The IRS has issued proposed regulations on how publicly held corporations would apply the expanded coverage of Internal Revenue Code (IRC) section 162(m). Section 162(m) prohibits publicly held corporations from deducting more than $1 million in annual compensation paid to certain “covered employees.” Beginning in 2027, the list of covered employees will be expanded to include five additional employees subject to the $1 million deduction limit.
The proposed regulations would take effect for taxable years beginning after December 31, 2026, or the date they are finalized, whichever is later. Until the final rules are published, corporations would be advised to follow a good faith interpretation of the law.
In 2021, to help raise revenue, the American Rescue Plan Act (ARPA) expanded the number of covered employees subject to the $1 million deduction limit under IRC section 162(m) to include the five highest compensated employees — regardless of position in the organization — for the taxable year. This change means that a minimum of 10 employees will be covered by the $1 million deduction limitation for most corporations.
Under pre-2027 section 162(m), a corporation’s covered employees included any principal executive officer or principal financial officer at any time during the taxable year. It also included any employee who is among the three highest compensated officers for that taxable year (other than the principal executive officer or principal financial officer).
In 2017, IRC section 162(m) was amended to provide that once an individual is a covered employee, he or she remains a covered employee for as long as compensation is paid by the corporation on the individual’s behalf — even after leaving the company and for payments after death. This “once/always” rule does not apply to employees who become subject to section 162(m) solely because of the ARPA expansion.
This means that paying deferred compensation to the ARPA group of covered employees after employment termination may, in some cases, avoid the application of the $1 million deduction limit. However, this technique generally would not work for pre-ARPA covered employees. That’s because the once/always rule means that deferred compensation earned during years while in that group generally is subject to the section 162(m) limit, regardless of when paid, unless those deferrals took place in years before the once/always rule took effect starting in 2017.
The proposed regulations generally follow the existing regulations as to how:
The proposed regulations address how to calculate “compensation” for purposes of ranking and identifying the additional five most highly compensated employees. Compensation would be calculated based on amounts that would, but for IRC section 162(m), be allowable as a deduction (as opposed to calculating compensation under the Securities and Exchange Commission disclosure rules pursuant to Item 402 of Regulation S-K for the three highest-compensated officers other than the CEO or CFO).
Corporations should consider how the section 162(m) expansion along with the proposed regulations would affect their “covered employee” determinations. Financial statements should reflect this expansion as a future lost tax deduction in the calculation of deferred tax assets if the corporation has not yet done so.
