IRS Notice 2018-68 Provides Transition Guidance Under IRC §162(m)

Aug 30, 2018

IRS Notice 2018-68 (the “Notice”) provides transition guidance under Internal Revenue Code (“Code”) §162(m) that allows publicly held corporations to deduct all grandfathered non-qualified deferred compensation:
  • paid after separation from service
  • paid at any time to the chief financial officer
  • paid at any time by employers who are subject to 162(m) starting in 2018 as a result of the Tax Cuts and Jobs Act (the “Act”) but would not have been subject to §162(m) before 2018
“Grandfathered” compensation is defined as non-discretionary compensation paid in 2018 or beyond under contracts in place as of November 2, 2017. This includes:
  • amounts deferred under nonqualified deferred compensation plans or contracts as of November 2, 2017, plus 
  • future deferrals of other grandfathered compensation (for example, salary earned under a grandfathered employment agreement)
Grandfathered deferrals may include notional earnings accrued after November 2, 2017 only if the employer does not have the right to reduce or eliminate future earnings.

Employers seeking grandfathered status will need to be able to identify grandfathered compensation as it is paid in the future. Employers will also need to avoid making “material modifications” to grandfathered contracts or they will lose full deductibility. The cost of implementing the required administrative systems would compare favorably if, for example, a non-qualified deferred compensation plan pays the CEO several million dollars of grandfathered compensation upon separation from service.

Pre-Act and Post-Act §162(m)

Code §162(m) caps a public company’s annual tax deduction to $1 million on amounts paid to the top officers. Prior to 2018, the top officers were the CEO and the three highest-paid officers, other than the chief executive officer. The chief financial officer's compensation was not subject to the cap. See IRS Notice 2007-49. Deductions were unlimited for shareholder-approved performance bonuses and post-separation payments. 

Effective for payments in 2018 and beyond, §162(m) also caps chief financial officer compensation and applies the cap to all compensation to former as well as current top officers, regardless of how it is earned or whether the officer has terminated employment. The cap also extends the deduction limit to employers who file financial statements with the SEC even if they do not have stock listed on a U.S. exchange.

Grandfathered Contracts

The Act provides that the pre-Act rules will continue to apply to compensation paid under contracts in place as of November 2, 2017. Examples of such “grandfathered” compensation could include amounts paid under:
  • non- qualified deferred compensation plans
  • multi-year employment agreements
  • compensation under long-term awards such as long-term incentive plans (LTIPs) and restricted stock units
For example, as of November 2, 2017 the CEO has accumulated $5 million under his employer’s nonqualified deferred compensation plan to be paid in a lump sum upon separation from service. Under pre-Act §162(m), the entire payment is deductible. Under post-Act §162(m), post-separation payments would be subject to the cap along with all of the other compensation the CEO received that year and likely would be non-deductible. Identifying the payment as made under a grandfathered contract allows the employer to deduct the full amount.

Material Modifications

If an employer amends a grandfathered contract on or after November 2, 2017 to increase the amount paid to the officer, Notice 2018-68 treats the employer as entering into a new contract. With respect to non-qualified deferred compensation plans, a material modification does not result from deferring or re-deferring grandfathered compensation as long as the additional earnings resulting from the delayed payment is based on a pre-determined actual investment (such as a mutual fund) or reasonable interest rate. 
  • Observation: Some plans credit participants with fixed interest rates based on the employer’s internal rate of return or a premium above a bond index. A participant re-deferring payment of an account under this type of plan would need to re-allocate the investment to an actual investment no later than the effective date of the payment modification, or the account would lose its grandfathering.
  • Observation: Employers may unilaterally delay non-qualified plan payments under Treasury Regulation §1.409A-2(b)(7)(i) until they become deductible under §162(m) without causing a material modification (subject to the actual investment requirement).
Non-financial amendments to a non-qualified deferred compensation plan are not material modifications. Amendments to conform a plan to regulatory requirements (such as applicable tax laws and recent DOL disability regulations) or amendments to freeze future deferrals or accruals also are not material modifications.

Accelerating payments from a non-qualified plan as permitted under Code §409A or the terms of a pre-409A arrangement is not a material modification as long as the participant is not receiving more than the present value of the scheduled payments. For account-based plans, the account balance is the present value.

Is Grandfathering Worthwhile?

There is a cost to grandfathering because the employer must take steps to 
  • identify grandfathered compensation as it is paid and
  • avoid inadvertent material modifications to the grandfathered contracts.
Grandfathering may entail a review of accounting, administrative and contract management systems. Employers may also need to coordinate with third-party service providers including payroll providers and third party record keepers for their deferred compensation plans.

The costs of implementation should be weighed against the expected tax savings. A lump sum payment of $10 million of grandfathered deferred compensation to the CEO upon separation from service may be worth grandfathering. The deduction, in that case, is worth up to $2.1 million in tax savings to the employer. The same $10 million paid upon separation in equal annual installments over 10 years may not be worth grandfathering because most if not all of the annual $1 million payments would be deductible under both pre and post-Act §162(m).

Grandfathering requires identification of the relevant officers who are expected to be subject to the cap at the time payment is made in the future. These would include the current CEO, CFO and top-paid three officers as of the end of the 2017 fiscal year and may include several more individuals who may become covered employees in the future. Each of the identified officers should have very large current balances of grandfathered deferred compensation.

Potential grandfathered deferred compensation includes the following:
  • Vested and unvested deferred compensation account balances and present values of pension-type supplemental executive retirement plans (SERPs) determined as of November 2, 2017;
  • Future elective deferrals or re-deferrals of salary, bonus and other compensation under employment agreements, LTIP awards and restricted stock units in effect or granted prior to November 2, 2017 (excluding any amounts determined in the sole discretion of the employer);
  • Earnings credited with respect to grandfathered deferrals after November 2, 2017 if the employer does not have the right under the terms of the plan or other contract to prospectively reduce or eliminate future earnings accruals.
With respect to future earnings on grandfathered deferrals, most non-qualified plans provide that the employer may amend the plan on a prospective basis as long as the amendment does not reduce previously accrued benefits. Whether this authority includes the right to eliminate future earnings accruals should be determined with counsel. The amendment provisions in the plan are not likely to be specific on this point, so the answer may depend on a full review of the plan document as well as the plan’s enrollment materials. Enrollment materials frequently illustrate the advantages of investing on a pre-tax basis through the plan as opposed to investing post-tax through an individual broker account. The illustrations are not guarantees as to results, but they do provide an inducement to make elective deferrals under the plan. The issue of whether the employer is prevented from terminating future earnings accruals altogether under state law doctrines of promissory estoppel should be reviewed with counsel. 

Future Guidance and Next Steps

The Notice provides transitional guidance that will become part of proposed regulations to be published in the future. For now, employers may rely on a reasonable interpretation of the Notice. Newport Group clients reviewing their options under the Notice may obtain participant account information at the sponsor website on Your Newport Group contact is also available to assist you in identifying grandfathered account balances as directed by your counsel.


Newport Group and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before making any decisions.

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