A version of this article previously appeared in the March/April 2020 edition of Employee Benefit Plan Review.
On December 20, 2019, the Internal Revenue Service (IRS) published proposed regulations under Section 162(m) of the Internal Revenue Code (Code). Section 162(m) limits the deduction that a publicly held corporation can claim for applicable employee remuneration paid to covered employees for a tax year that exceeds $1 million. The proposed regulations address amendments to Section 162(m) made pursuant to the Tax Cuts and Jobs Act (TCJA) and incorporates guidance on the TCJA amendments provided under IRS Notice 2018-68. The proposed regulations provide additional clarification with respect to the changes to Section 162(m) made by the TCJA.
While a complete discussion of the proposed regulations is beyond the scope of this article, the following are key elements of Section 162(m) described in the proposed regulations.
The TJCA amendments to Section 162(m) generally apply to tax years beginning after December 31, 2017. There is a grandfather rule for remuneration paid pursuant to a written binding contract in effect on November 2, 2017, that is not materially modified after such date. As a result, existing Treasury Regulation §1.162(m)-27 will continue to apply to remuneration that is grandfathered under pre-TCJA Section 162(m). When finalized, Regulation §1.162(m)-33 will apply to remuneration subject to Section 162(m), as amended by the TCJA. However, see Effective Dates below for details on various special effective dates under the proposed Section 162(m) regulations.
The proposed regulations reflect the expanded definition of “publicly held corporation” included in the TJCA. Previously, Section 162(m) defined a publicly held corporation as a corporation with common equity securities subject to “registration” under Section 12 of the Securities Exchange Act of 1934 (Exchange Act). Notwithstanding the statutory language, Regulation §1.162-27(c)(1), issued under pre-TJCA law, provides that such determination is based solely on whether such corporation is subject to the “reporting” requirements of Section 12.
The TCJA broadened the definition to include a corporation with any securities (including debt) required to be “registered” under Section 12 of the Exchange Act, or a corporation that is required to file reports under section 15(d) of the Exchange Act. The proposed regulations mirror the TCJA statutory language. Because the Section 12 registration requirements apply not only to a corporation seeking to list its securities on a national securities exchange, but also to corporations meeting certain asset and shareholder requirements, a publicly held corporation may include certain large corporations that are not publicly traded. A corporation is required to file reports under Section 15(d) of the Exchange Act if it offers securities for sale in a transaction subject to registration requirements under the Securities Act of 1933.
The proposed regulations clarify that S corporations and publicly traded partnerships treated as corporations that meet the registration or reporting requirements described above are also subject to Section 162(m). Similar to Regulation §1.162(m)-27, the proposed regulations provide that status as a publicly held corporation is determined as of the last day of the corporation’s tax year. The proposed regulations also provide additional guidance (including numerous examples) on the allocation of a Section 162(m) deduction disallowance within an affiliate group, depending on the number of publicly held corporations in such group.
The proposed regulations reflect the expanded definition of covered employee included in the TJCA, as clarified by Notice 2018-68. A covered employee includes the following:
The preamble to the proposed regulations clarifies that, in determining the three highest compensated officers (other than the PEO and PFO), only executive officers can qualify as a covered employee. This is because the reporting rules under the Exchange Act require disclosure with respect to the three highest compensated executive officers. The preamble also clarifies that the determination of the three highest compensated officers is not limited to remuneration that is otherwise deductible under the Code. Rather, the remuneration used to identify the three most highly compensated officers is based on the rules for determining such individuals under the Exchange Act.
For purposes of identifying a covered employee, the term “predecessor corporation” includes the following:
The proposed regulations include additional rules in defining a predecessor corporation in specified circumstances, such as sequential transactions.
Because all individuals identified as covered employees after December 31, 2016, retain their status as such, the application of the Section 162(m) deduction disallowance will expand significantly for many employers. For example, if an employer pays nonqualified deferred compensation to a covered employee after his or her termination of employment, such compensation will be subject to the Section 162(m) deduction limitations. The legislative history of Section 162(m) provides that Section 162(m) will continue to apply to compensation paid to a former covered employee, even after such individual dies. An employer will need to develop the necessary recordkeeping to comply with Section 162(m) in future years.
The proposed regulations state that Exchange Act disclosure rules are to be applied in identifying the three most highly compensated executive officers, using the corporation’s tax year rather that the corporation’s fiscal year in making the determination.
The proposed regulations incorporate the amendments to the definition of applicable employee remuneration under the TCJA, including the elimination of the exclusion for commissions and performance-based compensation. The TCJA also provides that employee remuneration will be taken into account if paid to a person other than the covered employee, such as after the death of the covered employee.
The proposed regulations clarify that a publicly held corporation must take into account remuneration that is not directly paid by it to one of its covered employees to the extent the corporation is allocated a distributive share of the deduction for such remuneration. Thus, if a publicly held corporation is a partner, any allocated distributive share of a deduction for remuneration paid to one of the corporation’s covered employees by the partnership will be added to the remuneration paid directly to the covered employee by the corporation in applying Section 162(m). This rule applies to deductions for a tax year ending on or after December 20, 2019. A grandfather rule applies for remuneration paid pursuant to a written binding contract in effect on December 20, 2019, that is not materially modified after that date.
A commenter to Notice 2018-68 suggested that applicable employee remuneration should not include remuneration for services other than as an executive officer. The proposed regulations do not adopt this suggestion. Thus, if a covered employee terminates employment as an executive officer and subsequently receives remuneration as a director, such remuneration will be taken into account in applying Section 162(m).
The final Section 162(m) regulations issued under pre-TJCA law provide for delayed application of Section 162(m) to a privately held corporation that become publicly held (e.g., via spin-offs or initial public offerings). The proposed regulations eliminate this transition period. Effective for corporations that become publicly held after December 20, 2019, Section 162(m) will apply to remuneration otherwise deductible for the tax year ending on or after the date the corporation becomes publicly traded. The proposed regulations provide that a corporation becomes publicly held on the date that its registration statement becomes effective under the Securities Act of 1933 or the Exchange Act.
As noted above, there is a grandfather rule for remuneration paid pursuant to a written binding contract in effect on November 2, 2017 that is not materially modified after such date. The grandfathered rule applies if the corporation is obligated under applicable law to pay the remuneration if the employee perform services or satisfies vesting conditions.
Both Notice 2018-68 and the proposed regulations adopt the same definitions of written binding contract and material modification applied when Section 162(m) was first adopted. If a written binding contract is renewed after November 2, 2017, the amendments to Section 162(m) under the TCJA will apply to payments made under the contract after the renewal. Similarly, if a written binding contract is terminable or cancelable by an employer after November 2, 2017, without the consent of the employee, the contract is treated as renewed as of the earliest date such termination or cancellation, if made, would be effective.
In contrast, if the employee has the sole discretion to renew or cancel the contract, payments under the contract remain grandfathered. In addition, payments under a qualifying contract remain grandfathered if the contract can be terminated or canceled only by the employee’s termination of employment or if the contract expires and the employee continues to provide services, provided that payments attributable to service rendered after such expiration are not grandfathered. The proposed regulations provide that, if a plan or arrangement is binding on November 2, 2017, payments made to an employee who becomes eligible to participate in such plan or arrangement after November 2, 2017, will be grandfathered provided that the employee was employed on November 2, 2017, or had a right to participate in the plan or arrangement under a written binding contract as of November 2, 2017.
Code Section 409A governs the time and form of payment of nonqualified deferred compensation (NQDC). The Section 409A regulations currently grant an employer the discretion (whether or not expressly stated in a plan) to delay a scheduled payment of NQDC to the extent the employer reasonably anticipates that the payment would be subject to the deduction disallowance under Section 162(m). If delayed, the payment must be made (i) in the first year the employer reasonably anticipates (or should reasonably anticipate) that Section 162(m) won’t apply to the payment, or (ii) if later, during the period beginning on the employee’s separation from service and ending on the last of the last day of the calendar year in which the employee separates from service or the 15th day of the third month following such separation from service. The Section 409A regulations require that all payments to an employee that could be delayed under this rule must be delayed.
The Section 409A regulations were drafted based on the pre-TCJA definition of covered employee. After 2016, the TCJA definition of covered employee provides that “once a covered employee, always a covered employee.” Thus, it may take years for a payment to fall outside the Section 162(m) deduction disallowance. In the preamble to the proposed Section 162(m) regulations, the IRS acknowledges the impact of the TCJA definition of covered employee and states that the Section 409A regulations will be revised to permit an employer to delay grandfathered amounts (not subject to the TCJA definition of covered employee) without delaying the payment of non-grandfathered amounts.
Further, the Section 409A regulations will be revised to permit NQDC plans and arrangements that expressly require the delay of payments reasonably anticipated to be subject to Section 162(m) to be amended to no longer require such delay, without violating Section 409A. Such amendments must be adopted no later than December 31, 2020. Employers are permitted to rely on the guidance in the preamble for any tax year beginning after December 31, 2017, until the issuance of proposed regulations under Section 409A incorporating these changes.
Generally, the proposed Section 162(m) regulations apply to tax years beginning on or after the date of publication of the final regulations.
Several special effective dates apply, some of which are noted above. For example, the rule requiring the determination of the three most highly compensated executive officers to be made under the Exchange Act rules applies to taxable years ending on or after December 20, 2019. Similarly, the definition of “predecessor employer” and the rule applying Section 162(m) for the tax year ending on or after the date a privately held corporation becomes a publicly held corporation applies to tax years ending on or after December 20, 2019. Some effective dates are based on the publication date of Notice 2018-68. Employers will need to carefully consider the various effective dates described in the proposed regulations.
Employers that are publicly held or anticipate becoming publicly held should review the proposed regulations for possible impact on their executive compensation arrangements. In particular, plans or arrangements requiring delay of payment until Section 162(m) is no longer applicable should be reviewed and, if appropriate, amended no later than December 31, 2020.
Lori Jones is the chair of Thompson Coburn’s Employee Benefits practice.
 Section 12(g) of the Exchange Act requires a corporation to register its securities if it has assets exceeding $10 million and has 2,000 or more shareholders of record or 500 or more shareholders of record who are not accredited investors.
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