On January 16, 2025, the IRS published proposed regulations to implement and provide guidance regarding amendments made to section 162(m) as part of the American Rescue Plan Act of 2021 (ARPA). These proposed regulations expand the compensation deduction limitation for publicly held corporations under I.R.C. section 162(m), beginning in 2027.
Section 162(m) generally disallows a deduction by any publicly held corporation for compensation of covered employees in excess of $1 million for the taxable year, when such compensation would otherwise be deductible. Since the Tax Cuts and Jobs Act, “covered employees,” is defined to include (i) individuals who served as the principal executive officer (“PEO”) or principal financial officer (“PFO”) during the tax year, (ii) the three highest-compensated named executive officers other than the PEO and PFO for the tax year, and (iii) officers who were covered employees for any preceding tax year beginning on or after January 1, 2017.
ARPA expanded this definition of covered employees but with a deferred effective date. For tax years beginning after December 31, 2026, covered employees include any employee, even if that employee is not an officer, who is among the five highest-compensated employees of a publicly held corporation, other than the PEO or PFO and the three highest-compensated executive officers.
The proposed regulations implement ARPA’s expanded definition of covered employees and provide guidance for determining when a covered employee is one of the five highest-compensated employees for purposes of the limitation.
- First, the proposed regulations provide that the term “employee,” as used in section 162(m)(3)(C) and defined in section 3401(c), includes, but is not limited to, officers. Additionally, an employee of a publicly held corporation will also include an individual who is employed by a person other than the publicly held corporation, but who functions as an employee of the corporation. For example, an individual who performs substantially all of their services during the tax year for the publicly held corporation would be considered an employee of that publicly held corporation, and amounts paid to that individual would be considered compensation for purposes of the deduction limitation.
- The proposed regulations also provide that employees of any corporation within a publicly held corporation’s affiliated group may be classified as one of the five highest-compensated employees for purposes of the limitation. This is true regardless of whether the employee is an employee of, or performs services for, the publicly held corporation. Treasury was concerned that publicly held corporations may employ highly compensated individuals at subsidiaries to avoid the deduction limitation. Therefore, this change is intended to capture the highest-compensated employees of a publicly held corporation who are employed at a non-publicly held corporation within an affiliated group.
- Finally, the proposed regulations include guidance for identifying the five most highly-compensated employees, particularly within an affiliated group. Compensation is calculated based on amounts that would be allowable as a deduction, but for section 162(m). Publicly held corporations will be required to track such compensation on an employee-by-employee basis to identify and rank the next five highest-compensated employees in a given tax year. Additionally, if an employee of a publicly held corporation is compensated by more than one corporation within an affiliated group, the compensation paid to that employee by each member of the affiliated group is aggregated. However, whether an individual is one of the five highest-compensated employees is determined separately for each publicly held corporation within the group, excluding any compensation already taken into account for another publicly held corporation within the group.
Takeaway
The proposed regulations would expand the compensation deduction limitation for covered employees beginning in 2027. However, publicly held corporations should begin to track employee compensation and consider what steps, if any, would need to be taken to if the regulation were finalized in its proposed form. Publicly held corporations should pay particular attention to highly-compensated employees of corporations within an affiliated group, individuals who function as employees of the publicly held corporation (but who are employed by a person other than the corporation), and non-officer highly-compensated employees.