Tax Code Section 162(m): You May Still Have Options for Grandfathering Protection

Tax Code Section 162(m): You May Still Have Options for Grandfathering Protection

October 30, 2018

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Winston & Strawn Attorney Mike Melbinger, author of the Executive Compensation Blog reflects on the nuances of Grandfathering Protection under the revised Tax Code Section 162(m).

Don’t Abandon All Hope of Grandfathering Protection Under Section 162(m)

In the Inferno, the first part of Dante Alighieri’s Divine Comedy, the inscription “abandon hope all ye who enter here” appears at the entrance to Hell. This language appears nowhere in IRS Notice 2018-68. Yet, many seem to have abandoned all hope of earning the protection of the grandfather rule from the Sec. 162(m) changes made by the Tax Cuts and Jobs Act of 2017, because their plans or agreements give the company discretion to reduce payments. Such language in a plan or agreement certainly casts doubt on whether a written binding contract exists, but there still may be hope under applicable law. Barbara Baksa and I discuss this issue in the upcoming edition of The Corporate Executive.

Under Notice 2018-68 and the language of the grandfather provision, the test to determine where an arrangement is eligible for the grandfather is based on whether “the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under such contract if the employee performs services or satisfies the applicable vesting conditions.” The statutory and common law (i.e., the law developed by court decisions) in many states includes doctrines of contractual interpretation and enforcement such as the implied covenant of good faith and fair dealing, promissory estoppel and detrimental reliance, and a requirement to interpret contracts so as to avoid illusory promises. Companies and their counsel must consider these state law doctrines, as directed by Notice 2018-68 when evaluating whether a legally binding right exists under applicable law.

Companies and their counsel also should review the specific facts and circumstances related to the award. The question of enforceability under state contract law could be based on other factors, such as:

  • Past practice, g.,has the company paid performance bonuses every year based on the actual performance results, and not arbitrarily reduced the payout amount?
  • Whether the contract imposes limits on when or how the company can exercise its discretion, g.,only in the event of unforeseen circumstances or non-recurring events.
  • Whether the performance metrics, goals, and thresholds were set forth in writing and communicated to the executives and, if so, how clear were those communications?

Most incentive compensation plans and agreements reserve to the compensation committee the absolute (or limited) discretion to reduce the amount of compensation payable under the objective performance metrics and goals of the plan or agreement. Ironically, the practice of providing the compensation committee with the absolute (or limited) discretion to reduce performance-based compensation, so-called “negative discretion,” evolved solely as a result of the deductibility limits of Sec. 162(m). This irony may not be lost on the IRS, but they may not feel that they have the ability to make allowance for it in their guidance.

This resort to “applicable law,” as directed by Notice 2018-68, may not offer great hope, but it does offer some.

Keep reading Fulcrum Partners News regularly for additional  insights on Guidance on the Application of Section 162(m). And contact any member of the nationwide Fulcrum Partners team of executive benefits professionals for customized, creative solutions to help your organization attract, retain, and reward key employees and top talent.

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