Section 162(m) of the Internal Revenue Code (“Section 162(m)”) generally prohibits publicly held corporations from taking income tax deductions for annual compensation in excess of $1 million paid to a “covered employee”.
As described in further detail herein, (i) on December 18, 2020, the Internal Revenue Service (“IRS”) issued final regulations (the “2020 Final Regulations”) that provided guidance with respect to certain provisions of Section 162(m) that were amended by the Tax Cuts and Jobs Act of 2017, which regulations were largely consistent with proposed regulations published by the IRS on December 20, 2019 (the “2019 Proposed Regulations”), and (ii) on March 11, 2021, President Biden signed into law the American Rescue Plan Act of 2021 (“ARPA”), which materially amended the definition of who constitutes a “covered employee” under Section 162(m).
“Covered Employee” Definition
Prior to the passage of ARPA, a publicly held corporation’s “covered employees” in any given fiscal year included its principal executive officer (“PEO”), principal financial officer (“PFO”) and three highest compensated officers other than the PEO and PFO (the “Top Three Officers”). Once an individual is deemed a covered employee for any taxable year beginning after December 31, 2016, the individual remains a covered employee in perpetuity.
ARPA expands the number of individuals required to be included as covered employees. For taxable years beginning after December 31, 2026, a publicly held corporation’s “covered employees” in any given fiscal year will also include its five highest compensated employees other than its PEO, PFO, and Top Three Officers (the “Top Five Employees”). Unlike the PEO, PFO and the Top Three Officers, any individual who is deemed a covered employee as a result of being in the group of the Top Five Employees will not remain a covered employee in perpetuity, and this group may vary significantly from year to year depending on compensation levels. This is the first time that employees who are not executive officers will be considered covered employees under Section 162(m).
In addition, the 2020 Final Regulations expand the definition of compensation subject to Section 162(m) to include any compensation paid to a covered employee on or following termination of employment, including severance, whether or not payable to covered employee or his beneficiaries or estate, director fees, consulting fees, etc.
Other Key Features of the 2020 Final Regulations
Features Consistent with the 2019 Proposed Regulations
The 2020 Final Regulations are generally similar to the 2019 Proposed Regulations, including the following key features that remained the same:
- A corporation is considered a publicly held corporation for purposes of Section 162(m) if, as of the last day of its taxable year, its securities are required to be registered under Section 12 of the Securities Exchange Act of 1934 (“the Exchange Act”) or it is required to file reports under Section 15(d) of the Exchange Act. Under this expanded definition, a real estate investment trust or a foreign private issuer can be subject to 162(m).
- Prior to the 2020 Finalized Regulations, when a corporation became publicly held, such public corporation was generally afforded post-initial public offering (“IPO”) transition relief from Section 162(m) for a period of time following the IPO with respect to compensation paid pursuant to an arrangement that pre-dated the corporation’s IPO. However, the 2020 Finalized Regulations eliminate post-IPO transition relief for any corporation that became publicly traded after December 20, 2019.
- Effective as of December 18, 2020 (as opposed to the December 20, 2019 date included in the 2019 Proposed Regulations), if a publicly held corporation owns an interest in a partnership, that publicly held corporation must take into account its distributive share of the partnership’s deduction for compensation paid to the publicly held corporation’s covered employees in determining the amount allowable to the corporation as a deduction for compensation under Section 162(m).
- In order to be deemed a covered employee, an individual does not need to be subject to Summary Compensation Table compensation disclosure for the publicly held corporation’s last completed fiscal year under the applicable Securities and Exchange Commission rules.
Features Different from the 2019 Proposed Regulations
- Under the 2020 Final Regulations, an extension of the exercise period of otherwise grandfathered nonqualified stock options and stock appreciation rights (i.e., those granted on or prior to November 2, 2017) will not be considered a material modification resulting in the loss of grandfathered status if the extension complies with Section 409A of the Internal Revenue Code. The 2019 Proposed Regulations and Section 162(m) as in effect prior to the 2020 Final Regulations were silent with respect to any such extension of the exercise period, so practitioners generally took the view that it would constitute a material modification resulting in the loss of grandfathered status.
- The 2020 Final Regulations also provide additional details about grandfathered status for amounts payable under account and non-account balance nonqualified deferred compensation plans. The 2020 Final Regulations specify the method for (i) determining lump sum value for non-account balance plans and (ii) corporations to treat the account balance (for account balance plans) or lump sum value (for non-account balance plans) as of the date the plan is frozen or terminated, as applicable, as the grandfathered amount.
The text of the final regulations can be found here and the text of ARPA can be found here.
