The Big Surprise Gotcha in the Million Dollar Pay Cap

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.

Compensating Executives Under the New 162(m)

Except for those who are either executives or people involved in determining the ways that executives are compensated, one of the changes to the Internal Revenue Code last fall seemed like a little throw-in designed to appease a small constituency, but that few would really care about. That small group that does understand the change, however, knows it is a pretty big deal.

Let's recap so that we can all be on the same page. Prior to the Tax Cut and Jobs Act (TCJA), and oversimplifying somewhat, public companies were entitled to deductions for executive compensation so long as such compensation did not exceed $1 million per year for a covered employee. Performance-based compensation was not to be counted against that limit and covered employees were the CEO plus the four other highest compensated employees.

Since the passage of the TCJA, there have been several key changes to Section 162(m):

• Once you become a covered employee of a company (beginning in 2017), you remain a covered employee of that company, essentially forever;
• The CEO plus four other highest paid has been changed to CEO plus CFO plus three other highest paid;
• Companies no longer get an exemption for performance-based compensation; and
• Some grandfathering exists for certain agreements that existed in writing.

That does not leave a whole lot of wiggle room for companies. And, for companies that have provided large amounts of performance-based compensation to their executive group, meaningful deductions may be gone.

I'm not about to suggest that I can fix this new problem. But, you should note that amounts that have been deductible under Section 404 are unaffected by these changes. Section 404 of the Internal Revenue Code relates to qualified pension plans. What this means is that to the extent that parts of an executive's compensation which would be subject to Section 162(m) are somehow moved into a qualified pension plan, the funding of that plan will, subject to the rules of Section 404, generally qualify for a corporate tax deduction.

Of course, there are a myriad of rules around what it takes to keep such a pension qualified including the nondiscrimination rules of Section 401(a)(4). But, for most companies that still maintain ongoing pensions, the ability to transfer some otherwise nondeductible compensation to such a pension plan may still exist. It's one of the tools in the tool box that companies should look into.