Executive decision: IRS finalizes section 162(m) regulations

Eversheds Sutherland (US) LLP

Eversheds Sutherland (US) LLPOn December 18, 2020, the Internal Revenue Service and Treasury Department issued final regulations under section 162(m) of the Internal Revenue Code, following proposed regulations issued in December 2019. The final regulations generally follow the proposed regulations, with a few minor clarifications, and reflect the changes made to section 162(m) by the Tax Cuts and Jobs Act. This legal alert summarizes certain changes from the proposed regulations, reviews the general structure of the final regulations, and provides a summary of the grandfathering rules of the final regulations.

Changes in the final regulations

The final regulations are generally effective for tax years beginning on or after December 30, 2020, the date of publication in the Federal Register. However, taxpayers can rely on the final regulations for any tax year beginning after December 31, 2017 (subject to certain consistency rules), and certain provisions of the final regulations are generally effective on earlier dates (e.g., the definitions of a covered employee, written binding contract, and material modification are effective for tax years ending on or after September 10, 2018, when Notice 2018-68 was issued).

The final regulations did not make substantial changes to the proposed regulations, which themselves were similar to the initial guidance on new section 162(m) contained in Notice 2018-68. However, there were some clarifications that will affect some taxpayers; a number of these are shown in the chart below.

Provision Proposed Regulations Final Regulations
Foreign private issuer as publicly held corporation The proposed regulations provided that a foreign private issuer is a publicly held corporation if it issues securities required to be registered under section 12 of the Securities Exchange Act of 1934 or if it is required to file reports under section 15(d) of the Securities Exchange Act of 1934, even if it is not required to disclose executive compensation. Despite several comments recommending that most foreign private issuers not be included as publicly held corporations, the final regulations retain the rule from the proposed regulations.
Publicly held corporations that own partnerships The proposed regulations provided that compensation paid to an employee of a partnership in which a publicly held corporation was a partner would be non-deductible by the corporation to the extent of its distributive share of partnership deductions. The final regulations retain the positon of the proposed regulations and retain a transition rule under which amounts as of December 20, 2019 (the date of publication of the proposed regulations) are generally grandfathered under the old rules that did not disallow the deduction.  The final regulations add another transition rule under which the new rules are not effective until December 18, 2020.
Clawback rights and grandfathering The proposed regulations provided that for purposes of the grandfathering rules, if compensation was subject to a clawback, and the condition for the clawback occurred, any compensation subject to clawback would not be grandfathered, even if the company chooses not to claw back the compensation. The final regulations treat the clawback rights as a separate contract, and therefore provide that a clawback provision does not impact grandfathering, even if the condition that enables the clawback occurs.
Grandfathered amounts and earnings The proposed regulations addressed the determination of grandfathered amounts, including earnings and losses, in account balance plans and analogous concepts in non-account balance plans primarily through numerous examples. The final regulations make the rules for determining the grandfathered amounts explicit, retaining the substantive results of the proposed regulations.  The final regulations add a rule of administrative convenience that allows the grandfathered amount to be determined based on the account balance as of November 2, 2017 (or, in some cases, a later date) without taking account of future earnings and losses.  An analogous rule applies for non-account balance plans.
Extension of option or SAR exercise period The proposed regulations implied that an extension of the exercise period was a material modification causing the loss of grandfathering. The final regulations do not generally treat an exercise period extension as a material modification, consistent with the section 409A regulations.
ESsentials: The new rule that allows grandfathered amounts to be determined based on a frozen amount may be useful in situations in which companies find that tracking ongoing earnings and losses related to such amounts to be administratively burdensome, and the additional deductible amounts resulting from such tracking to be immaterial.

Overview of the final regulations

The following provides an overview of section 162(m) and the final regulations. Section 162(m) was amended in significant ways by the Tax Cuts and Jobs Act, effective for tax years beginning after December 31, 2017. The amendments eliminated the exception for performance-based compensation and expanded the group of individuals who are treated as covered employees, among other modifications.

Section 162(m) now provides that in the case of a publicly held corporation, deductions are disallowed for compensation paid to a covered employee in a tax year in excess of $1,000,000.  Certain key terms are underlined in the preceding sentence.

The following chart describes the main elements of each of these terms, as well as certain differences between new and old section 162(m).

Provision Details
“Publicly held corporation”

A publicly held corporation means any corporation that issues securities required to be registered under section 12 of the Exchange Act or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934 (referred to below as the “Exchange Act requirements”).

  • This covers corporations that are traded on public exchanges, but also generally includes corporations with publicly-held debt and certain foreign private issuers that were not previously covered by section 162(m).
  • If an affiliated group of corporations has more than one entity that is a publicly held corporation, each entity is separately subject to section 162(m). The regulations provide rules for allocating the deduction disallowance in cases in which the entities have overlapping covered employees.
  • A publicly held corporation includes (i) a corporation that owns a disregarded entity that meets one of the Exchange Act requirements, and (ii) a real estate investment trust that owns a qualified real estate investment trust subsidiary that meets one of the Exchange Act requirements.

Compensation means the amount that is deductible in a tax year with respect to a covered employee’s services, regardless of when paid, and even if paid to a beneficiary or estate after the covered employee’s death.

  • Once an individual is a covered employee by reason of serving as an executive officer, compensation includes all amounts paid to that individual in any capacity (e.g., if the CEO later becomes a non-employee director, director compensation is included).
  • Amounts that are excluded from taxable income when paid are not considered compensation for this purpose, and neither are amounts deferred under and paid from tax-qualified retirement plans.
  • Old section 162(m) contained a critical exception for certain performance-based compensation; new section 162(m) does not have any such exception.
“Covered employee”

A company’s covered employees include, for any taxable year:

  • Each person serving as the CEO or CFO at any time during the year;
  • The three other highest paid executive officers, without regard to whether they are employed on the last day of the year; and
  • Any person who was a covered employee in any prior tax year beginning January 1, 2017 or later (i.e., the once-a-covered-employee, always-a-covered-employee concept).

For purposes of identifying who are executive officers and ranking the three highest-paid officers, the proxy compensation disclosure rules apply, even if the company is not subject to such disclosure.

The rule that once an individual is a covered employee, the individual is always treated as a covered employee is a key change from old section 162(m). This means that an individual continues to be a covered employee even after termination of employment, which was not the case under prior law.

An individual who is an executive officer of a disregarded entity that is owned by a publicly held corporation (and not an executive officer of the publicly held corporation) is generally not treated as a covered employee, because the individual is not a covered employee of a corporation.
ESsentials: Section 162(m) traps for the unwary include private companies with publicly traded debt, foreign private issuers, post-employment payment of compensation for consulting and director services, and companies that have substantial turnover in top executives.

Grandfathering overview

Although new section 162(m) is effective for tax years beginning after December 31, 2017, it contains a grandfathering rule for certain compensation. Specifically, compensation that is payable pursuant to a written binding contract in effect on November 2, 2017 remains subject to old section 162(m). The grandfathering treatment continues as long as the written binding contract is not materially modified; upon a material modification, the compensation becomes subject to new section 162(m). The final regulations generally follow the proposed regulations, and the following chart reflects the key elements of the grandfathering rules of the final regulations.

ESsentials: If an amount is grandfathered, it is not automatically exempt from section 162(m). Instead, it is subject to the rules of old section 162(m), before amendment by the Tax Cuts and Jobs Act. This entails applying all of the rules of old section 162(m), including the prior method of determining if a recipient is a covered employee. For example, if a grandfathered amount is considered performance-based compensation under old section 162(m), it will generally be exempt from section 162(m). Similarly, if a grandfathered amount is payable to an individual who would not be considered a covered employee under old section 162(m) (such as a payment following termination of employment or payment to the CFO), it will generally be exempt from section 162(m).
Provision Details
“Written binding contract”

A written binding contract is considered grandfathered if the corporation is obligated to pay the compensation under applicable law (such as state law) if the employee performs services or satisfies vesting conditions.

  • If the corporation can unilaterally terminate or cancel the contract, it is not grandfathered.
  • A provision allowing for the corporation to exercise negative discretion and pay a reduced amount may result in the contract not being grandfathered to the extent the negative discretion could be exercised under applicable law.
  • The regulations provide rules for calculating the amount subject to grandfathering in various types of plans, including earnings in account balance plans.
“Material modification”

A material modification occurs when a contract is amended to increase the amount payable to the employee.

  • Accelerations and deferrals may not constitute a material modification to the extent that the acceleration is discounted for the time value of money and a deferral does not result in unreasonable additional earnings, pursuant to rules provided in the final regulations.
  • A new, supplemental payment based on the same elements as the underlying grandfathered amount is generally a material modification to the grandfathered amount.
  • An acceleration of vesting is generally not a material modification.


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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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