The Section 162(m) Grandfather and Negative Discretion - Banner

The Section 162(m) Grandfather and Negative Discretion

September 04, 2018

As I noted in my blog last week, IRS Notice 2018-68 provides guidance on application of the provision in the Tax Cuts and Jobs Act that grandfathers some compensation arrangements from amended Section 162(m).  One of the areas of the notice that is still somewhat unclear however, is how the inclusion of “negative discretion” in a compensatory arrangement impacts eligibility for the grandfather provision.

What Is Negative Discretion?

Negative discretion is a provision that is commonly included in performance-based compensation, including performance equity awards, that allows the board to discretionarily reduce payouts under the award. It gives the board an out if they believe that, for some reason, the compensation shouldn’t be paid. For example, a board might use this discretion if the goals were met but the company’s overall financial condition doesn’t warrant payment or if an executive is subject to some massive scandal that reflects poorly on the company at the time that the goals are met. Including negative discretion in performance awards is generally considered a best practice.

So What’s the Problem?

The problem is that the TCJA says that compensation is grandfathered only if it is paid pursuant to a written, binding contract in effect as of November 2, 2017—emphasis on the word “binding.” Notice 2018-68 interprets this to mean that the contract under which the compensation is paid must legally obligate the company to pay the compensation under state law, provided that the vesting and performance requirements necessary to earn the payment are fulfilled. And here’s the rub: if the board can decide, at its discretion, not to make the payment, does this constitute a legally binding obligation on the part of the company?

The notice includes an example in which an executive is entitled to bonus of up to $1.5 million if a specified goal is met, but the board can discretionarily reduce the bonus to no less than $400,000, even if the executive achieves the goal. The example indicates that, under applicable law, taking into account the negative discretion built into the bonus arrangement, only the $400,000 minimum that cannot be discretionarily reduced by the board is grandfathered.

What’s the Verdict?

Well, we don’t really have one yet. Opinions vary as to how to interpret the example.  A cursory review of the client alerts on the notice that are posted to either or reveals the following:

  • Nine seem to take a fairly firm position that compensation that is subject to negative discretion isn’t grandfathered. Two actually use the word “torpedo” in explaining the effect of the notice on the company’s tax deduction for compensation subject to negative discretion.
  • Seven say that it’s likely that such compensation won’t be grandfathered.
  • Four say that compensation subject to negative discretion may not be grandfathered or that the treatment isn’t clear. One of these alerts suggests that a legal opinion may be necessary to support a position that awards with negative discretion are grandfathered.
  • Two don’t address this issue.

My hope is that we’ll get some clarification on this from Stephen Tackney of the IRS Chief Counsel’s office during his panels at the 26th Annual NASPP Conference. If you want to check them out, Stephen's session are "The IRS Speaks" and "Navigating Equity Plan and Award Changes After Tax Reform and Other Guidance."

  • Barbara Baksa
    By Barbara Baksa

    Executive Director