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.

The Section 162(m) amendments apply to plans that are materially modified after November 2, 2017. Amounts received pursuant to the agreement before the material modification occurs are not subject to the Section 162(m) amendments, but amounts received after the material modification occurs are subject to the Section 162(m) amendments. The IRS has provided examples of when a material modification will occur:

The contract is amended to increase the amount of compensation payable to the employee,

The contract is amended to accelerate payment of compensation, unless the amount paid is discounted to reasonably reflect the time value of money,

A supplemental contract or agreement that provides for increased compensation, or the payment of additional compensation, if the facts and circumstances demonstrate that the additional compensation is paid on the basis of substantially the same elements or conditions of the compensation that is otherwise paid pursuant to the written binding agreement (although supplemental plans that provide for reasonable cost of living increases do not result in material modification).

Failure to exercise negative discretion under a contract does not result in material modification. Additionally, if the contract is modified to defer the payment of compensation, any compensation paid (or to be paid) in excess of the original amount payable to the employee under the contract is not a material modification if the additional amount is based on either a reasonable rate of interest or a predetermined actual investment (whether or not assets associated with the amount originally owed are actually invested as such) so that the amount payable by the employer at the later date will be based on the actual rate of return on the predetermined actual investment (including any decrease, as well as any increase, in the value of the investment).³

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Planning Point: Pre-reform, companies could deduct certain compensation in excess of the $1 million limit so long as the compensation was based on performance goals certified by the company’s compensation committee. Tax reform eliminated that exception so that companies cannot deduct this excess compensation even if it is performance based--therefore, many companies may decide there is no tangible tax benefit to having a compensation committee certify that those goals were met. Despite this, in order to qualify under the grandfathering provisions, performance-based compensation must continue to satisfy all of the standards that existed prior to the reform, so it is important to continue the certification practice if the compensation otherwise qualifies for grandfathering treatment.

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