The Internal Revenue Code is famously complicated, and changes to discrete parts of the code—such as those adopted by the Tax Cuts and Jobs Act of 2017 (TCJA)—have a notorious history of leading to unpredictable and unintended consequences. One such consequence may require prompt action by publicly-traded companies to mitigate the impact of a common provision in nonqualified deferred compensation plans relating to the limitations on deductions for excess compensation paid to top executives.
A nonqualified deferred compensation plan can permit or mandate a payment delay if the employer reasonably anticipates that the deduction for a payment would be limited or eliminated by application of code section 162(m). Section 162(m) limits the deduction of compensation in excess of $1 million in one year paid to “covered employees” (i.e., a chief executive officer, chief financial officer, and the other three top-paid executive officers disclosed in a publicly-traded company’s proxy statement). For a plan that permits or requires delayed payment, the U.S. Department of the Treasury regulations applicable under section 409A of the Internal Revenue Code specify that the delayed payment be made when the employer reasonably anticipates that section 162(m) will not apply or the year in which the employee separates from service, whichever is earlier.
The TCJA made significant changes to section 162(m), including how to identify which officers of a publicly-traded company are treated as covered employees subject to section 162(m). Prior to the change, covered employees were determined annually, and an employee generally could not be a covered employee in the year in which he or she separated from service. TCJA implemented a “once-in-always-in” rule: if an employee is subject to section 162(m) in taxable year 2017 or later, then the employee will always be a covered employee, even after separation from service.
Theoretically, under the new rules, if a nonqualified deferred compensation plan requires a payment delay where the employer reasonably anticipates section 162(m) will apply, then a covered employee’s payments could be subject to significant—and possibly indefinite—a – unanticipated delay in payment. However, if a delay is required by the plan document, then the employer cannot simply ignore or amend this provision for existing deferrals: Section 409A expects strict compliance with stated plan terms and severely limits the circumstances when changes can safely be made. Waiving or amending a section 162(m)-related delay provision would typically violate section 409A’s prohibition on accelerating payments and therefore trigger a potentially-significant adverse tax consequence to the impacted employee.
Recognizing that the TCJA amendments to section 162(m) fundamentally altered the basis on which many employers structured the distribution provisions of their nonqualified plans, in December 2019 the Internal Revenue Service issued proposed regulations that, among other things, provide transition relief from the anti-acceleration rules under section 409A. To take advantage of the transition relief, an employer must amend its nonqualified plan by December 31, 2020, to modify or remove any mandatory section 162(m) payment delay provision. Helpfully, such an amendment will not be considered to be a “material modification,” meaning that its adoption will not cause a so-called grandfathered plan to lose that status (i.e., to become more broadly subject to section 409A). As a result, employers may want to consider amending grandfathered nonqualified plans for this issue, where present.
Given the fast-approaching December 31, 2020, deadline, employers may want to consider reviewing their nonqualified deferred compensation plans before unexpectedly having to inform executives that their deferred compensation benefits may be stuck in perpetual limbo.