Publicly Traded Companies’ Deduction Limit for Compensation Over $1 Million Expanded; Section 162(m) Regulations Finalized

Internal Revenue Code (IRC) Section 162(m) disallows deductions for publicly traded companies that pay over $1 million in compensation to its “covered employees”—CEO, CFO and the next three most highly compensated officers. For taxable years beginning after December 31, 2026, the American Rescue Plan Act of 2021 (ARPA) (P.L. 117-2) expands Section 162(m) to cover the next five most highly compensated employees for the taxable year, in addition to the “covered employees.” Thus, starting in 2027, 10 employees of a publicly traded company will be subject to the IRC Section 162(m) cap on deductions for compensation over $1 million.

The ARPA expansion of 162(m) is not limited to officers of the publicly traded company. For example, the disallowance of the corporate deduction for compensation over $1 million will apply to non-officer employees who have significant salaries, bonuses, contract payouts, severance packages, nonqualified deferred compensation payments, equity plan grants or exercises, etc. 


On December 22, 2017, the Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to Section 162(m). Under the TCJA changes, once an individual is a covered employee, he or she will remain a covered employee forever (even after leaving the company and including after death). However, that evergreen rule would not apply to employees who become subject to Section 162(m) solely as a result of the ARPA expansion. For example, if an employee ceases to be one of the ARPA expansion’s additional five highest paid employees, but is not the CEO, CFO or top-three highest paid officers, then that employee’s compensation would no longer be subject to the Section 162(m) $1 million deduction limit for public companies.


Final 162(m) Regulations

On December 30, 2020, the IRS published final 162(m) regulations implementing the TCJA changes. The final rules made such minor changes to the December 2019 proposed regulations that the IRS did not even request clearance from the Office of Management and Budget before finalizing them. The final regulations clearly set the tone that the IRS will broadly apply the Section 162(m) executive compensation deduction disallowance. The following summarizes the key changes introduced by the TCJA and included in the final regulations.

Performance-Based Exception Repealed. Since its enactment, Section 162(m) had provided an exception for performance-based compensation, which the TCJA repealed with some exceptions for grandfathered plans (see below).
Once a Covered Employee, Always a Covered Employee. The TCJA also expanded the scope of Section 162(m) by amending the definition of “covered employee” to include principal executive officers, principal financial officers and the three highest paid executive officers (even if the federal securities laws do not require disclosing the officers’ compensation to shareholders, as is the case for smaller reporting companies), and that once someone is a covered employee, he or she will remain a covered employee forever (even after their death). Thus, the Section 162(m) deduction limit applies to death benefits paid to beneficiaries of deceased covered employees, except those covered by reason of the ARPA.  

Public Company Definition Expanded. The TCJA also expanded the scope of Section 162(m) by amending the definition of “public corporation” to include many entities that would not generally be considered “publicly traded” under federal securities laws. For example, amounts that public company executives receive for services they provide to a partnership in which the company has an ownership interest are subject to the Section 162(m) $1 million deduction limit effective December 20, 2019. Accordingly, compensation paid to an employee of a partnership in which a publicly held corporation was a partner would be nondeductible by the corporation to the extent of its distributive share of partnership deductions. But the IRS provided a transition rule for existing written agreements that are not materially modified after that date. 


In addition, the final rules confirm that foreign private issuers and real estate investment trusts (REITs) are subject to Section 162(m) if they are required by the U.S. Securities Exchange Act of 1934 (Exchange Act) to either (1) register securities under Section 12 of the Exchange Act or (2) file reports under Section 15(d) of Exchange Act.
The final rules also adopt the “affiliates” rule set out in the proposed regulations. Consequently, each entity within the affiliated group that is a publicly traded corporation is separately subject to Section 162(m) and must have its own set of covered employees. The final regulations clarify that compensation paid by a member of an affiliated group that is not a publicly held corporation to an employee who is a covered employee of two or more other members of the affiliated group is prorated when determining the deduction disallowance among the members that are publicly held corporations of which the employee is a covered employee.
The final regulations set out rules for determining the predecessor of a publicly held corporation for various corporate transactions, and adopt a “gross operating assets” rule (instead of “net operating assets” rule, as in the proposed regulations).

IPO Transition Rule Eliminated. The final regulations eliminate the transition relief in the existing Section 162(m) regulations for any corporation going public after December 20, 2019. The existing IPO transition relief was based on the pre-2017 exception for performance-based compensation under Section 162(m); since that exception has been eliminated, the IRS has said IPO transition rules are no longer necessary.

Grandfather Rule. The TCJA also provided limited transition relief for certain existing compensation arrangements. Specifically, the TCJA changes do not apply to compensation provided to a covered employee under a written binding contract (including a severance agreement) that was in effect on November 2, 2017, and was not modified on or after that date. The final regulations explain in detail how the “grandfather rule” works, including examples of when a contract will be considered materially modified so that it is no longer considered “grandfathered,” how earnings on grandfathered amounts are treated for Section 162(m) purposes, how accelerated payments and/or vesting are treated, and ordering rules that apply to payments that include both grandfathered and non-grandfathered amounts.
The final rules clarify that a corporation’s clawback right does not affect the determination of the grandfathered amount, regardless of whether the corporation exercises its right to recover any compensation.


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