As I blogged last week, the IRS has proposed new regulations under Section 162(m). These regulations would implement the amendments to Section 162(m) under the Tax Cuts and Jobs Act of 2017 and expand upon the guidance in Notice 2018-68. For today’s blog entry, I continue my coverage of the proposed regs by discussing clawback provisions and the grandfather exemption, a topic that I wasn’t able to get to last week.
Section 162(m) limits the tax deduction public companies can claim for compensation paid to specified executive officers to $1 million per officer. The TCJA significantly expands the scope of Section 162(m), by both increasing the executives covered under the provision and eliminating the exception for performance-based compensation. Prior to the TCJA, both stock options and performance awards were exempt from Section 162(m).
The TCJA includes a grandfather provision that exempts compensation paid under a contract that was in effect on or before November 2, 2017, provided three conditions are met: 1) the compensation would have previously been exempt from Section 162(m)—options and performance awards are a great example of previously exempt compensation, 2) the contract legally obligates the company to pay the compensation, and 3) the contract is not materially modified after November 2, 2017.
The proposed regulations provide guidance on whether the existence of a clawback provision affects whether compensation is eligible for the grandfather exemption.
This is an issue that was not addressed under Notice 2018-68. The question here is whether the presence of the clawback requirement might cause the arrangement to no longer be legally binding, i.e., because, in some circumstances, the company would not be required to pay the compensation. The proposed regulations offer some marginally good news: a clawback provision in and of itself generally does not impact eligibility for the grandfather provision unless/until conditions occur under which the clawback would be triggered.
Of course, if an event occurs that would trigger recoupment of the compensation under the clawback provision, payment of the compensation is no longer legally binding and, thus, the compensation is no longer grandfathered. If the company recoups the compensation, this isn’t a concern—the company doesn’t need a tax deduction for compensation it has recovered. Unfortunately, however, even if the company chooses not to exercise its rights under the clawback provision, the compensation would no longer be eligible for the grandfather to the extent that the company would have been legally able to recoup it (i.e., because the company is no longer legally obligated to pay the compensation).
There are many reasons a company might choose not to recoup compensation it is entitled to under a clawback provision. One reason might be that the clawback isn’t enforceable under state law. Another reason might be to avoid expensive and protracted litigation, even if the compensation might ultimately be recoverable. I’m not sure how companies will figure out the former (i.e., that the compensation isn’t recoverable) without undertaking the latter (i.e., expensive and protracted litigation).
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