Firm Focuses on Executive Comp Plans With ‘Negative Discretion’

January 31, 2018

Ilya Enkishev
Attorney — Executive Compensation
CC:TEGE:EB:EC
Internal Revenue Service
5132 IR
1111 Constitution Ave., NW
Washington, DC 20224

Catherine Fernandez
Branch Chief — Executive Compensation
CC:TEGE:EB:EC
Internal Revenue Service
5039 IR
1111 Constitution Ave., NW
Washington, DC 20224

Stephen LaGarde
Attorney-Adviser
Department of the Treasury
4024-B MT
1500 Pennsylvania Ave., NW
Washington, DC 20220

Veena Murthy
Legislation Counsel
Joint Committee on Taxation
H2-502 Ford House Office Building
Washington, DC 20515

Robert Neis
Benefits Tax Counsel
Department of the Treasury
3050 MT
1500 Pennsylvania Ave., NW
Washington, DC 20220

William Paul 
Deputy Chief Counsel (Technical)
Internal Revenue Service
3034 IR
Internal Revenue Service
1111 Constitution Ave., NW
Washington, DC 20224

Stephen Tackney
Deputy Associate Chief Counsel (Employee Benefits)
CC:TEGE:EB
Internal Revenue Service
4302 IR
1111 Constitution Ave., NW
Washington, DC 20224

Re: Application of Section 162(m) Transitional Relief for Performance-Based Awards that have Negative Discretion Feature

Dear Ilya, Catherine, Stephen, Veena, Robert, William and Stephen:

This letter provides the support for the position that a Compensation Committee's ability to exercise negative discretion (and the exercise of such discretion) with respect to outstanding awards does not prevent the application of the Section 162(m) transitional relief provided by Section 13601(e)(2) of the Tax Cut and Jobs Act. The transitional relief allows outstanding performance-based awards subject to a written binding contract as of November 2, 2017 to continue their eligibility under the Section 162(m) performance-based exemption and permit a full tax deduction for such amounts when paid, unless materially modified after that date.

This point has received much attention in certain tax reform presentations and in discussions that public companies are having with auditors, along with raising the need to disclose on financial statements filed with the Securities and Exchange Commission an estimate of the effect of the unavailability of the Section 162(m) transitional relief. At various presentations, government representatives have requested information regarding the transitional relief.

The following points should be considered by auditors and by the government to avoid the need to disclose any financial statement estimates. Showing an estimate would seem to place the burden on the IRS and Treasury to specifically address the issue to remove the estimate.

1. Transitional Rule. The transitional relief applies to “remuneration which is provided pursuant to a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date.”

The Conference Committee report further elaborates on the point by stating that the mere right to participate in a plan can qualify for transitional relief if part of a written binding contract with the covered employee in effect on November 2, 2017.

2. Prior Transitional Relief and its Interpretation. Back in 1993, an identical transitional relief was available for compensation payable pursuant to a written binding contracts in effect on February 17, 1993, as stated in Section 162(m)(4)(D) (the “Prior Transition Relief'). Compensation payable pursuant to such binding contracts in tax years commencing in 1994 and later were deductible and not subject to the Section 162(m) limitation, without regard to the “performance based” exemption.

Treasury Regulation Section 1.162-27(h)(1) provided detailed guidance regarding the application of the Prior Transition Relief, which should be equally applicable and insightful here. This regulation provides the following points that can help shed light on the current transitional rule.

a. The Prior Transition Relief was available only if the corporation was obligated to pay compensation if the employee performs services. Reg. 1.162-27(h)(1)(i).

b. The Prior Transitional Relief was available if an employee had a right to participate in an arrangement, even though the employee was not eligible to participate under the arrangement on February 17, 1993. Reg. 1.162-27(h)(1)(ii).

The Prior Transitional Relief would cease to be available if the corporation could cancel the arrangement. Reg. 1.162-27(h)(1)(i). As explained below, the mere fact that an award is subject to negative discretion does not mean that the Compensation Committee can totally cancel the amount payable. The mere right to exercise negative discretion to reduce an award payable (but not cancel the arrangement) does not negate a binding contract arrangement.

d. Arrangements that provided employees with a right to participate in a plan were considered materially modified when the contract was amended to increase the compensation payable to the employee. The right to participate would then no longer be eligible under the Prior Transitional Relief. Reg. 1.162-27(h)(1)(iii)(A). The Prior Transitional Relief contained no statement that the Committee's right to reduce compensation payable would deny such relief

A material modification of an agreement was treated as a new contract entered as of the date of such modification

e. The Prior Transitional Relief allowed an acceleration of compensation pursuant to a written binding contract, provided the payment was discounted to reasonably reflect the time value of money. Reg. 1.162-27(h)(1)(iii)(A). By noting that present value reductions would be required, this point acknowledges that reductions are permissible and not treated as a new contract. On the premise that all reductions are permissible and that reduced amounts would still be treated as payable pursuant to a binding contract, this regulation mandates that some reduction is necessary to assure that there has not been an increase in compensation. Again, it is the increase in compensation that is the focus of the regulations, not a right to reduce or an actual reduction in compensation.

3. Negative Discretion Does Not Defeat Binding Contract. Covered employees that have awards subject to negative discretion still retain enforceable rights under state law. At least one appellate court addressed the situation of whether an employer had total discretion to deny any bonus under an arrangement that contains subjective factors. McCleary v Wells Fargo Securities, LLC 2015 Illinois Appellate (1st) 141287 (3/17/15). In rejecting the employer's motion to dismiss the claim, the appellate court stated that the employee had a reasonable expectation to a bonus and that any discretion is subject to an implied standard of good faith and fair dealing and such discretion could not be exercised in a manner that results in an abuse and unjust enrichment to the employer.

In the McCleary decision, the bonus arrangement included subjective factors and the employee was terminated prior to the end of the performance period. In contrast, the Section 162(m) performance based-arrangements have very specific performance metrics to receiving bonuses and, in general, the “covered employees” are employed on the payment date. The typical Section 162(m) performance based arrangements present an even better fact situation for the position that employers do not have unlimited discretion to eliminate the bonuses payable and that there is a binding agreement to a payout.

4. Award Terms Illustrate Limited Application of Negative Discretion. Many performance-based awards have the statement that no amendment shall adversely affect the rights of a grantee without the grantee's consent. Inclusion of this statement further strengthens the position that there is a binding agreement for covered employees to receive a payout.

5. IRS Interpretation of the Effect of Negative Discretion under Prior Transitional Relief. IRS ILM 199926030 (4/15/99) presents situations where the IRS reviewed whether certain awards that were subject to adjustments were eligible under the Prior Transition Relief. Separate sets of awards were granted, and the factors stated below did not impair the application of the Prior Transition Relief. The IRS concluded that the outstanding awards were pursuant to a binding contractual obligation, were not materially modified, and were fully deductible.

a. Adjustable upward or downward within a range of 80 to 120% of the guideline bonus opportunity.

b. Compensation Committee discretion to adjust the formula by an increase of a specified percentage based on a showing of outstanding performance by an individual.

c. Compensation Committee had discretion to make positive individual performance adjustments of 20% per executive.

d. Compensation Committee could increase or decrease performance criteria, targets, and payment schedules if in its discretion there were unanticipated extraordinary occurrences.

e. Compensation Committee approved certain targets in the second year of the performance cycle. On this point, it is not stated whether the date that the targets were approved preceded February 17, 1993.

Of these award provisions, it is most interesting that the positive discretion to increase compensation did not impair the application of the Prior Transitional Relief If the stated discretion to increase compensation does not impair the application of the transitional relief (as interpreted in the IRS ILM), how can the discretion to reduce compensation have such effect?

The IRS Legal Memorandum concludes that the employees relied on the potential bonus compensation when they rendered services for the years in the performance period and the awards contained the provision that if the plans were amended, no such amendment could impair an employee's rights under an outstanding award. These facts and analysis are equally applicable to the issue discussed regarding the effect of negative discretion under the new transitional relief provision.

The IRS Legal Memorandum goes on to make the statement that if an employer's plan promises the employee compensation and the employee relied on the promise, then the plan is binding on the corporation. The New York State decision cited is DePetris v. Union Settlement Assn. 86 N.Y. 2d 406, 410; 633 N.Y.S. 2d 274 (1995)

This analysis in the IRS Legal Memorandum continues to have merit today.

6. Conference Committee Example. Part of the confusion regarding the issue of whether negative discretion impairs the application of the transition relief is the following statement provided by the Conference Committee report with respect to an example, “. . . amounts payable under the plan are not subject to discretion, . . . One interpretation is that this statement is taken totally out of context with respect to whether it applies to negative discretion provisions.

The example is addressing solely the point of whether eligibility to participate in the future in an employer plan can be considered pursuant to a written binding contract. In that context, the plan needs to have some sort of fixed payment terms and not have a lack of detail regarding the amount payable. The statement that the amounts payable cannot be subject to discretion is not addressing negative discretion in a performance-based award. It would be more reasonable to view such language as addressing positive discretion and, even so, it might be the actual exercise of positive discretion (and not the mere right to exercise discretion) that would trigger an issue.

To be more specific, this example is addressing a totally unrelated situation than the application of transitional relief to performance-based arrangements. The Conference Committee example is not a performance-based situation where the payout is dependent on established performance-based metrics. Instead, this example is addressing the application of the transition rule to the prior Section 162(m) exemption with respect to compensation payable to a former covered who is no longer employed on the last day of the employer's tax year. If the deferred compensation arrangement (supposedly an employer-sponsored SERF) referenced in the Conference Committee report is within the transitional rule, then payment to a terminated covered employee would be fully deductible. The example states the factors needed for a non-performance based deferred compensation arrangement. This is far different from performance-based awards that are tightly stated to provide specific payouts pursuant to the achievement of specified metrics. For reasons stated throughout this letter, performance-based arrangements that meet the Section 162(m) standards should be treated as pursuant to a binding agreement, without any impairment for negative discretion.

7. Elimination of Transitional Relief for Outstanding Performance-Based Awards. If the mere existence of negative discretion prevents the application of the Section 162(m) transitional relief, transitional relief would be eliminated for all outstanding performance-based arrangements. When reviewing the changes made to the transitional relief as the bills moved through Congress, eliminating transitional relief for outstanding performance-based awards would be totally inconsistent with the consideration and efforts by Congress when viewing the earliest form of the proposal to its final form.

The earliest version of the provision originated in the House bill. It had no transitional relief Under that version, all deductions in tax years beginning after December 31, 2017 would have been subject to the deduction limitation with no exception for any outstanding performance-based awards or outstanding deferred compensation. The Senate Chair's modification added a transitional relief for vested compensation as of December 31, 2017 that was pursuant to a written binding contract in effect on November 2, 2017. Pursuant to this version, any outstanding performance-based awards that had a performance period that extended past December 31, 2017 would not be within the transitional rule. When the billed moved for approval to the Senate Finance Committee, the Senate Finance Committee dropped the requirement that the compensation be vested as of December 31, 2017. The effect was that the Senate provision allowed outstanding unvested awards to be eligible for transitional relief. The Conference Committee accepted the Senate version of the transitional relief as the final version. Congress enacted the transition rule with the fact that negative discretion was an acceptable provision of qualifying performance-based awards and such provision was permitted by the Treasury Regulations. Reg. 1.162-27(e)(2)(iii)(A) (second sentence). “A performance goal is not discretionary for purposes of this paragraph (e)(2)(iii) merely because the compensation committee reduces or eliminates the compensation or other economic benefit that was due upon attainment of the goal.”

In short, qualifying performance-based awards were allowed to have negative discretion provisions and almost all such outstanding awards have such negative discretion features. Any position that negative discretion prevents the transition rule from applying would mean that Congress would have enacted a broad transitional rule applicable to unvested awards that would have no application to outstanding performance-based awards. This just cannot be. To have Congress establish a favorable broad transition rule with no application to outstanding performance-based awards is illogical.

8. Extension of Negative Discretion Point to Section 409A Elections. In other contexts, specific rules address whether an employer's unilateral discretion to reduce compensation prevents a legally binding right. Reg. 1.409A-1(b)(1) (third sentence). In the Section 409A context, there is a general rule that negative discretion can prevent a deferral arrangement. However, for Section 409A purposes, a negative discretion provision has never been viewed as preventing a legally binding right for deferral purposes. Instead, negative discretion provisions have been treated as not having substantive significance and, thereby, not negating a legally binding right. Reg. 1.409A-1(b)(1).

For Section 409A purposes, bonus arrangements that contain negative discretion features are treated as creating a legally binding right. If the answer had been otherwise, the IRS and Treasury would be very surprised with the position that some might take in the Section 409A context with respect to the required timing of a deferral election. Assume a bonus arrangement with a negative discretion provision is granted in early 2018 with payment to be made in 2019 after the 2018 performance period. Typically, any deferral election with respect to the bonus payable is made either by the end of 2017 (before the performance period begins) or as permitted for deferral election for performance-based compensation. If negative discretion is treated as denying a legally binding right to receive the award, then some might take the position that the deferral election could be made later in time. While this result would not be correct, it would seem like a normal extension of not having a legally binding right.

Consistent with the position taken for Section 409A purposes (that negative discretion does not negate a legally binding right), the same is true for the Section 162(m) transition rule.

Further, in the Section 162(m) transitional relief context, there is no discussion that negative discretion (other than the ability to cancel the full award) negates a legally binding agreement. In fact, as stated above, the general Section 162(m) rules (Reg. 1.162-27(e)(2)(iii)(A) (second sentence)) acknowledges that negative discretion can be a permitted component of performance-based arrangements.

9. Comparison to Tax Accrual All-Events Requirements. An additional reason for the confusion is the effect of negative discretion under the all events accrual tax deduction test. The all events requirements to claiming a tax accrual deduction requires various components. A basic component is that the amount payable must be vested, which is a critical component to the fact of the liability requirement. While negative discretion could prevent a tax accrual prior to the year that the exercise (or nonexercise) of such discretion has been concluded, that is a separate analysis from whether there is a binding contract for purposes of the transitional rule.

As discussed above through the explanation of how the transitional rule was developed to its final form, there is no requirement that the obligation be vested. Having a vested award is a critical component under the tax accrual all events test. The transitional rule is a much less onerous standard than what is needed for purposes of the tax accrual all events test. The points stated above illustrate that there is a binding contract for purposes of the transitional rule, even though no tax accrual deduction might be claimed prior to the payment year.

Summary

Focusing solely on the question of whether (by itself) the Compensation Committee's discretion to reduce an award should negate the existence of a legally binding contract, the answer should be no. The above positions support such conclusion.

Even in an umbrella plan (i.e., where negative discretion is used to determine the actual amount payable), employees have a reasonable expectation that they will receive a bonus if certain targets are met and many such plans contain certain second level metrics to determine how the negative discretion will be applied (i.e., a plan within a plan).

Corporations should not need to provide an estimate on their financial statements on the effect of a problem that does not exist. While some companies have already addressed this issue with their auditors, this would seem to be an issue that all public companies would be addressing with their auditors in the next few weeks. We hope the above points illustrate what would need to be addressed in the consideration of this issue.

Very truly yours,

Francesco A. Ferrante
Thompson Hine LLP
Miamisburg, OH

cc:
Shane Starkey, Thompson Hine LLP
Nathan Holmes, Thompson Hine LLP