IRS Clarifies Its $1 Million Tax Deduction Limit on Executive Pay

New guidance helps apply Section 162(m) as amended by the 2017 tax act

Stephen Miller, CEBS By Stephen Miller, CEBS August 29, 2018
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On Aug. 21, the IRS issued Notice 2018-68 with much-anticipated guidance on changes made to the tax deductibility of executive compensation under Internal Revenue Code Section 162(m), particularly as regards performance-based awards. Stricter limits on deducting executive pay were part of the Tax Cuts and Jobs Act, passed at the end of 2017.

"Public companies and other issuers subject to these deduction limitations will want to closely consider this guidance in connection with filing upcoming periodic reports with securities regulators," advised attorneys at McDermott, Will & Emery in an online post.

Section 162(m) prohibits publicly held companies from deducting more than $1 million per year in compensation paid to senior executive officers. The tax act removed an exemption for commission- and performance-based pay. The legislation also expanded the scope of covered individuals to include CFOs, along with an organization's CEO and three highest-paid employees, beginning in 2018.

"The exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined" when Section 162(m) was enacted in 1993, explained John Lowell, a partner with October Three Consulting in Atlanta. "Many companies saw this as a license to offer base pay of $1 million to their CEO while offering incentive pay—some only very loosely incentive-based—without limits while taking current deductions."

An IRS transition rule issued shortly after the tax act was passed allows the exemption to apply to performance-based payments under written binding contracts that were in effect Nov. 2, 2017, and "not modified in any material respect" after that date.

Notice 2018-68 clarifies which employers are covered by Section 162(m) and the transition rule for legally binding contracts, including what constitutes a "material modification" of these contracts.

Covered Employees

For determining whether an executive is a covered employee to whom Section 162(m) applies, the notice states, in part:

  • No end-of-year employment requirement. There is no requirement that an employee must have served as an executive officer at the end of the taxable year to be considered a covered employee, the IRS clarified. If, in addition to the CEO or CFO, an employee is among the three most highly compensated executive officers for the taxable year, the employee's pay will be subject to Section 162(m) limits regardless of whether he or she was serving in such a position at the end of the taxable year.
"Public companies must now carefully track any and all covered employees and those employees (and former employees) who may be determined to be covered employees … even if their employment terminates midyear," advised Michael S. Melbinger, a partner in the Chicago office of law firm Winston & Strawn. This will require companies to maintain a clear historical record and retain that information until all payments subject to Section 162(m) limits have been made to the employee or to his or her beneficiaries, Melbinger said.


  • Divergence from reporting requirements. Executive officers of publicly held corporations can be covered employees even when disclosure of their compensation is not required under Securities and Exchange Commission (SEC) executive compensation reporting rules, the IRS explained. For instance, executives of a corporation whose securities are delisted and no longer traded on a public exchange can still be covered employees. Executive officers of small stock-issuing companies can be covered employees notwithstanding their compensation may not have to be reported in proxy statements.

"Companies should not assume that their named executive officers for SEC executive compensation disclosure purposes will entirely align with their Section 162(m) covered employees," Melbinger advised.


[SHRM members-only toolkit: Designing Executive Compensation Plans]

Contract Modifications

"The first step in determining whether any payment to any person in any year after 2017 is subject to the draconian limits of Section 162(m) is to determine whether there was a written binding contract in effect on Nov. 2, 2017," Melbinger noted.

In Notice 2018-68, the IRS specifies factors to consider in evaluating whether an agreement constitutes a "written binding contract" under its transition rule, such as enforceability under applicable state or other laws.

The notice also described certain types of modifications to written binding contracts that will result in the loss of grandfathered status, such as increased compensation and changes in the time or forms of payment.

"Unless public companies all over America suddenly decide to cut dramatically the compensation of their executives and officers, a priority for executive compensation professionals will be to find a way to maximize the deductibility of current and future compensation," Melbinger said. "And the best way to maximize the deductibility of current and future compensation is to protect it under the grandfathering rules."

'Negative Discretion' Upended?

An example given in the notice "makes clear that, to the extent that the compensation committee retains negative discretion to reduce an award"—that is, the ability to reduce an award that otherwise would be paid for meeting a performance goal, based on the committee's consideration of other factors—the arrangement is not a binding contract that is grandfathered for performance-based compensation, said a client alert from Texas law firm Wilkins, Finston and Friedman. "What is particularly punitive about the IRS position is that, in our experience, most plans provide that the compensation committee has unlimited negative discretion to reduce performance-based awards," the firm's alert stated.

The McDermott, Will & Emery attorneys weren't so sure, finding that although the example given in the IRS notice "can be read to suggest that the IRS generally believes that broad-based negative discretion clauses are inconsistent with the existence of an 'obligation' to pay, unless there is a stated minimum amount in the contract," the notice "does not address how applicable law might apply to arrangements in effect on Nov. 2, 2017" that permit but do not require the exercise of negative discretion by compensation committees.

Melbinger commented that, to the extent that compensation is subject to employer discretion, "the transition rule is far less likely to apply unless the payment of such amounts is legally enforceable under applicable law."

Notice 2018-68, however, "is clear in that the right to unilaterally reduce compensation on the part of the company or compensation committee, known as negative discretion, is equivalent to the lack of a written binding contract, and therefore the transition rule is not available for such plans," said Peter Klinger, a San Francisco-based principal in consultancy BDO's compensation and benefits practice.

The example given in the notice, Klinger explained, has negative discretion regarding part of the bonus and also a portion that's to be paid under a written binding contract in effect prior to Nov. 2, 2107, and for that portion "the compensation committee does not have a right to unilaterally reduce the payment. In the example, only the portion not subject to negative discretion is subject to the transition rule."

Stay Tuned

Notice 2018-68 states that the IRS plans to issue further guidance in the form of proposed regulations regarding the changes to Section 162(m).

Any future guidance addressing matters covered by Notice 2018-68 "that either restrict what is a written binding contract or broaden who is a covered employee subject to the new tighter deduction limits under Section 162(m) will be prospective only," McDermott, Will & Emery's attorneys explained.

Related SHRM Articles:

Reports of Sky-High CEO Pay Fuel Fairness Debate, SHRM Online Compensation, August 2018

Responding to the Tax Act's Executive Compensation Changes, SHRM Online Compensation, January 2018

Tax Act Alters Executive Pay, Affects Bonus Deductions and Withholding, SHRM Online Compensation, December 2017

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