New Section 162(m) Proposed Regulations

Kramer Levin Naftalis & Frankel LLP

Kramer Levin Naftalis & Frankel LLP

The Tax Cuts and Jobs Act of 2017 (TCJA) made significant changes to Section 162(m) of the Internal Revenue Code (Section 162(m)), expanding the scope of individuals and entities subject to Section 162(m), in addition to eliminating the exclusion for performance-based compensation. Last week, Proposed Regulations1 were published that confirm the broad scope of amended Section 162(m) and the relatively narrow scope of the grandfather provisions.

Section 162(m) limits employer deductions to the first $1 million of applicable employee remuneration paid by a publicly held corporation to a covered employee. Under the Proposed Regulations, each of these components is broadly defined.

Publicly Held Corporation

The Proposed Regulations make clear that “publicly held corporation” includes any corporation whose securities (including debt securities) are required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) or that is required to file reports under Section 15 of the Exchange Act. Whether a corporation is publicly held is determined as of the last day of the corporation’s taxable year.

The following entities are now subject to Section 162(m):

  • Corporations that register debt securities. The TCJA significantly increased the scope of Section 162(m) by including corporations that register debt, even though the company does not have any publicly traded stock.
  • Foreign private issuers. The IRS rejected suggestions to exclude foreign private issuers.
  • Certain publicly traded partnerships. Publicly traded partnerships that are treated as corporations under Section 7704 of the Internal Revenue Code are also treated as publicly held corporations for purposes of Section 162(m).
  • Affiliated groups. All entities in an affiliated group of corporations are subject to Section 162(m) if one of the group members is a publicly traded corporation. While this applied to Section 162(m) even pre-TCJA, more entities will now be included due to the broader scope of Section 162(m). Significantly, under the Proposed Regulations, the privately held parent of a publicly held subsidiary is subject to Section 162(m). In addition, a publicly held subsidiary of a publicly held parent company will be considered a separate publicly held entity for purposes of Section 162(m), and the Section 162(m) rules will separately apply to each entity.

Covered Employees

The covered employees subject to Section 162(m) generally are the principal executive officer (PEO), the principal financial officer (PFO), and the three highest compensated executive officers for the year, aside from the PEO and PFO. This follows the pre-TCJA rule, with the addition of the PFO, which had been excluded since 2006 due to a disconnect between the Internal Revenue Code and securities law rules.

The Proposed Regulations clarify the following with respect to covered employees:

  • Covered employee during the year. The Proposed Regulations confirm that an individual can be a covered employee regardless of whether the individual is serving at the end of the publicly held corporation’s taxable year and regardless of whether the individual’s compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules.
  • Covered employee status never lapses. Individuals who are covered employees for years starting in 2017 remain covered employees of the corporation, even if they are no longer employed by the corporation. The Proposed Regulations further clarify that payments to a beneficiary of the covered employee with respect to the covered employee’s past service remain subject to Section 162(m). Employers can no longer avoid the Section 162(m) deduction limitation by deferring payment of Section 162(m)-impacted compensation until the covered employee terminates employment.
  • Covered employees of a “predecessor corporation” remain covered employees of the “successor corporation.” The Proposed Regulations broadly consider predecessor corporations. For example, covered employee status continues in the following scenarios:
    • Covered employees of a publicly held corporation that is acquired by another publicly held corporation.
    • Covered employees of a publicly held corporation, 80% of whose assets are acquired by another publicly held corporation.
    • Covered employees of a publicly held corporation that becomes privately held and then subsequently (within 36 months after the due date for the federal income tax return for the last year as a publicly held corporation) becomes publicly held again or is acquired by a publicly held corporation.

Applicable Employee Remuneration

Applicable employee remuneration is similarly broadly defined under the Proposed Regulations.

  • The recipient of the compensation is irrelevant. All compensation paid in respect of the covered employee’s services is covered, even if paid to another person, e.g., if paid to a beneficiary after the employee’s death.
  • The compensation need not be for service as a covered employee. Any compensation paid to a covered employee is covered, even if paid for services as an independent contractor or director, including compensation for periods after the individual terminated employment.
  • The payor of the compensation need not be the publicly held corporation or a member of the affiliated group. Compensation paid to the covered employee by a partnership is covered to the extent that the publicly held corporation receives the tax deduction for that compensation. This can arise where the corporation sets up a joint venture and the corporation’s executives perform services for the joint venture. As this change goes against prior IRS guidance, the IRS has proposed transition relief for taxpayers who may have entered into such arrangements on the understanding that the partnership compensation was excluded from Section 162(m).
  • Newly public corporations. The Proposed Regulations do not include any transition rules for newly publicly held corporations. All compensation paid to a covered employee in the year in which the entity became a publicly held corporation (i.e., including compensation for the period during the year when the corporation was privately held) will be subject to the deduction limitation under Section 162(m).

Grandfather Rules

Compensation provided pursuant to a written binding contract that was in effect on Nov. 2, 2017, is not subject to the amended Section 162(m) rules, unless the written contract is materially modified. A material modification generally is an increase in the employee’s compensation under the contract. The Proposed Regulations include several clarifications with respect to the grandfathered agreement:

  • Negative discretion. The Proposed Regulations confirm that a payment is not grandfathered to the extent that the corporation has the right to reduce the payment amount.
  • Contingent negative discretion. A contingent right to claw back or reduce compensation (e.g., if the financial statements are restated) does not negate the grandfather status of the agreement until the corporation has an actual right to claw back or reduce the compensation. Note that the grandfather status of any agreement is affected by the right to reduce compensation, even if the right is not exercised.
  • Earnings. Earnings on grandfathered agreements are grandfathered only to the extent that the corporation was obligated to pay the earnings pursuant to a written contract in effect on Nov. 2, 2017.
  • Acceleration of payment. Acceleration of a payment is a material modification unless the amount paid is reduced to reflect the early payment.
  • Severance. Severance that is a multiple of the employee’s compensation may be a grandfathered payment, but only with respect to compensation that the corporation was obligated to pay under a written contract in effect as of Nov. 2, 2017. In other words, severance may not be grandfathered to the extent that it is a multiple of a discretionary bonus. Furthermore, a material increase in salary (i.e., an increase that exceeds a reasonable cost of living adjustment) will be considered a material modification resulting in a loss of grandfather status.
  • Accelerated vesting. If a grandfathered amount is subject to a substantial risk of forfeiture, a modification that results in a lapse of the substantial risk of forfeiture is not a material modification.
  • Deferrals. It is not a material modification to defer a grandfathered payment and to pay earnings on the deferred amount (although the earnings will not be grandfathered), provided that the earnings represent no more than a reasonable rate of interest or the rate of return on a predetermined actual investment.

Next Steps

The Proposed Regulations generally supersede prior guidance in Notice 2018-68. In addition, the Proposed Regulations are subject to comments. Any comments must be submitted by Feb. 18, 2020 (within 60 days of the publication of the Proposed Regulations in the Federal Register). A public hearing has been scheduled for March 9, 2020.


1 The full text of the proposed regulations and preamble can be found here.

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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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