Even those of us who have been hiding under rocks know that late last year, the President signed into law the Tax Cuts and Jobs Act. And, as part of that Act, there was language that amended Code Section 162(m) also known as the million dollar pay cap. After Treasury gave us guidance on those changes in Notice 2018-68, some observers were surprised by a few of the interpretations that the regulators took. One in particular, however, that they didn't quite spell out, meets my criteria for a big surprise gotcha.
I'll come back to that and consider how an employer might get around it, but first some background. Under the old 162(m), deductions for reasonable compensation under Section 162 were limited to $1,000,000 per year for the CEO and the four other highest compensated employees of, generally speaking, publicly traded companies. However, most performance-based compensation was exempt from that calculation and was deductible as it would have been before the cap came into being.
Under the new 162(m), the definition of covered employee has been changed to be the CEO, CFO, and the three other highest paid employees. But, once you become a covered employee, you remain a covered employee. So, by 2030, for example, a company could easily have 25 covered employees. [Hats off to the cynics who know this is a silly example because no law stays in place unchanged for 13 years anymore.] Further, performance-based compensation is no longer exempt.
Like most law changes that affect compensation and benefits, this one, too, has a grandfather provision. Here, the new rules are not to apply to remuneration paid pursuant to a binding contract that was in effect on November 2, 2017, and which has not been materially modified after that date. The keys then relate to what is compensation for these purposes, what sort of modifications might be material, and what constitutes a binding contract.
Compensation is essentially any compensation that would be deductible were it not for the million dollar pay cap. Whether a modification is material remains a bit subjective, but the guidance does specify that cost-of-living increases in compensation are not material, but that those that meaningfully exceed cost-of-living are.
The binding contract issue is the really sneaky one. Your read and your counsel's read may be different, but my read is that if the employer has the ability to unilaterally change the contract, it's not binding. That is problematic.
Consider a nonqualified retirement plan be it a defined benefit (DB) SERP or a traditional nonqualified deferred compensation (NQDC) plan. In my experience, it's fairly common (completely undefined term) to see language that gives an employer the unilateral right to amend said plan, subject to any employment agreements that may overrule. Well, if the company can amend the plan, there would seem to be no binding agreement. And, that means that when that nonqualified plan is paid out to the employee, perhaps none of a large payout will be deductible for the employer. I'm aware of some payouts well into nine figures.
When it's a nine-figure payout, there really aren't great solutions. But, for the typical nonqualified plan, whether it's DB or DC, qualifying some of the benefits changes the treatment. If the benefits can be qualified in a DB plan using a QSERP device, employer funding will be deductible if it is deductible under Section 404. That's far more forgiving and, in fact, it is not at all unlikely that the deductions will already have been taken before the covered employee retires.
Yes, it's still a big surprise gotcha, but don't you prefer a surprise gotcha when it has a surprise solution.