IRS Proposes Regulations on Compensation Deductions and NQDC Plan Effects

The regulations explain how grandfathered amounts are treated when a distribution is made from a nonqualified deferred compensation (NQDC) plan.

The Tax Cuts and Jobs Act of 2017 (TCJA) included changes to the treatment of executive compensation and nonqualified deferred compensation (NQDC) plans.

The IRS has issued proposed regulations implementing the amendments made to section 162(m) of the Internal Revenue Code by the TCJA. Section 162(m) disallows the deduction by any publicly held corporation of compensation paid in any taxable year to a covered employee that exceeds $1 million. The proposed regulations update the definitions of covered employee, publicly held corporation and applicable employee compensation.

During a conference in 2018, R. Lee Nunn, a senior vice president at Aon Hewitt, said Section 162(m) of the Code started with the idea that executives are paid too much, so employers could pay someone $1 million and receive a tax deduction, but for earnings greater than that, there would be no deduction. The TCJA expanded the definition of compensation for purposes of the $1 million deduction limit to include all remuneration paid for services by eliminating the performance-based compensation and commission exceptions for compensation paid to top executives at publicly traded companies.

In addition, Nunn noted that the Securities and Exchange Commission (SEC) had previously changed the rules so that the chief financial officer (CFO) of a company was not a covered employee. However, under the TCJA, the definition of “covered employee” expanded to include anyone who is the chief executive officer (CEO) or the CFO at any time during the tax year, as well as the three highest paid officers during the year.

The TCJA also provided a transition, or “grandfather” rule, for certain outstanding compensatory arrangements. Specifically, the TCJA changes do not apply to compensation that is provided to a covered employee under a written binding contract that was in effect on November 2, 2017, and was not modified on or after that date. The proposed regulations further explain the grandfather rule, including when a contract will be considered materially modified so that it is no longer considered “grandfathered.”

The regulations also explain how grandfathered amounts are treated when a distribution is made from a nonqualified deferred compensation (NQDC) plan.

The text of the proposed regulations gives notice of a public hearing and requests comments. However, the IRS says taxpayers may rely on these proposed regulations for tax years before the final regulations are effective. Text of the proposed regulations may be downloaded from here.

TCJA and 457(f) plans

Though the proposed regulations say they impact publicly held corporations, it is notable that the TCJA also has some effect on tax-exempt entities and their nonqualified 457(f) plans.

Specifically, a new 21% percent excise tax will apply to the top-five highest-paid employees (or former employees) of a tax-exempt or governmental entity each year on any compensation that exceeds $1 million per employee. 457(f) deferred compensation that is vested (no longer subject to a substantial risk of forfeiture) counts toward the $1 million threshold.