Consultants Suggest Adding Language to Excess Remuneration Regs

February 18, 2020

CC:PA:LPD:PR (REG–122180–18)
Room 5203
Internal Revenue Service
P.O. Box 7604, Ben Franklin Station
Washington, DC 20044

Re: [REG-122180-18] RIN 1545-BO95 Certain Employee Remuneration in Excess of $1,000,000 under Internal Revenue Code Section 162(m)

To whom this may concern:

This letter provides Willis Towers Watson's comments with respect to the proposed regulations under IRC §162(m) cited above.

Willis Towers Watson is a leading global advisory, broking and solutions company that employs more than 45,000 colleagues worldwide. Our approximately 600 Enrolled Actuaries provide actuarial and consulting services to more than 2,000 qualified defined benefit (DB) plans, and many nonqualified DB plans, in the U.S. Our actuaries often help clients determine balance sheet liabilities to be held for nonqualified deferred compensation that will be paid to employees and former employees in the future. Companies also determine deferred tax assets held on their balance sheets that represent the future tax deductions expected when the nonqualified deferred compensation is ultimately paid. Since §162(m) will render some of those future payments non-deductible, our actuaries often assist clients in determining adjustments needed to those deferred tax assets to account for amounts that will be non-deductible. Our comments are focused therefore on the determination of “grandfathered amounts” (i.e., (§1.162-33(g)), and in particular the handling of “earnings”. We also comment on the definition of “material modification”.

Determination of, and Earnings on, Grandfathered Amounts

We note that Prop. Reg. §1.162-33(g) does not provide separate rules for account balance and non-account balance plans, and we do not believe separate rules should apply. However, as described below, we believe the scenarios selected for the examples in Prop. Reg. §1.162-33(g)(3) could be interpreted (or misinterpreted) to suggest the rules are different. We ask that the regulations and/or examples be revised to clarify that the treatment is the same.

Grandfather Rule

In general, the amendments to §162(m) made by the Tax Cuts and Jobs Act (TCJA) apply to taxable years beginning after December 31, 2017. However, under a grandfathering provision, the changes to IRC §162(m) do not apply to compensation “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.” This statutory rule appears to apply in the same manner to account balance and non-account balance plans. Similarly, Prop. Reg. §1.162-33(g) makes no distinction, and we agree there should be no distinction.

Recommendation: Harmonize the Examples for Account Balance and Non-account Balance Plans Earnings on grandfathered amounts in account balance plans are included if and only if they are, as of November 2, 2017, guaranteed to be paid. This is illustrated by two examples.

• In Example 7, an employee elects to defer from grandfathered salary where it is stipulated that there is a written binding contract under applicable law in effect on November 2, 2017 to provide salary through 2020, that the salary under the contract is grandfathered under these rules, and the election is made after November 2, 2017. The guaranteed salary remains grandfathered, but the earnings are not grandfathered because under the written binding contract in effect on November 2, 2017

  • the corporation would have been obligated to pay the grandfathered salary to the employee had it not been deferred,

  • but was not obligated to pay any earnings on the salary that was deferred.

• In Example 12, the employee made the deferral election before November 2, 2017 and the plan provided that the company was not permitted to reduce deferred amounts or future earnings. It is stipulated that under applicable law, the deferred compensation agreement, combined with the pre November 2, 2017 election to defer, constitutes a written binding contract in effect on November 2, 2017, to pay a bonus plus earnings, and as a result both those deferred grandfathered amounts and the specified future earnings are grandfathered. This is true even if the employee prospectively changes the investment return credited to another option that had been available on or before November 2, 2017.

The examples for account balance plans described above do not specifically discuss whether the employer has the unilateral right to terminate the plan and pay out the balances (and thereby cut off future earnings).

• For non-account balance plans, the relevant examples (i.e., Examples 13 – 15) all stipulate that, as permitted under §409A, the plan permits the plan sponsor to unilaterally terminate the plan if certain conditions are met (including termination of all other nonqualified deferred compensation plans of the same type), and all benefits are paid out not less than 12 months and not more than 24 months after the company takes all steps necessary to terminate the plan. As a result, the examples conclude that any “earnings” on the deferred amounts (which for a non-account balance plan generally means the difference between the dollar amounts ultimately paid and their current present value) are not guaranteed to be paid and are therefore not grandfathered¹.

We note that all nonqualified deferred compensation plans, whether account balance or non-account balance, are subject to §409A, and both types may (or may not) have language permitting the plan sponsor to unilaterally terminate the plan and pay out benefits. By raising this issue for non-account balance plans (and assuming in all 3 examples that the plan sponsor has that right), and not directly discussing it in the 2 account balance plan examples, the regulations could leave the impression that the rules differ for the 2 types of plans (e.g., the impression that whether such a provision exists is not relevant for account balance plans, but such provision should be presumed to exist for non-account based plans).

Recommendation: We believe the rules for determining grandfathered amounts should not differ by plan type and the regulations should make this clear by including in Examples 7 and 12 additional language that specifies that the written binding contract does or does not give the plan sponsor the unilateral right to terminate the plan and pay out the balances (and thereby cut off future earnings).

What Should the Rule Be?

We believe that earnings guaranteed under a written binding contract in effect on November 2, 2017 should be grandfathered even when the plan sponsor has the right under plan terms and the employment agreement to terminate the plan unilaterally, since in all likelihood this right will not be exercised given the considerable

restrictions involved, including terminating all similar plans. In addition, from a practical standpoint, whether such an action would be permitted under state contract law or the terms of an executive's contract (and perhaps even by the plan document itself) would often be unclear. In states with stronger employee wage law protections or doctrines of contractual interpretation (e.g., the implied covenant of good faith and fair dealing, promissory estoppel and detrimental reliance), it may be that this right to unilateral plan termination with lump sum payment of benefits (thereby cutting off otherwise protected future earnings) simply does not exist.

We note that the §3121(v) regulations (relating to employment taxes) did not take the position that, for grandfathered amounts earned as of December 31, 1993, earnings (including the difference between amounts ultimately paid and their present value at the grandfathering date) were not grandfathered simply because the plan sponsor might theoretically terminate the plan and pay benefits sooner. Rather, the benefits ultimately paid that had been earned as of December 31, 1993 were grandfathered and not subject to HI tax, rather than simply their present value at December 31, 1993.

There are other situations in these proposed regulations where the fact that the employee or plan sponsor might do something that (a) is even more likely than plan termination and (b) would cause the benefit not to be paid is disregarded. For example, a contract is not treated as terminable or cancellable if it can be terminated only by terminating the employment relationship of the employee, whether voluntarily by the employee or involuntarily by the employer.

If the regulations retain the rule that a plan sponsor's ability to unilaterally terminate a plan and pay a lump sum prevents future earnings from being grandfathered we ask that the regulations clarify that in determining whether a written binding contract exists, the ability to unilaterally terminate a plan should be recognized only where the plan expressly provides the employer with this right and the termination is not barred by state contract law, an executive's employment contract, or any other legal restriction.

In addition, it would be helpful if the regulations made clear that under some employment agreements, just as future salary and bonus may be guaranteed for a period, accruals under a nonqualified deferred compensation plan (e.g., a Supplemental Executive Retirement Plan, or SERP) may also be guaranteed for some future credited service and/or compensation, and in such cases the grandfathered nonqualified benefit would be greater than the benefit accrued on November 2, 2017 because such higher benefits are promised under a legally binding agreement in effect on November 2, 2017.

Calculation of Grandfathered Amounts for Traditional SERPs Where the Plan Sponsor Can Unilaterally Terminate the Plan and Convert an Annuity Promise to a Lump Sum

The proposed regulations do not directly address typical DB SERP arrangements that promise an annuity benefit for life, rather than promising a fixed lump sum. The three examples of a non-account balance plan (Examples 13-15) all are based on an atypical plan design where the promised benefit is a single sum payment.

Assuming that the rule remains as proposed, and a plan sponsor has a unilateral right to terminate the plan (so that future “earnings” are not guaranteed), it is clear from the ordering rules (where the payment of benefits comes first from grandfathered amounts — a first-in first-out (FIFO) approach) that a single lump sum grandfathered amount will need to be determined. Because (in this scenario) the plan sponsor has a right to terminate the plan and pay a lump sum, the methodology for converting the grandfathered amount to a lump sum may be specified in the plan document, and in such a case the plan's terms will determine that lump sum. Where such methodology is not provided, reasonable assumptions will need to be made to convert the promised annuity benefits to a lump sum. These assumptions include:

With respect to (a) we ask that the regulations make clear that the grandfathered amount can take into account future service for purposes of qualifying for early retirement subsidies. This would be consistent with the approach generally taken by the regulations that an amount does not fail to be grandfathered simply because the employee must render future service to vest in the benefit.

With respect to (e) we ask that the regulations make clear that the determination can be made similarly to Example 13 and Example 15², in which a lump sum promised to be paid in the future is reduced to a present value by discounting using “a reasonable rate of interest”, with 3% used in the examples.

With respect to (b), (c) and (d) we ask that the regulations specify that any such assumptions must be reasonable and must take into account the known data as well as applicable plan provisions (e.g., because of the requirements of §409A the time and form of payment may already be known, or alternatively may be dependent on an unknown date of termination requiring an assumption).

Calculation of Grandfathered Amounts for Traditional SERPs Where the Plan Sponsor Cannot Unilaterally Terminate the Plan

Assuming that the rule remains as proposed, and a plan sponsor determines that it does not have a unilateral right to terminate the plan and pay benefits early (so that future “earnings” are guaranteed), it is clear from the ordering rules (where the payment of benefits comes first from grandfathered amounts) that a single lump sum value will need to be determined at some point so that the FIFO ordering rule can be applied. However, since earnings remain guaranteed, once the amount is established, future earnings on the unpaid amount should also be guaranteed (just as, we presume, if an account balance plan with grandfathered earnings pays out benefits in instalments, the earnings would continue to be grandfathered on the unpaid balance.)

We ask that the regulations make clear that the grandfathered amount would be established at commencement of payment, and that the “reasonable rate of interest” (discussed above) used to establish that present value would continue to be credited on unpaid grandfathered amounts.

For example, we believe the following example could be included:

Note that we continue to believe it would be cleaner if the dollar amount of grandfathered accrued annuity benefits simply retained its grandfathered status as it is paid, so that, in the example above, $1,500,000 of each year's payment would be subject to §1.162-27, and $615,000 would be subject to §1.162-33. This approach would eliminate the need to set assumptions to convert the grandfathered amount to a present value and track the remaining amount of that present value during the payout stage. However, we have structured our example to be consistent with the proposed FIFO ordering rule.

Material Modifications

We continue to believe the rules regarding material modifications are unreasonable. If, for example, an executive's employment agreement guarantees compensation of $1,000,000 for each of 2017-2021, and the Board of Directors determines that the executive is doing an excellent job and decides to increase his or her compensation to $1,200,000 for each of 2020 and 2021, it is not reasonable that the $1,000,000 loses its grandfathered status. It is particularly unreasonable since the Board could instead decide to recognize the performance by providing an additional restricted stock grant or some other type of compensation that would not be considered paid “on the basis of substantially the same elements or conditions as the compensation under the written binding contract”. We do not believe that tax law should dictate the type of compensation that will be provided by providing a draconian result if one approach is taken vs. another.

In addition, there will likely be many situations of loss of grandfathered status because of lack of awareness of this rule, as well as situations where whether the additional compensation is “on the basis of substantially the same elements or conditions” will be unclear and subjective.

We recognize that the standard “on the basis of substantially the same elements or conditions as the compensation under the written binding contract” existed in the 1993 regulations. However, the revision to the regulations provides an opportunity to revisit this standard, especially given that the recent revisions to §162(m) have significantly increased the potential consequences of this rule. Previously, performance-based compensation was not subject to §162(m). Perhaps more importantly, most nonqualified deferred compensation was not subject to §162(m) because it was paid after termination of employment when the recipient was no longer a covered employee. Applying this rule post-TCJA means that innocuous, non-abusive modifications to a deferred compensation plan, which could be made many years after November 2, 2017, could invalidate the grandfathered status of the amount payable under a written, binding contract in effect on November 2, 2017.

We also note that a contract can be amended to eliminate the substantial risk of forfeiture, or otherwise accelerate vesting, without being treated as a material modification (i.e., it can remain grandfathered). This means that a contract can be amended to effectively increase the amount owed from potentially nothing (due to failure to satisfy vesting or other conditions within the specified time) to a significant amount, while the granting of a pay increase above cost-of-living eliminates the deduction for the entire previously grandfathered amount. We believe this is unreasonable.

Finally, we would note that there is a sentence in the preamble that we believe needs clarification via a new example. The preamble states “Finally, if amounts are paid to an employee from more than one written binding contract (or if a single written document consists of several written binding contracts), then a material modification of one written binding contract does not automatically result in a material modification of the other contracts unless the material modification affects the amounts payable under those contracts.” We wonder if this means there would be differing treatment for two different grandfathered defined benefit SERPs whose benefits to be paid will be the same, but whose benefit formulas differ.

For example, if the first SERP consisted of a single benefit formula whereas the second SERP had two separate benefit formulas, one developed by an acquired employer and the second developed post-acquisition, it appears the preamble would find the second grandfathered plan would potentially lose grandfathered treatment only for the portion of the benefit that is materially modified. This would place plans with similar benefit provisions on completely different footing, and further amplifies why applying the “on the basis of substantially the same elements or conditions as the compensation under the written binding contract” rule would be unworkable. However, if the IRS determines to retain this rule, we request that it provide several examples about how the rule should be applied in the circumstances described.

Recommendation: We believe increases should be viewed as separate promises, made later and thus not grandfathered, but not causing loss of grandfathered status of the amounts originally promised.

In addition, further guidance on what constitutes a material modification in a situation like Example 12 would be useful. If there is a contractual right to an objective earnings rate or rates within the plan, but that rate or investment line-up is changed after November 2, 2017 by mutual agreement because the existing options are not performing as anticipated, or have ceased to exist, we do not believe that should be treated as a material modification. If it were, and the newly credited rate exceeded a reasonable, annual cost-of-living adjustment, it would seem that grandfathered status would be lost.

Conclusion

We appreciate the IRS and Treasury Department considering these comments. Please contact any of the undersigned if you have any questions or would like to discuss our comments in more detail.

Maria M. Sarli, FCA, FSA, EA, MAAA
Senior Director, U.S. Retirement Resource Actuary
Willis Towers Watson
5 Concourse Parkway
Atlanta, GA 30328
(678) 684-0782
maria.sarli@willistowerswatson.com

Steve Seelig, JD, LLM
Senior Director, Executive Compensation
Research and Innovation Center
Willis Towers Watson
800 N. Glebe Road | Arlington, VA 22203
(703) 258-7623
steven.seelig@willistowerswatson.com

William A. Kalten
Senior Director, Retirement and Executive Compensation
Research and Innovation Center
Willis Towers Watson
3001 Summer Street │Stamford, CT 06905
(203) 326 4625
william.kalten@willistowerswatson.com