Public companies maintaining deferred compensation arrangements for their executive officers should consider how recent changes to the regulations under Section 162(m) of the Internal Revenue Code (the Code) may impact the timing of payments to be made to participants and their beneficiaries under such plans – if action is required, the affected plans must be amended before December 31, 2020 to avoid complications or penalties.

Section 162(m) of the Code disallows a tax deduction for any compensation paid to a “covered employee” of a public company over one million dollars (Million Dollar Limit). On December 16, 2019, the IRS issued proposed regulations (Proposed Regulations) implementing certain changes that were made to Section 162(m) of the Code by the Tax Cuts and Jobs Act of 2017 (2017 Tax Act). The 2017 Tax Act made several significant revisions to Section 162(m), including changing the definition of “covered employee” such that a covered employee in any year remains a covered employee for all subsequent taxable years (and thus subject to the Million Dollar Limit), including after termination of employment.  In other words, once an individual is determined to be a Section 162(m) “covered employee,” that individual is always a “covered employee.”

Under Section 409A of the Code, a non-qualified deferred compensation plan may delay a payment past the designated payment date to the extent that the service recipient reasonably anticipates that the payment would not be deductible because of the Million Dollar Limit.  Many deferred compensation plans (including employment agreements that contain rights to deferred compensation) take advantage of this 409A provision by providing that compensation subject to the Million Dollar Limit will be deferred and paid out only as and when the deduction would not be limited by the Million Dollar Limit. In most cases before the 2017 Tax Act, this provision resulted in only a short deferral until the service provider was no longer an employee of the service recipient, at which point the Million Dollar Limit would no longer apply, and fully deductible, regularly scheduled payments could be made.

However, as a result of the new “once a covered employee, always a covered employee” rule under Section 162(m), if an employer’s deferred compensation arrangements provide for delay of payments until the Million Dollar Limit no longer applies, deferred compensation balances may require a significant passage of time before they become paid in full (generally limited to $1 million per year).  So, for example, a covered employee with a deferred compensation plan balance of $25 million might not receive full payment for 25 years.

Practical Takeaways for Employers

Recognizing this disconnect, the IRS is allowing companies to amend deferred compensation arrangements to remove any provision that requires a delay in payment due to the Million Dollar Limit, as long as the amendment is made by December 31, 2020. Of course, if these deferral provisions are removed, the company’s deduction for any payments that are not ”grandfathered” (e.g., payments made according to a written binding contract that was effective on November 2, 2017, and not materially modified on or after that date, all as described further in the Proposed Regulations) will be disallowed under Section 162(m) to the extent such amounts, when combined with other compensation paid to the covered employee in the same year, exceed $1 million. These amendments may be drafted to apply only to deferred compensation not otherwise exempt from the 2017 Tax Act changes to Section 162(m) under various grandfathering provisions.

We strongly encourage public companies to review applicable non-qualified deferred compensation arrangements to determine if amendments are necessary before December 31, as well as to consider the impact that the disallowance of a portion of the compensation deduction attributable to deferred compensation payments may have.

If you have questions regarding the information in this alert, please contact the attorneys in our Employee Benefits and Tax practice groups.

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Photo of Susie Bilbro Susie Bilbro

Susie Bilbro advises clients on all aspects of employee benefit plan design and administration including compliance with ERISA, the Patient Protection and Affordable Care Act (healthcare reform), COBRA and the Internal Revenue Code. She has counseled public and private clients on employee welfare…

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Photo of Noah Black Noah Black

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Photo of Doug Dahl Doug Dahl

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Photo of Curtis Fisher Curtis Fisher

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Photo of Fritz Richter Fritz Richter

Fritz Richter has more than 30 years of experience counseling clients on employee benefit plan design and administration, and compliance with the Internal Revenue Service (IRS), Pension Benefit Guaranty Corporation (PBGC) and Employee Retirement Income Security Act (ERISA). His clients span a wide…

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