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.

Proposed Tax Bill Would Change the Face of Executive Compensation

Yesterday, Representative Kevin Brady (R-TX), Chair of the powerful House Ways and Means Committee, rolled out the Republican tax reform proposal. And, while no tax bill in my lifetime or likely anyone else's lifetime has made it through the legislative process unscathed, the draft bill fashioned as HR 1 certainly provides an indicator of where we may be headed.

Much seems completely as expected. We knew about the slimming to four tax brackets. We knew about the narrowing of deductions. We knew that some of the more heavily-taxed states would feel the pain of restructuring. What we didn't know and what frankly came as a surprise to me and to others that I know would completely change the face of executive compensation in the US. Honestly, on its surface, these proposed changes look to me as if they they had been constructed by Democrats. It wouldn't surprise me if these changes had been pre-negotiated, but that's entirely speculation on my part.

So, what's the big deal?

There are two extremely significant proposed changes according to my initial reading.

1. The draft would amend Code Section 162(m) (the $1 million pay cap) to eliminate the exemption for performance-based compensation. In addition, that section would be amended to cover the Chief Financial Officer in addition to the Chief Executive Officer. 
2. Code Section 409A would be repealed (you thought that was good news, didn't you?) and replaced with a new Code Section 409B. Essentially, 409B as drafted would apply the much more stringent taxation upon vesting rules that have previously applied generally only to 457(f) plans. 

162(m) Changes

Section 162(m) was added to the Internal Revenue Code by the 1993 tax bill. Widely praised at the time as a way to limit executive compensation, the exemption for performance-based compensation turned out to be a far bigger loophole than had been imagined. 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.

That would change. 

My suspicion is that companies would return to paying their top executives as they and their Boards see fit, but with the knowledge that particularly high compensation whether performance based or not would not be deductible. Additionally, so called mega-grants and mega-awards would likely become much rarer as the cost of providing them would no longer be offset by tax savings.

409B

The ability to defer compensation has long been a favorite of high earners. The requirement to defer compensation has also been considered a good governance technique by many large employers (for example, a number of large financial services institutions require that percentages of incentive compensation be paid in company stock and that receipt must be deferred),

Much of this would go away as very few people have the ability or desire to pay taxes on large sums of money before they actually receive that money.

What Might Happen If the Bill Passes

Nobody really knows what might happen. But since this is my blog, I get to guess. Here, readers need to understand that there is no hard evidence that what I say in this section will happen, but it seems as if it could.

The draft of HR 1 appears to keep tax-favored status for qualified retirement plans. That's important because qualified retirement plans are a form of deferred compensation with some special rules and requirements attached. What this means is that to the extent that an individual would like to defer compensation on a tax-favored basis, he would need to do it through a qualified plan.

However, qualified plans need to be nondiscriminatory; that is, they must (not an exhaustive list):

• Provide benefits that are nondiscriminatory (in favor of highly compensated employees)
• Provide other plan elements sometimes known as benefits, rights, and features that are nondiscriminatory
• Cover a group of employees that is nondiscriminatory

There are techniques by which this can be accomplished in a currently legal manner, but they are not simple. It would not surprise me to see more interest in these techniques.

As I said at the beginning, I don't expect this bill to pass as is. But, these particular provisions written by Republicans should not draw ire from Democrats. We'll see where it goes.

IRS Withdraws Troubling Provision of Proposed Nondiscrimination Regulations

Yesterday, the IRS released Announcement 2016-16 withdrawing parts of the nondiscrimination regulations it proposed at the end of January. Those proposed regulations had troubled many in the defined benefit industry since their proposal for a number of reasons (more below). From the standpoint of the IRS, the troubling part of the proposal addressed some serious abuses by practitioners and the sponsors they consult to. From the standpoint of practitioners, the proposed regulations took an objective test that has been around for quite a while and essentially changed the rules of the game.

I'm going to have to get a little bit technical here before I bring you back to reality. What the proposed regulations would have done was to make retirement plans with multiple formulas show that each formula applied to reasonable business classifications of employees or to pass a more difficult test.

Under regulations that were finalized in 1993 and then amended for cross-tested plans in the late 90s, a rate group in the testing population must have a coverage ratio at least equal to either

• 70% if the plan uses the Ratio Percentage Test to pass minimum coverage tests or
• The midpoint of the safe harbor and unsafe harbor (the midpoint is typically in the 25% to 40% range, but is determined through a somewhat convoluted formula) if the plan uses the Average Benefit Test to satisfy minimum coverage

It is far easier for a rate group to satisfy a lower minimum coverage ratio than a higher one. And, many plans had been designed around satisfying the lower threshold. While the preamble to the proposed regulation said that it was targeting QSERPs, practitioners found that they also were potentially problematic for many plans of small businesses and plans of professional service firms. 

Why would this be troubling? Certainly, among larger corporations, the prevalence of ongoing defined benefit plans has dropped precipitously, but many small businesses and professional service firms have adopted new defined benefit plans (DB) over the last 15 years or so and many of these plans would have found it more difficult or perhaps impossible to pass these proposed rules.

This doesn't mean that DB plans of this sort are out of the woods yet, so to speak. Clearly, the current Treasury Department views that plans of this sort may be abusive in their application of the nondiscrimination regulations, so we could see another effort from the IRS to make the regulations a bit less QSERP-friendly. 

In the meantime, there are some great DB designs that exist for companies that wish to provide meaningful retirement benefits to their rank and file employees. You can learn more about them here.

IRS Proposes Updated Pension Nondiscrimination Rules

I wrote recently about some of the causes of the relative demise of defined benefit (DB) plans. Last Thursday, although it was dated Friday, the IRS released a new proposed nondiscrimination regulation. We had been told that this was coming down the pike. It was going to be all good. It was going to provide relief so that a DB plan that was compliant and was frozen to new entrants (sometimes called soft frozen) would not suddenly become non-compliant due to natural turnover and promotions of active employees in the plan. That the IRS addressed this nearly 23 years after the regulations were finalized was long overdue, but good news.

We didn't know that there were going to be other changes. One of the hallmarks of the suite of nondiscrimination regulations (nondiscrimination, coverage, minimum participation) is that they provided objective tests to determine whether a plan discriminated unfairly in favor of highly compensated employees (HCEs). In fact, the final regulations tell us that satisfying the various tests included in them are the sole method of demonstrating nondiscrimination. While this caused a significant burden for some companies and their plans, it gave plan sponsors comfort in knowing that passing those tests meant that there plans were, in fact, nondiscriminatory. Many design and redesign studies were done because of this knowledge.

Then came last week,

I now digress into some technical mumbo jumbo the likes of which this blog has not seen for a while. If you don't like or care about the technical stuff, please stick with me; I'll return to the more common language soon.

The rules for nondiscrimination in amount under 1.401(a)(4)-2 and -3 contain something known as the general test. Under the general test, there exists a concept known as the rate group. For each HCE, there is a rate group consisting of that HCE and all other nonexcludable employees whose normal and most valuable accrual rates are at least as big as those of that particular HCE (people with similar accrual rates can be grouped to be considered to have the same accrual rate as each other). Once we establish the rate groups, we must demonstrate that each rate group satisfy the head counting portion of the same coverage test under Code Section 410(b) that the plan uses to satisfy coverage. So, if the plan uses the Ratio Percentage Test to satisfy 410(b), then each rate group must have a ratio percentage of at least 70%. On the other hand, if the plan uses the more complex Average Benefit Test to satisfy 410(b), then each rate group must have a ratio percentage at least equal to the lesser of the actual ratio percentage for the testing population or the midpoint of the safe and unsafe harbors (this threshold is far less than 70% and is frequently in the neighborhood of 30%).

This has been the case since 1993. In fact, there are now people performing testing who were not alive when we started doing testing this way.

Under the proposed regulations, however, that lower threshold would not be available to plans that have separate formulas for which there is not a reasonable business criterion. The proposed regulation tells us that naming names (common in designs often known as QSERPs) does not constitute a reasonable criterion. The problem is that when the word reasonable is used, we, the practitioners never know what someone else thinks is reasonable.

So, will we be left doing tests that we think are correct only to learn that someone else with a higher authority thinks that we have misconstrued what is reasonable? Is this a calling to just stop providing retirement benefits? After all, we could design perfectly good retirement plans for our clients today that we learn tomorrow have suddenly failed to still be nondiscriminatory.

From a personal standpoint, the good news is that even most of the aggressive designs that my colleagues work with would seem to satisfy the reasonable business criterion test. There are lots of plans out there, however, that do not, and these plans may be in trouble if and when the proposed regulations are finalized.

Would you like to know if your plans seem safe or potentially in trouble? I'll be happy to help you figure that out.

Getting Around Code Section 162(m)(6)

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I am working to remember how to embed it in this blog, but in the meantime, you can go to it by clicking on this link.

New Pay Limit for Covered Health Insurance Providers and Maybe a Way Around It

Perhaps you like the Patient Protection and Affordable Care Act (PPACA, ACA, or ObamaCare). Perhaps you don't. You are entitled to your opinion. I think we can all agree that it has its good provisions and it has those that perhaps could have been better thought through. One that falls into the latter category is the [relatively] new Code Section 162(m)(6) dealing with the limit on compensation for Covered Health Insurance Providers (I'll refer to them as CHIPs because it's much easier for me to type). In a nutshell, the section and its new proposed regulations limit the deduction for compensation that can be taken by a CHIP to $500,000 annually with respect to any person.

If you want to read the regulation like I did, you can find it here. If you want a good technical overview with the requisite cynicism, I direct you to Mike Melbinger's blog.

If you would like a solution, read on.

In a nutshell, you are a CHIP if 2% of the gross revenues received by your controlled group are from health insurance premiums. Yes, that means that if you happen to be part of a controlled group that contains a health insurer, you are likely a CHIP. Congratulations!

Most of Code Section 162(m) deals with deduction of compensation (as a reasonable business expense). The parts that limit it generally limit it to $1 million, except for CHIPs. And, for CHIPs, and only for CHIPs, the determination of whether an individual's compensation exceeds $500,000 includes deferred compensation earned, nonqualified plan benefits earned, equity compensation awarded, and severance benefits paid. The calculation is not easy, but this post is not about that. If you'd like to know more about the calculation, contact me and I'll be happy to charm you with its details.

I said I have a solution, and for many companies, I think I do. What was left out? Did you notice that qualified plan contributions and accruals were left out? And, for qualified plans, we have an objective set of nondiscrimination rules.

The solution involves a technique often referred to as a QSERP. What this technique does is to take nonqualified deferred compensation amounts and moves them from a nonqualified plan to a qualified plan. In this case, it has lots of advantages:

• Frequently immediate tax deductibility
• Tax-favored buildup
• More security
• Pooling with significant other obligations in a large trust

Most often, QSERPs are utilized in a defined benefit context. But, realizing that many companies no longer have defined benefit plans providing for current accruals, QSERPs can be utilized in a defined contribution context as well. 

Again, the explanation is long and has been covered elsewhere, so I'm not going to bore my readers here, but if you'd like a detailed explanation, contact me directly.

I know the cynics among you will say that this deduction limitation is the right thing to do. For you, I will say that you should have asked Congress to craft the law in a way that doesn't leave creative minds the opportunity to find loopholes.

If you're reading this today (it's a Friday) or even if you're not, have a great weekend whenever that may come for you.

MAP-21 and SERP Funding, Now May be the Time

If you work with US defined benefit (DB) pensions and you haven't been living under a rock, then you are probably familiar with MAP-21, the law passed this summer whose more formal name is Moving Ahead for Progress in the 21st Century. It was positioned as a highway bill, but you are too smart for all that and know all about positioning. Where building highways costs money, lowering corporate deductions for pension plans raises money (or gets scored that way by the Congressional Budget Office). So, MAP-21 included pension funding relief.

In a nutshell, MAP-21 allows plan sponsors to use significantly above-market discount rates in the determination of funding requirements for their qualified pension plans. The trade-off comes in increases in PBGC premiums. But, while the first of these items is optional, the second is required.

So, where am I going with this? If you read the title of this post, you may be wondering.

Flashback to late 2004. Congress passed and a different president signed into law another act supposedly designed to create jobs. This one had a much more in-your-face title, the American Jobs Creation Act of 2004. With that innocuous name, however, came a new section of the Internal Revenue Code, Section 409A that among other things removed distribution and funding flexibility for DB SERPs. Since that time, many executives have wondered how to get their benefits, or at least portions of them, out from under the dark veil of 409A.

For some companies, MAP-21 may have provided an answer.

WARNING: before considering an option such as what I am about to describe, plan sponsors should very carefully consider the underlying risks.

The time may be right to consider a QSERP. Briefly, a QSERP is a means to transfer certain nonqualified benefits to a qualified plan. You can read about them in more detail here.

So, why might now be the right time. MAP-21 has given companies the ability to use higher discount rates in funding their pension plans. This means that any restrictions that might have arisen due to low funded statuses have likely disappeared. So, companies have the opportunity to fund this obligation in a qualified plan without having to fund it all at once.

Risk managers might tell you not to do this and there are good reasons. Paramount among them is that temporary use of above-market discount rates does not change the "true" funded status of a plan.

Other risk managers might tell you that you should do this and you should do it now. Why? Let's consider a simple example. Suppose you have agreed to pay your CEO an additional $100,000 per year (for life starting at age 65) from the SERP. This is over and above what he will get from the qualified DB plan. The present value of that obligation is the same whether that benefit is in the qualified plan or in the SERP. But, in the qualified plan, you get these advantages and many others:

• The benefit will not be subject to 409A
• You could efficiently fund the benefit immediately and generally get an immediate tax deduction for that funding
• That tax deduction may be taken at a higher corporate tax rate than it will be in the future
• When the CEO retires, his benefit can be paid out of a large pool of assets rather than creating a cash flow crunch

This is a complex process and there is much to consider. But, for the right company, now is the time. You'll only know if you are the right company after careful analysis. Ask an expert.

A New Look at an Old Friend

About 10 years ago, they were all the rage for companies that had defined benefit (DB) plans. Lots of DB plans were still in surplus, or at least thought they were, and lots of companies still had ongoing DB plans. Something happened in the interim (OK, a few somethings happened), but that's not the point here. Roughly 10 years ago, lots of companies were looking for an ideal way to fund their DB Supplemental Executive Retirement Plans (SERPs), In my opinion, the most effective way to fund these nonqualified (NQ) benefits was through a qualified plan (QP). This strategy has gone by many names, but the most prevalent in the industry has been the QSERP.

On the surface, the QSERP is simple. An executive has a NQ accrued benefit which is usually composed of a gross benefit offset by a QP accrued benefit. The resultant net benefit is what the executive would get from the SERP. In a QSERP, the QP is amended to increase the QP benefit to include some or all of the SERP benefit, thus (because of the offset feature) decreasing the net SERP benefit by an equal amount.

What does this do for the executive? Here are some of the benefits.

• It generally secures the benefit. Of course, if the plan sponsor goes bankrupt, such security is subject to PBGC limits on guaranteeable benefits.
• It takes the benefit out from under the purview of Code Section 409A.
• While the benefit is still in the plan, it does not fall prey to the doctrine of constructive receipt under Code Section 83.
• If the benefit is payable in a lump sum, it can be rolled over into an IRA further deferring taxation.
• The executive can wait until just before his benefit commencement date to make an election as to the timing and form of benefit distribution.
• The benefit is exempt from FICA taxes.
• The benefit is protected in the event of a change-in-control.

And, for the plan sponsor, here are some of the benefits.

• To the extent that the benefit is funded immediately, the sponsor gets an immediate tax deduction.
• Since the plan is qualified under Code Section 401(a), the trust will be exempt from taxes under Code Section 501(a), meaning that the plan assets grow tax-free.
• Payment of the benefit comes from a trust that holds all of the plan assets, not from the corporate coffers, or a far smaller rabbi trust.
• Qualified plans have better optics than do SERPs.

How about for the shareholder? How does a QSERP affect them?

• In every case that I can think of, implementation of a QSERP has been either income-neutral or income-positive.
• The company is less likely to have sudden cash flow requirements.
• From a risk standpoint, it is far easier to use risk management techniques in a qualified plan than in a SERP.

So, why can companies put in these QSERPs? Generally, from a technical standpoint, it goes to two things in the Internal Revenue Code: 1) the nondiscrimination rules of Code Section 401(a)(4) are highly objective; and 2) the combined limits under Code Section 415(e) were repealed.

Yes, that's highly technical stuff. But, suffice to say that it works. For years, I had the extreme pleasure <cough, cough> of teaching nondiscrimination testing to generally younger and aspiring actuaries. One of the things about the testing that I drilled into their heads was this: if you don't pass, you're not trying hard enough. 

Sometimes benefits actually are discriminatory, and there is nothing that any of us can do to change that. But, I have seen some benefit formulas over time that are extremely discriminatory to the naked eye. So, what do we do? We take the employee data and put it in a big pot. We add in the benefit provisions. We stir a bit with the nondiscrimination rules (remember, they are objective; either you pass or you fail.) and out comes a nondiscriminatory plan.

We're late in 2011 now. The funding rules have changed. There are fewer large defined benefit plans, and of those that remain, many are in one state of freeze or another. 10 years ago, there was no 409A. There was no Dodd-Frank, 

There is still lots of merit to this approach. Consider it. Talk to us.