IRS proposes rules to implement expansion of Section 162(m)

A company’s ability to deduct significant compensation may be further limited under new tax rules beginning in 2027, which may also impact a company’s financial statements and tax provisions in earlier years. Businesses concerned about these deductions can benefit from evaluating the potential impact of these new rules and determining whether there are opportunities to change existing compensation arrangements and/or establish new ones to mitigate the impact of the new rules.

Section 162(m) limits a public company’s compensation deduction to $1 million per taxable year for each covered employee. The American Rescue Plan Act (ARPA) expanded the definition of “covered employee” for tax years beginning after Dec. 31, 2026. In January, the IRS released proposed regulations to implement this expansion of covered employees subject to Section 162(m), and they are scheduled to become effective in 2027.

Under current law, the term “covered employee” includes the company’s principal executive officer (PEO) and principal financial officer (PFO) as well as the three highest-paid officers for the taxable year, other than the PEO and PFO (original covered employees). The highest-paid officers are determined based on the SEC proxy disclosure definition of compensation. Anyone treated as an original covered employee for any taxable year beginning after Dec. 31, 2016, remains an original covered employee in all future taxable years, regardless of whether the officer is still employed or an officer in the future taxable year ꟷ that is, once an original covered employee, always an original covered employee.

ARPA amends the definition of “covered employee” to include the top five highest-paid employees during the taxable year (the “ARPA five”). The ARPA five are defined as additional to the original covered employees, so most publicly held companies will have a minimum of 10 covered employees during a taxable year. However, unlike the original covered employees, an employee who is part of the ARPA five for a taxable year would not automatically be a covered employee for future taxable years ꟷ the ARPA five are determined separately for each taxable year.   

The proposed regulations would clarify several aspects of determining who is included in the ARPA five.

Definition of ‘employee’

The ARPA five may include any service provider who is an employee within the meaning of Section 3401(c) (the federal income tax withholding definition), which includes common law employees and officers. This would mean that while the original covered employees are limited to executive officers, the ARPA five could include service providers who are not officers. Also, if a publicly held corporation is a member of an affiliated group (discussed further below), all employees of the affiliated group may be part of the publicly held corporation’s ARPA five group.

The proposed regulations include a new concept where an individual service provider of an unaffiliated organization (e.g., a related but unaffiliated organization) who performs substantially all of the individual’s services for the publicly held corporation and/or an affiliated organization) would be treated as an employee of the publicly held corporation when determining the ARPA five and nondeductible compensation under Section 162(m). 

The proposed regulations also clarify that, for a particular taxable year, a service provider can be considered part of the ARPA five even though the service provider was an original covered employee for a preceding taxable year. The ARPA five definition for a particular taxable year expressly excludes anyone who falls within the original covered employee definition for that taxable year (that is, PEO, PFO and three other highest-paid officers for that taxable year), but does not expressly exclude anyone who is an original covered employee solely because of the application of the “once an original covered employee, always an original covered employee” rule from a prior taxable year. 

Definition of ‘compensation’

The proposed regulations clarify that the compensation used to determine the ARPA five for a particular taxable year is the compensation that would be allowable as a deduction for federal income tax purposes for that taxable year (determined without regard to any Section 162(m) limitation). 

Types of affiliated groups

Under the current final regulations that apply for purposes of determining the original covered employees, a publicly held corporation is defined to include any other corporation that is part of an “affiliated group,” as defined in Section 1504 (without regard to Section 1504(b)), that includes the publicly held corporation. An affiliated group under Section 1504 is generally determined by applying a “more than 80%” voting and value test for determining affiliation (subject to various special rules and exceptions).

The proposed regulations clarify that a similar rule applies for purposes of determining the ARPA five and provide that any employee of any corporation in the affiliated group that includes the publicly held corporation may be in that corporation’s ARPA five regardless of whether the employee is an employee of or performs services for the publicly held corporation.  

• Affiliated groups with more than one publicly held corporation
  The current final regulations that apply for purposes of determining the original covered employees include special rules for affiliated groups that include more than one publicly held corporation. The proposed regulations include similar special rules for purposes of determining the ARPA five in this context.
  
  For example, in this scenario, each publicly held corporation would have its own set of ARPA five members and, if an individual is an employee of an affiliated group member that is not publicly held, the affiliated group would have to be divided into smaller groups for purposes of determining each set of ARPA five members in accordance with the special rules prescribed in the proposed regulations. Similarly, the proposed regulations provide special rules for making these determinations if an employee is paid compensation by more than one member of an affiliated group.

• Affiliated groups that include a foreign corporation
  Consistent with the current final regulations for original covered employee determinations, the proposed regulations provide that compensation for ARPA five determinations generally would include remuneration paid by a member of an affiliated group that is a foreign corporation to the extent it is otherwise allowable as a deduction for federal income tax purposes, which generally occurs only with respect to compensation and other expenses incurred in connection with a trade or business carried on in the United States. However, the IRS noted in the preamble to the proposed regulations that, if the foreign corporation is a controlled foreign corporation as defined in Section 957, a pro rata share of certain types of income less associated deductions may be taken into account by a United States shareholder of the corporation under Sections 951 through 965 (Subpart F of the IRC).