 2017. 
• Clawbacks. The Proposed Regulations appear to conclude that clawbacks are not treated as impermissible negative discretion authority until the event triggering the clawback (e.g., financial restatement) is satisfied, and then only to the extent that a legally permissible clawback is not utilized.
• Narrow Application of Grandfather to Formulaic Arrangements. Numerous examples in the Proposed Regulations illustrate that each component of a severance arrangement (e.g., base and bonus) is separately analyzed for purposes of the grandfather, with the results that an amount of severance payment determined with reference to a discretionary bonus is not grandfathered and that increases in base salary beyond cost of living jeopardize treatment of the base salary component of severance as grandfathered.

Application of Section 162(m) to New (Non-Grandfathered) Arrangements. The Proposed Regulations contain a number of other clarifications regarding the ongoing application of Section 162(m), including: 

• No IPO Transition Period. The provisions of the existing final regulations under Section 162(m) that grandfathered certain compensation arrangements of privately held corporations that become public are eliminated for any corporation going public after the proposed rules are published (which is scheduled for December 20, 2019). The IRS reasoned that the earlier exception was predicated on the pre-2017 exception for performance-based compensation and that, with the elimination of the performance-based exception, the transition rule is unwarranted.
• Directors’ Fees and Other Non-Employee Compensation Are Subject to Deduction Disallowance. The Proposed Regulations conclude that all forms of remuneration (whether reported on a Form W-2 or Form 1099) are subject to the deduction limitation of Section 162(m) if paid to someone who is or had been an officer covered by Section 162(m). Special provisions regarding compensation paid to a covered employee by a partnership are included.
• Determination of “Publicly Held Corporation”. Guidance is provided on the application of Section 162(m) to various forms of entities and affiliated groups of parent/subsidiaries, including foreign private issuers, where one entity satisfies the expanded application of Section 162(m) to (i) any corporation with any class of securities (rather than only a class of common equity securities) that is required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) or (ii) a corporation that is required to file reports under Section 15(d) of the Exchange Act.
• M&A Rules. Generally, acquisition activity involving a publicly held corporation will result in multiplication of “covered employees” if the remaining group contains a publicly held corporation. Prior status as a “covered employee” is also resurrected if a private company returns to publicly held status within 36 months.
• Modification of 409A Arrangements by December 31, 2020. Employers wishing to amend their nonqualified deferred compensation plans to remove a provision requiring delay of payment of deferred compensation until the time when the payment would be deductible under Section 162(m) may do so before December 31, 2020, without the amendment being treated as a material modification for purposes of the grandfathering rule of Section 162(m) or an impermissible acceleration for purposes of Section 409A. Payments previously suspended under the original provisions of the plan must be paid by December 31, 2020.

The Proposed Regulations are subject to comment and revision, and will generally be effective when finalized. Because the interim guidance was in large part incorporated into the Proposed Regulations, taxpayers may no longer rely on Notice 2018-68. However, with limited exceptions, taxpayers may rely on the Proposed Regulations provided they do so consistently and in their entirety.