Private companies that go public face a new, negative tax consequence under IRS regulations—another factor that could make initial public offerings less attractive than they already are.
The IRS in proposed regulations (REG-122180-18) eliminated a transition period that would allow newly public companies to temporarily disregard tax code Section 162(m), which prevents public companies from getting a tax deduction for executive compensation exceeding $1 million. The agency said that relief is unnecessary in light of changes Congress made to the limitation in the 2017 tax law.
The IRS’s decision undermines the U.S. Securities and Exchange Commission’s efforts to make accessing U.S. capital markets easier for companies, said Taylor W. French, a partner at McGuireWoods LLP. SEC Chairman Jay Clayton has made it clear in statements and through regulatory actions that he wants to encourage more initial public offerings.
“IPOs are already at very low levels and eliminating this relief adds another impediment to going public,” said French, co-chair of his firm’s employee benefits and executive compensation group.
An average of 310 operating companies went public every year in the U.S. from 1980 through 2000, said Jay R. Ritter, a finance professor at the University of Florida who tracks the IPO market. From 2001 through 2019, the average has been 110, he said.
The regulations, which were released Dec. 16, do contain some good news.
The IRS said it would only eliminate the transition relief on a prospective basis.
That means only companies that become public on or after Dec. 20 will be subject to the change. Those that went public before that date can continue to rely on the old transition rules.
No Longer Necessary?
Under the old transition rule included in 2015 final regulations, the IRS said newly public companies for a period of time wouldn’t have to apply the $1 million deduction limit to certain types of compensation paid under plans that existed when the company was private and that have been adequately disclosed under securities laws.
The idea was to give those companies time to adapt their plans to meet the requirements of Section 162(m) and potentially take advantage of exceptions, such as those available for performance-based compensation. This would put them on equal footing with their more established publicly held competitors.
The 2017 tax law eliminated commission and performance-based compensation exceptions to the $1 million deduction limit, which the IRS cited as the reason for removing the IPO transition relief.
“In enacting section 162(m), Congress recognized that privately held corporations may have difficulty adopting compensation arrangements that satisfy the requirements for performance-based compensation,” the IRS said in the proposed regulations. “Specifically, Congress was concerned about the shareholder approval requirement,” the agency said, adding that those concerns are no longer relevant.
But that doesn’t mean transition relief isn’t still necessary, the American Institute of CPAs said in response to Notice 2018-68, which provided initial guidance on the Section 162(m) changes and asked for comments on the IPO issue.
Companies still must determine which of their employees are covered by the $1 million deduction limit, the group said. The limit only applies to certain top executives.
“Private companies that have never had to consider section 162(m) may not have this information readily available,” the AICPA said.
Some Good News
Practitioners anticipated that the IRS might get rid of the IPO transition relief because the agency overall has been more stringent in the way it’s interpreted Congress’s changes to Section 162(m), said Alex Lifson, who leads the National Compensation & Benefits practice at BDO USA LLP.
“The theme has been that it’s going to be—in most cases—the strictest possible interpretation of what’s in the law,” he said.
Stricter regulations don’t help the already-lagging IPO market, Ritter said. But they also aren’t the main reason those transactions have declined.
The larger issue is that globalization and technological advancements have expanded the reach and profits of big companies—making it harder for smaller companies to compete, he said. Many are selling out and merging with those larger companies rather than going public and remaining independent, he said.
“Tweaking U.S. regulations is only going to affect the annual number of IPOs by a handful of companies in one direction or the other,” Ritter said.