Proposed 162(m) Regulations Add Another Layer of Executive Compensation Issues in M&A
- The Tax Cuts and Jobs Act of 2017 (TCJA) upended public company compensation structures nationwide. Prior to the TCJA, Section 162(m) of the Internal Revenue Code of 1986, as amended, generally provided for a $1 million annual deduction limit for compensation paid to certain executives
- In an attempt to curb excess executive compensation, the TCJA amended Section 162(m) to eliminate the performance-based pay exemption and expand the rule to a larger number of executives and companies subject to public reporting requirements.
- A public hearing on the proposed regulations is scheduled for stakeholders on March 9, 2020.
The Tax Cuts and Jobs Act of 2017 (TCJA) upended public company compensation structures nationwide. Prior to the TCJA, Section 162(m) of the Internal Revenue Code of 1986, as amended, generally provided for a $1 million annual deduction limit for compensation paid to certain executives (usually the top five to seven executives at large public companies). This limit contained a carve-out that exempted performance-based compensation if it was paid under an arrangement that complied with strict rules regarding performance goals and plan governance. In an attempt to curb excess executive compensation, the TCJA amended Section 162(m) to eliminate the performance-based pay exemption and expand the rule to a larger number of executives and companies subject to public reporting requirements. On Dec. 16, 2019, the IRS issued proposed regulations to replace the initial guidance issued with regard to Section 162(m) in IRS Notice 2018-68, and if finalized, these regulations would further broaden the reach of Section 162(m). Some companies that will feel the greatest impact from these regulations are companies that have been involved in corporate mergers, acquisitions and other transactions, including initial public offerings (IPOs) and spinoffs. This Holland & Knight alert focuses on select provisions of the proposed regulations relating to corporation transactions, but the proposed regulations include other guidance relating to the grandfather rule for performance-based compensation that existed prior to Dec. 31, 2017, the intersection of deferred compensation rules under Section 409A with Section 162(m), and the definition of "applicable employee remuneration."
The $1 million deduction limit under Section 162(m) applies to covered employees of publicly held corporations. The TCJA and the proposed regulations made significant changes to the definitions of "covered employees" and "publicly held corporations" and imposed a permanent limitation on deductions of compensation paid in excess of $1 million annually to an individual once the individual is a covered employee.
This alert provides the key takeaways from the proposed regulations for decision-makers and counsel to consider when reviewing executive compensation issues in a transaction.
Definition of "Publicly Held Corporation." Prior to the enactment of the TCJA, Section 162(m) only applied to corporations issuing securities subject to the registration requirements of Section 12 of the Securities Exchange Act of 1934 (Exchange Act), which includes corporations that list their securities on a national exchange. Under the TCJA, a "publicly held corporation" subject to Section 162(m) now includes corporations required to file reports under Section 15(d) of the Exchange Act. The proposed regulations clarify that, in addition to publicly traded corporations, an entity that is subject to the Section 12 registration requirements or the Section 15(d) reporting requirements and falls into one of the following categories as of the last day of the taxable year is subject to Section 162(m):
- S corporations, including the parents of qualified subchapter S subsidiaries that issue securities
- publicly traded partnerships treated as corporations for federal tax purposes
- foreign private issuers publicly traded through American Depositary Receipts
- parents of disregarded entities issuing securities subject to the Exchange Act
- issuers of publicly traded debt, including noncorporate entities
Affiliated Groups. The proposed regulations clarify the situations where the Section 162(m) limitations apply to affiliated groups with at least one publicly held corporation. Publicly held corporations include members of its affiliated group, as defined in Code Section 1504, and all are subject to Section 162(m) on an individual and group basis. This means that 1) if one member of an affiliated group is subject to Section 162(m), then the entire affiliated group is subject to Section 162(m), and 2) if more than one member of the affiliated group is subject to Section 162(m), then Section 162(m) applies to those entities separately and to the entire affiliated group. To add another dimension of complexity to this rule, the proposed regulations explain the allocation of nondeductible compensation expense among members of an affiliated group:
- If a covered employee of one member of an affiliated group is paid compensation from more than one member of the affiliated group, all compensation paid by those members is aggregated and the disallowed compensation expense is allocated on a prorated basis in proportion to the amount of compensation each member paid in compensation.
- If the covered employee is a covered employee with respect to more than one member of the affiliated group, the disallowed compensation expense is determined for each member separately.
The proposed regulations provide several examples to demonstrate the affiliated group rules in action, which provide important guidance based on the facts of a particular situation. Decision-makers should carefully consider the financial impact of these rules when structuring transactions.
IPO Transition Rule. Under the old Section 162(m) regime, newly public companies were given a transition period to bring their compensation arrangements into compliance with Section 162(m) as long as the arrangement was disclosed to investors at the time of the transaction. Companies experiencing an IPO had until the first shareholder meeting that occurred after the third calendar year following the IPO to comply, and companies that became publicly held following a spinoff had until the first shareholder meeting that occurred after the first calendar year following the spinoff to comply. The proposed regulations have eliminated that relief period for IPOs occurring after Dec. 20, 2019. Companies that become publicly held after that date must now recognize the limitations on deductibility under Section 162(m), including for performance-based compensation, for the taxable year ending on or after the date the company becomes publicly held. Before the IPO is effective, the company's current executive compensation arrangements need to be carefully reviewed to determine whether any amendments need to be made or other actions should be taken to prepare for the application of Section 162(m) immediately following the IPO.
Definition of "Covered Employee." In tax years prior to 2018, "covered employees" subject to Section 162(m) were limited to the principal executive officer and the three highest-compensated officers. A covered employee under the TCJA includes the company's principal executive officer, principal financial officer and the next three highest-compensated officers for the taxable year. If an executive was a covered employee in any tax year beginning after Dec. 31, 2016, the executive will be a covered employee in all subsequent tax years going forward. This rule in effect means that once an individual is a covered employee, the individual is always a covered employee at that company.
Predecessor Aggregation. One of the more complex rules in the proposed regulations relates to "predecessor" entities in a transaction. Covered employees of predecessors of a publicly held corporation are also subject to Section 162(m). Generally, covered employees of a public company acquired by another public company become covered employees of the acquirer because the target is considered a predecessor of the acquirer. Even if the target ceases to exist after the transaction, the executives were once covered employees, so they remain covered employees. The proposed regulations clarify the designation of predecessor entities following certain transactions:
- Reorganizations. Public companies acquired in a tax-free corporate reorganization are predecessors of their acquirer, and a distributing public company is the predecessor of a spun-off public company where covered employees of the distributing company become employees of the spun-off company within the period beginning 12 months before and ending 12 months after the spinoff.
- Asset Sale. If a company buys 80 percent of the assets of a publicly held company, the target is a predecessor of the acquirer.
- Former Public Companies Now Private. A previously public private company is a predecessor of its acquirer if it is acquired before the end of a tax year ending before the 36-month anniversary of the due date for the target's federal income tax return for the last year in which the target corporation was publicly held.
- Private Acquirer Goes Public. A public company is a predecessor of a private company acquirer if the acquirer becomes a public company for a tax year ending before the 36-month anniversary of the due date of the target's federal income tax return for the last tax year in which the acquisition was taken into account.
- Former Public Company Goes Public Again. Even if neither entity in an acquisition is publicly held at the time of the transaction, a target that was previously publicly held will be a predecessor of a private company acquirer if the acquirer becomes publicly held for a tax year ending before the 36-month anniversary of the due date for the target's federal income tax return for the last tax year for which the target was publicly held.
Simply reverting from a public company back to a private company does not automatically foreclose the application of Section 162(m). The rules can be very fact specific, so companies that once were public or acquired a public company will need to keep careful records of corporate transactions and all former "covered employees." In addition, in light of this expanded interpretation of "predecessor," transaction teams should carefully analyze a target company's history during the diligence process to determine whether it has accumulated additional covered employees from past transactions, the impact its ownership history will have on the acquirer's ability to deduct compensation and whether records have been well maintained.
Public companies that are active in mergers and acquisitions, and private companies that either acquire public companies or were formerly public, will find that these rules cause the number of executives subject to Section 162(m) to accumulate quickly. It will be vital for companies to keep accurate records of transactions, and a review of which executives would be considered covered employees should be considered during annual executive compensation reviews. Company compensation decision-makers should work closely with counsel to determine which provisions apply to their situation.
A public hearing on the proposed regulations is scheduled for stakeholders on March 9, 2020. If you have any questions about how the proposed regulations may affect your company, please contact the authors or another member of Holland & Knight's Employee Benefits and Executive Compensation Group, including Partners Bob Friedman, Ari Alvarez, Kelly Bley, Gregory Brown, Christopher Buch, Kerry Halpern, John Martini, David Pardys and Rachel Shim.
Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem. Moreover, the laws of each jurisdiction are different and are constantly changing. If you have specific questions regarding a particular fact situation, we urge you to consult competent legal counsel.