Introduction
On January 14, 2025, the Internal Revenue Service (“IRS”) and the U.S. Treasury Department (the “Treasury Department”) issued proposed regulations (the “Proposed Regulations”) under Section 162(m) of the Internal Revenue Code (“Code”), which generally prohibits publicly held corporations from taking income tax deductions for annual compensation in excess of $1 million paid to a “covered employee”. This blog post summarizes the key features of the Proposed Regulations and also serves as a reminder of upcoming significant changes to Section 162(m) of the Code that will be effective for taxable years beginning after December 31, 2026.
As summarized in our blog post titled “Recent Developments on Section 162(m)”, dated March 23, 2021, available here, on March 11, 2021, President Biden signed into law the American Rescue Plan Act of 2021 (“ARPA”), which expanded the number of individuals required to be included as a “covered employee” under Section 162(m) of the Code for taxable years beginning after December 31, 2026 (the “ARPA Covered Employee Expansion”). The Proposed Regulations provide guidance with respect to the application of the ARPA Covered Employee Expansion.
ARPA Covered Employee Expansion Background
Prior to the passage of ARPA, a publicly held corporation’s “covered employees” in any given fiscal year included only its principal executive officer (“PEO”), principal financial officer (“PFO”) and three highest compensated officers other than the PEO and PFO (the “Top Three Officers”). The ARPA Covered Employee Expansion added a new Section 162(m)(3)(C) of the Code that expanded the number of individuals required to be included as covered employees for any taxable year beginning after December 31, 2026 to also include a publicly held corporation’s five highest compensated employees other than its PEO, PFO, and Top Three Officers, even if they are not executive officers (the “Top Five Employees”). Once the PEO, PFO and Top Three Officers are deemed covered employees, they remain covered employees in perpetuity. However, 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 the Top Five Employees may vary significantly from year to year depending on compensation levels.
Key Features of the Proposed Regulations
The Proposed Regulations provide that for purposes of determining whether an employee is one of the Top Five Employees, the term “employee” means an “employee” as defined in Section 3401(c) of the Code, under which the term “employee" includes a common law employee and an officer of a corporation.
The Proposed Regulations provide that for purposes of determining whether an employee is one of the Top Five Employees, publicly held corporations should use “compensation” as defined in Treasury Regulation 1.162-33(c) (i.e., compensation that would be deductible but for Section 162(m) of the Code). This differs from the measurement used to determine the Top Three Officers, which is based on an officer’s total compensation required to be disclosed to shareholders pursuant to Item 402 of Regulation S-K of the Securities Exchange Act.
In order to prevent companies from attempting to avoid the deduction limitations by transferring employees to subsidiaries or adopting a holding company structure, the Proposed Regulations provide that any employee of any corporation in the affiliated group may be one of the publicly held corporation’s Top Five Employees regardless of whether the employee is an employee of or performs services for the publicly held corporation, and that the compensation paid to the employee by all the members of the affiliated group is aggregated when making the determination. The Proposed Regulations set forth guidance on how to determine the composition of an affiliated group for purposes of Section 162(m) of the Code and allocate the lost deduction among the members, including when the affiliated group consists of multiple publicly held corporations, privately held corporations and/or foreign corporations.
Similarly, the Proposed Regulations also provide that “compensation” includes amounts paid by a publicly held corporation (or member of its affiliated group) to an employee of a third party (such as a professional employer organization) who provides substantially all the individual’s services for the publicly held corporation.
Timing
The Proposed Regulations are expected to apply to compensation that is otherwise deductible for taxable years beginning after the later of December 31, 2026 and the date the Treasury Department finalizes the Proposed Regulations and publishes them in the Federal Register.
