Tax Facts
3520 / Is there an upper limit on the amount of executive compensation that a publicly-traded corporation may deduct? How did the 2017 Tax Act legislation legislation impact this limit?
Editor’s Note: Under IRC Section 162(m), publicly traded corporations are not permitted to deduct compensation paid to “covered employees” to the extent the employees’ annual compensation exceeds $1 million. Covered employees generally include the CEO, CFO and next three-highest paid employees. For tax years beginning in 2027 and thereafter, the ARPA will require corporations to include the five next most highly compensated employees, increasing the number of covered employees to at least 10. However, under prior law, employees were counted as covered employees permanently once they became subject to the Section 162(m) limits discussed below. With respect to employees who only become covered under Section 162(m) because of the ARPA changes, the employee will not continue to be subject to Section 162(m) if the employee later ceases to qualify as a covered employee (i.e., covered employee status will not be permanent for employees who are not the CEO, CFO or among the top three most highly paid employees).
Prior to 2018, a “covered employee” was defined as the corporation’s principal executive officer or any other employee who is one of the corporation’s three highest compensated officers (other than the corporation’s principal financial officer).3 This determination is made under the executive compensation disclosure rules of the Securities Exchange Act of 1934.4 The 2017 tax reform legislation expanded the definition of “covered employee” to include the chief financial officer and the chief executive officer (if the individual holds one of these positions at any time during the tax year). A covered employee now includes the three (rather than four) most highly compensated officers (other than the CEO and CFO) for the tax year who must be reported on the company’s proxy statement for the tax year (or who would be required to be reported if the company is not required to provide a proxy statement).5
Planning Point: The IRS proposed regulations provide that the employee need not have served as an executive officer as of the end of the company’s tax year in order to be treated as a covered employee (adopting the rule set forth in Notice 2018-68). Further, executive officers can be covered employees even if their compensation need not be disclosed. In determining the three most highly compensated employees, employers are entitled to rely on a reasonable, good faith interpretation of the statute until further guidance is released. The guidance also clarified that covered employees identified during a tax year that began in 2017 in accordance with pre-tax reform rules will continue to be covered employees for 2018 and beyond.
For tax years beginning after 2017, once the employee becomes a covered employee, he or she will stay a covered employee (even if the compensation is eventually paid to a beneficiary after the individual has died, to a beneficiary of a qualified domestic relations order or if the employee is no longer employed by the employer).6
The term “covered employee” also means any employee who was a covered employee of any predecessor of a publicly held corporation of the taxpayer for any preceding taxable year beginning after December 31, 2016. The proposed regulations use the term “predecessor of a publicly held corporation” for clarity. An individual who is a covered employee for one taxable year (including a taxable year of a predecessor of a publicly held corporation) remains a covered employee for subsequent taxable years. Specifically, a predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held.
The proposed regulations also provide that the term “predecessor of a publicly held corporation” includes a publicly held corporation that is acquired (as a target corporation), or the assets of which are acquired, by another publicly held corporation (the acquiror corporation) in certain transactions. The covered employees of the target corporation in those transactions are also covered employees of the acquiror corporation. With respect to asset acquisitions, if an acquiror corporation or one or more members of an affiliated group (acquiror group) acquires at least 80 percent of the operating assets (determined by fair market value on the date of acquisition) of a publicly held target corporation, then the target corporation is a predecessor of the acquiror corporation or group. For acquisitions of assets that occur over time, only acquisitions that occur within a 12-month period are taken into account to determine whether at least 80 percent of the target corporation’s operating assets were acquired.
The 2017 tax reform legislation also expanded the category of publicly held companies that are subject to the limit to include any company that is required to file reports with the SEC under Section 15(d) of the Securities Exchange Act of 1934, as well as any company with securities registered under Section 12 of the Act.7 The proposed regulations clarify that this determination is made as of the last day of the company’s tax year. However, a corporation will not be considered publicly held if its obligation to file reports under Section 15(d) of the Exchange Act is suspended. A publicly held subsidiary is separately subject to Section 162(m) and, therefore, has its own set of covered employees (in other words, a subsidiary is treated separately from its parent company) under the proposed rules.
Planning Point: Late in 2019, the SEC proposed amendments to the definition that would add new categories of individuals and expand the types of entitles that will qualify as accredited investors. The definition of “accredited investor” is generally important because satisfying those criteria allows taxpayers to participate in certain private investments. Relevant criteria include things like the taxpayer’s net worth, but the new definition would also consider professional knowledge, experience or certifications (for example, a Series 7 license). Entities that meet an “investments test” would also qualify. Importantly, a company may be exempt from SEC registration requirements under Section 12(g) if fewer than 2,000 persons hold their securities, if fewer than 500 of those people are not accredited investors. Exemption from registration can exempt a company from the Section 162(m) requirements.
If a disregarded entity that is owned by a privately held corporation is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act, these proposed regulations treat the privately held corporation as a publicly held corporation for purposes of Section 162(m). Similarly, a Qualified Subchapter S Subsidiary (QSub)’s S corporation parent will be treated as a publicly held corporation for purposes of Section 162(m) if the QSub is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act, or is required to file reports under Section 15(d) of the Exchange Act.8
See Q for a discussion of the transition relief that applies with respect to certain executive compensation agreements entered into before the enactment of the 2017 tax reform legislation.
“Applicable employee remuneration” is the aggregate amount of remuneration paid to an employee for services performed (whether or not during the taxable year) that would be deductible if not for this limitation.9 Amounts not considered to be wages for FICA purposes under IRC Sections 3121(a)(5)(A) through 3121(a)(5)(D), including payments to or from any qualified plan, SEP, or Section 403(b) tax sheltered annuity, are not included.10 Pension plan payments received by a chief executive officer who retired and then returned to work within the same tax year were not considered applicable employee remuneration.11 Also excluded are any benefits provided to an employee that are reasonably believed to be excludable from his or her gross income and salary reduction contributions described in IRC Section 3121(v)(1) ( Q 3941).12
Questions also arose as to how a company should identify its most highly compensated employees if their tax year was not also a fiscal year. The proposed regulations provide that the amount of compensation used to identify the three most highly compensated executive officers is determined pursuant to the executive compensation disclosure rules under the Exchange Act using the taxable year as the fiscal year for purposes of making the determination. For example, if a publicly held corporation uses a calendar year fiscal year for SEC reporting purposes, but has a taxable year beginning July 1, 2023, and ending June 30, 2024, then the three most highly compensated executive officers are determined for the taxable year ending June 30, 2024, by applying the executive compensation disclosure rules under the Exchange Act as if the fiscal year ran from July 1, 2023 to June 30, 2024. The same rule applies to short taxable years.
The 2017 tax reform legislation provided for only limited grandfathering of existing remuneration payable under a written binding contract that was in effect on November 2, 2017 (not the date of enactment or later date) and not thereafter modified in any material respect on or after that date.13 Notice 2018-68 narrowed the grandfathering even further by requiring the contract to be binding under applicable law (i.e., primarily applicable state contract law) if the employee performs services or satisfies any vesting requirements. The Notice also ends grandfathering as soon as the written contract is unilaterally terminable or cancelable by the employer, or is renewable. However, amounts under the contract remain grandfathered if: (a) the written binding contract is terminated or cancelable only by terminating the employee’s employment relationship; (b) employee consent is required; or (c) the amount is required to be paid under an arrangement in place as of November 2, 2017, even though the employee was not eligible on that date to participate, as long as that employee had the right to participate in the arrangement under a written binding contract on November 2, 2017.14 Grandfathering is complicated since it not only requires that the administrator identify the covered and noncovered employees in a plan but maintain the grandfathered and nongrandfathered amounts separately for each group, based upon the transition rule (using the November 2, 2017 or other date as determined appropriate). See Q for more detail.
1. IRC § 162(m).
2. IRC § 162(m)(1).
3. IRC § 162(m)(3); Notice 2007-49, 2007-25 IRB 1429.
4. Treas. Reg. § 1.162-27(c)(2)(ii).
5. IRC § 162(m)(3).
6. IRC § 162(m)(4)(F).
7. IRC § 162(m)(2).
8. Prop. Treas. Reg. § 1.162-33(c)(1)(iv).
9. IRC § 162(m)(4).
10. Treas. Reg. § 1.162-27(c)(3)(ii)(A).
11. Let. Rul. 9745002.
12. Treas. Reg. § 1.162-27(c)(3)(ii)(B).
13. 162(m) as amended by PL 115-97.
14. Notice 2018-68.
IRS proposed regulations released early in 2025 clarify that the definition of "employee" for this purpose is the Section 3401(c) definition, including common law employees and officers of the corporation. "Compensation" for this purpose includes any compensation that would be deductible as a business expense absent Section 162(m).
IRC Section 162(m) mandates an upper limit on the amount that a publicly-traded corporation may deduct for compensation paid to certain executives, even though it may well otherwise be reasonable.1 No deduction is permitted for “applicable employee remuneration” in excess of $1 million paid to any “covered employee” by any “publicly-held corporation.”2
Prior to 2018, a “covered employee” was defined as the corporation’s principal executive officer or any other employee who is one of the corporation’s three highest compensated officers (other than the corporation’s principal financial officer).3 This determination is made under the executive compensation disclosure rules of the Securities Exchange Act of 1934.4 The 2017 tax reform legislation expanded the definition of “covered employee” to include the chief financial officer and the chief executive officer (if the individual holds one of these positions at any time during the tax year). A covered employee now includes the three (rather than four) most highly compensated officers (other than the CEO and CFO) for the tax year who must be reported on the company’s proxy statement for the tax year (or who would be required to be reported if the company is not required to provide a proxy statement).5
Planning Point: The IRS proposed regulations provide that the employee need not have served as an executive officer as of the end of the company’s tax year in order to be treated as a covered employee (adopting the rule set forth in Notice 2018-68). Further, executive officers can be covered employees even if their compensation need not be disclosed. In determining the three most highly compensated employees, employers are entitled to rely on a reasonable, good faith interpretation of the statute until further guidance is released. The guidance also clarified that covered employees identified during a tax year that began in 2017 in accordance with pre-tax reform rules will continue to be covered employees for 2018 and beyond.
For tax years beginning after 2017, once the employee becomes a covered employee, he or she will stay a covered employee (even if the compensation is eventually paid to a beneficiary after the individual has died, to a beneficiary of a qualified domestic relations order or if the employee is no longer employed by the employer).6
The term “covered employee” also means any employee who was a covered employee of any predecessor of a publicly held corporation of the taxpayer for any preceding taxable year beginning after December 31, 2016. The proposed regulations use the term “predecessor of a publicly held corporation” for clarity. An individual who is a covered employee for one taxable year (including a taxable year of a predecessor of a publicly held corporation) remains a covered employee for subsequent taxable years. Specifically, a predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held.
The proposed regulations also provide that the term “predecessor of a publicly held corporation” includes a publicly held corporation that is acquired (as a target corporation), or the assets of which are acquired, by another publicly held corporation (the acquiror corporation) in certain transactions. The covered employees of the target corporation in those transactions are also covered employees of the acquiror corporation. With respect to asset acquisitions, if an acquiror corporation or one or more members of an affiliated group (acquiror group) acquires at least 80 percent of the operating assets (determined by fair market value on the date of acquisition) of a publicly held target corporation, then the target corporation is a predecessor of the acquiror corporation or group. For acquisitions of assets that occur over time, only acquisitions that occur within a 12-month period are taken into account to determine whether at least 80 percent of the target corporation’s operating assets were acquired.
The 2017 tax reform legislation also expanded the category of publicly held companies that are subject to the limit to include any company that is required to file reports with the SEC under Section 15(d) of the Securities Exchange Act of 1934, as well as any company with securities registered under Section 12 of the Act.7 The proposed regulations clarify that this determination is made as of the last day of the company’s tax year. However, a corporation will not be considered publicly held if its obligation to file reports under Section 15(d) of the Exchange Act is suspended. A publicly held subsidiary is separately subject to Section 162(m) and, therefore, has its own set of covered employees (in other words, a subsidiary is treated separately from its parent company) under the proposed rules.
Planning Point: Late in 2019, the SEC proposed amendments to the definition that would add new categories of individuals and expand the types of entitles that will qualify as accredited investors. The definition of “accredited investor” is generally important because satisfying those criteria allows taxpayers to participate in certain private investments. Relevant criteria include things like the taxpayer’s net worth, but the new definition would also consider professional knowledge, experience or certifications (for example, a Series 7 license). Entities that meet an “investments test” would also qualify. Importantly, a company may be exempt from SEC registration requirements under Section 12(g) if fewer than 2,000 persons hold their securities, if fewer than 500 of those people are not accredited investors. Exemption from registration can exempt a company from the Section 162(m) requirements.
If a disregarded entity that is owned by a privately held corporation is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act, these proposed regulations treat the privately held corporation as a publicly held corporation for purposes of Section 162(m). Similarly, a Qualified Subchapter S Subsidiary (QSub)’s S corporation parent will be treated as a publicly held corporation for purposes of Section 162(m) if the QSub is an issuer of securities that are required to be registered under Section 12(b) of the Exchange Act, or is required to file reports under Section 15(d) of the Exchange Act.8
See Q for a discussion of the transition relief that applies with respect to certain executive compensation agreements entered into before the enactment of the 2017 tax reform legislation.
“Applicable employee remuneration” is the aggregate amount of remuneration paid to an employee for services performed (whether or not during the taxable year) that would be deductible if not for this limitation.9 Amounts not considered to be wages for FICA purposes under IRC Sections 3121(a)(5)(A) through 3121(a)(5)(D), including payments to or from any qualified plan, SEP, or Section 403(b) tax sheltered annuity, are not included.10 Pension plan payments received by a chief executive officer who retired and then returned to work within the same tax year were not considered applicable employee remuneration.11 Also excluded are any benefits provided to an employee that are reasonably believed to be excludable from his or her gross income and salary reduction contributions described in IRC Section 3121(v)(1) ( Q 3941).12
Questions also arose as to how a company should identify its most highly compensated employees if their tax year was not also a fiscal year. The proposed regulations provide that the amount of compensation used to identify the three most highly compensated executive officers is determined pursuant to the executive compensation disclosure rules under the Exchange Act using the taxable year as the fiscal year for purposes of making the determination. For example, if a publicly held corporation uses a calendar year fiscal year for SEC reporting purposes, but has a taxable year beginning July 1, 2023, and ending June 30, 2024, then the three most highly compensated executive officers are determined for the taxable year ending June 30, 2024, by applying the executive compensation disclosure rules under the Exchange Act as if the fiscal year ran from July 1, 2023 to June 30, 2024. The same rule applies to short taxable years.
The 2017 tax reform legislation provided for only limited grandfathering of existing remuneration payable under a written binding contract that was in effect on November 2, 2017 (not the date of enactment or later date) and not thereafter modified in any material respect on or after that date.13 Notice 2018-68 narrowed the grandfathering even further by requiring the contract to be binding under applicable law (i.e., primarily applicable state contract law) if the employee performs services or satisfies any vesting requirements. The Notice also ends grandfathering as soon as the written contract is unilaterally terminable or cancelable by the employer, or is renewable. However, amounts under the contract remain grandfathered if: (a) the written binding contract is terminated or cancelable only by terminating the employee’s employment relationship; (b) employee consent is required; or (c) the amount is required to be paid under an arrangement in place as of November 2, 2017, even though the employee was not eligible on that date to participate, as long as that employee had the right to participate in the arrangement under a written binding contract on November 2, 2017.14 Grandfathering is complicated since it not only requires that the administrator identify the covered and noncovered employees in a plan but maintain the grandfathered and nongrandfathered amounts separately for each group, based upon the transition rule (using the November 2, 2017 or other date as determined appropriate). See Q for more detail.
1. IRC § 162(m).
2. IRC § 162(m)(1).
3. IRC § 162(m)(3); Notice 2007-49, 2007-25 IRB 1429.
4. Treas. Reg. § 1.162-27(c)(2)(ii).
5. IRC § 162(m)(3).
6. IRC § 162(m)(4)(F).
7. IRC § 162(m)(2).
8. Prop. Treas. Reg. § 1.162-33(c)(1)(iv).
9. IRC § 162(m)(4).
10. Treas. Reg. § 1.162-27(c)(3)(ii)(A).
11. Let. Rul. 9745002.
12. Treas. Reg. § 1.162-27(c)(3)(ii)(B).
13. 162(m) as amended by PL 115-97.
14. Notice 2018-68.
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