On August 21, 2018, the IRS released Notice 2018-68 providing its initial guidance on the Tax Cuts and Jobs Act (Act) transition rule for changes under 162(m). Before the Act, 162(m) limited a public company’s tax deduction to $1,000,000 for annual compensation paid to its “covered employees” (i.e., the CEO and the other three most highly compensated executives (excluding the CFO)). Important pre-Act limitations/exceptions to this rule included (i) a more narrow definition of covered employee, and (ii) an exclusion for performance-based compensation.
The Act substantially broadened the definition of covered employee and eliminated the performance-based compensation exception. However, the Act offered a transition rule for compensation paid under a written binding contract that was in effect on November 2, 2017 and that is not materially modified after that date.
The Notice provides much needed guidance on the following three key transition rules areas:
- Who is a Covered Employee? – The Notice provides additional guidance (and examples) to assist employers in determining which executives are covered employees under the transition rule. Importantly, the Notice seems to further expand the category of executives who are covered by the 162(m) deduction limits.
- What is a Written Binding Contract? The Notice narrowly construes the universe of pre-existing contracts that will fall within the transition rule and reminds us that any contract “renewed” after November 2, 2017 is not subject to the transition rule. The Notice goes to great lengths to explain (and provide examples of) when a contract is deemed renewed under the transition rule.
- What is a Material Modification? The Notice explains that a contract is materially modified if the contract is amended to increase the compensation to the executive. The Notice provides guidance (and examples) on the impact of certain cost of living increases, accelerations and deferrals of compensation. Importantly, the Notice provides that adopting a new contract with increased compensation will be considered a material modification of a pre-existing contract under certain circumstances.
The rules in the Notice providing guidance on the 162(m) transition rule are complex and should be reviewed carefully on a case-by-case basis to determine whether transition relief is available for a pre-existing contract.