3522 / What is the grandfathering rule that provides transition relief with respect to executive compensation agreements entered into before the 2017 Tax Act was enacted?

A transition rule applies to exempt compensation paid pursuant to a written binding contract in effect on November 2, 2017 and which was not materially modified on or after that date. If the contract is renewed after November 2, 2017, it does not qualify for the transition relief (i.e., it is treated as a new contract). The IRS has provided guidance with respect to this transition relief, and has clarified that the grandfathering provision applies only with respect to amounts that the employer is obligated to pay under applicable law (i.e., state contract law) if the employee provides the relevant services or satisfies applicable vesting conditions. If the employer pays more than this amount, those excess amounts are subject to the 2017 tax reform legislation amendments to Section 162(m).

Contracts that can be terminated unconditionally by either party without the other party’s consent, or by both parties, are treated as new contracts entered into on the date the termination would be effective if it was made (contracts that can only be terminated by terminating the employment relationship are not treated as new contracts under this provision).¹ For example, if the terms of a contract provide that the contract will be automatically renewed unless one party provides notice of termination at least 30 days prior to the renewal date, the contract is treated as though it was renewed as of the date the termination would have been effective if the notice was given.

If the employer remains legally obligated to perform under the contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed as of that date if the employee exercises the discretion to keep the corporation bound to the contract. A contract will not be treated as though it was renewed if, upon termination or cancellation of the contract, the employment relationship continues but is no longer covered by the contract. If the employment relationship continues, payments with respect to the employment are not made pursuant to the contract, so they are no longer grandfathered.²

If a compensation arrangement is binding, amounts required to be paid as of November 2, 2017 pursuant to the plan are not subject to the Section 162(m) amendments even if the employee was not eligible to participate in the plan as of that date. The amendments do apply if the employee was not employed by the employer as of November 2, 2017, or if the employee had the right to participate in the plan under a binding written contract.