Key takeaways
Assuming further tax legislation under the new Congress does not change the rules again:
- Publicly held companies listed in the US (including foreign private issuers) and companies that are going public imminently should prepare for including their five highest compensated employees as Section 162(m) covered employees for taxable years beginning after December 31, 2026 by gathering compensation information for potential members of this group and determining the year in which such compensation will be deductible and therefore counted as "compensation" under the Proposed Regulations, factoring in future equity compensation settlement dates and any compensation deferral arrangements. Additional planning will be required where stock options make up a significant component of compensation held by employees (such as for companies that recently went public).
- As this new group of covered employees may include individuals employed by another member of the publicly held corporation's affiliated group, individuals employed through a professional employer organization or other third-party, and non-US employees, companies will need to take a broad view of their employee population and hiring arrangements to ensure they correctly identify their five highest compensated employees under these new rules.
Background
Current Law
In 2017, the Tax Cuts and Jobs Act amended Code Section 162(m) by, among other things, expanding the definition of "covered employee" to include the CEO, CFO, and the three other highest-paid executive officers at any time during the taxable year for taxable years beginning after December 31, 2017. In addition, for tax years beginning after December 31, 2016, once an individual is designated as a covered employee, that covered employee status will extend to all future years, even after a termination of employment. In 2018, the IRS issued Notice 2018-68, which provided guidance on these amendments. For additional information on Notice 2018-68, please see our blog: IRS Issues Guidance on Section 162(m) Amendments.
In 2021, the ARPA amended Code Section 162(m) by expanding the definition of "covered employee" for taxable years beginning after December 31, 2026 to add any employee who is among the five highest-compensated employees for the taxable year, excluding the CEO, the CFO and the three highest compensated executive officers for the taxable year. For additional information on this ARPA amendment, please see our blog: American Rescue Plan Act Expands Group Subject to Compensation Deductibility Limits.
Proposed Regulations
The Proposed Regulations provide guidance on how to determine the additional group of employees that constitutes the five highest compensated employees under Code Section 162(m), as amended by the ARPA.
1. Definition of Employee
In determining whether an employee is one of the five highest compensated employees, the Proposed Regulations provide that the term "employee" follows the definition in Code Section 3401(c), which generally includes common law employees and corporate officers. This definition includes an individual who is an employee of a person other than the publicly held corporation, such as a related but unaffiliated organization or a certified professional employer organization, but nevertheless functions as an employee of the publicly held corporation by performing substantially all of the individual's services during the taxable year for the publicly held corporation.
2. Determination of Five Highest Compensated Employees
For purposes of determining whether an employee is one of the five highest compensated employees, the Proposed Regulations define "compensation" as compensation that would be deductible for the taxable year if not for the limitation on deductibility under Code Section 162(m). The IRS commented that this approach should be easier to administer because companies currently track compensation to determine their tax liability for the taxable year for their employees, instead of calculating compensation under the SEC's proxy disclosure rules (which are used for calculating compensation of the three highest-paid executive officers under Code Section 162(m)).
The Proposed Regulations also provide that any employee of any corporation within the affiliated group of corporations (including foreign corporations) that includes a publicly held corporation may be one of the five highest compensated employees of the publicly held corporation, regardless of whether the employee is directly employed by or performing services for the publicly held corporation. The compensation paid to an employee by each member of a publicly held corporation's affiliated group (including by foreign corporations) is aggregated when determining whether the employee is one of its five highest compensated employees. The Proposed Regulations include specific rules for addressing circumstances where more than one publicly held corporation is a member of an affiliated group and where an affiliated group includes a foreign corporation.
Additionally, an individual who has been a covered employee since January 1, 2017, such as a former officer who remains employed by the publicly held corporation, may qualify as one of the five most highly compensated employees, which would have the impact of reducing the company's overall number of covered employees for the applicable tax year, given that one of the five additional slots is taken by a person who is already a covered employee.
Notably, the "once a covered employee, always a covered employee" rule that applies to the current group of executive officer covered employees does not apply to the five additional employees who become covered as a result of ARPA.
Proposed Applicable Date
The Proposed Regulations are generally effective for compensation that is otherwise deductible for taxable years beginning after the later of December 31, 2026 or the date of publication of the final regulations. Comments on the Proposed Regulations may be submitted through March 17, 2025.
