The IRS issued final regulations on Dec. 18, 2020 to implement changes to) section 162(m). The Tax Cuts and Jobs Act of 2017, P.L. 115-97 (TCJA) significantly amended section 162(m) by changing the definitions of: i) publicly-held corporation; ii) covered employee; and iii) applicable employee remuneration. The TCJA also provided a transition rule for existing compensatory arrangements (the so-called ‘grandfather rule’). In August 2018 the IRS released interim guidance on amended section 162(m) in Notice 2018-68 (the Notice). Next, on Dec. 16, 2019 Treasury issued proposed regulations. The final regulations largely follow prior guidance provided in the proposed regulations and the Notice, with certain additional clarifications and revised examples.
Highlights of the final regulations are summarized here.
Consistent with the proposed regulations, the final regulations define a publicly-held corporation as any corporation that issues securities required to be registered under section 12 of the Securities Exchange Act of 1934 (Exchange Act) or that is required to file reports under section 15(d) of the Exchange Act as of the last day of its taxable year, which can include:
- S corporations;
- Publicly-held subsidiaries;
- Foreign-private issuers;
- Publicly-traded partnerships;
- Affiliated groups with private parent company and public subsidiary or domestic public parent and its foreign private subsidiary (e.g. CFC); and
- Certain disregarded entities of private corporations and qualified subchapter S subsidiaries.
The TCJA amended the definition of covered employee in section 162(m)(3) to include the following employees: i) the principal executive officer (PEO) or principal financial officer (PFO) at any time during the tax year; ii) an employee whose total compensation is required to be reported under the Exchange Act because such employee is among the three highest-paid officers for the taxable year; and iii) any covered employee of the taxpayer (or predecessor) for any taxable year beginning after Dec. 31, 2016. The final regulations retain the rule in the proposed regulations clarifying that the amount of compensation used to identify the three highest-paid officers is determined based on the executive compensation rules under the Exchange Act using the taxable year as the fiscal year.
The final regulations maintain consistency with the position set out in Notice 2018-68 and the proposed regulations that a covered employee means any employee who is among the three highest-compensated executive officers for the taxable year regardless of whether; i) the executive officer is employed by the publicly-held corporation on the last day of its taxable year; or whether ii) his or her compensation is subject to disclosure for the fiscal year under SEC rules.
It should also be noted that the definition of covered employee applies to anyone who was a covered employee of a predecessor entity for tax years beginning on or after Jan. 1, 2017. The regulations provide that a predecessor of a publicly-held corporation includes:
- The publicly-held corporation, itself, if it was public in a prior tax year (with certain timing rules);
- A publicly-held corporation that is acquired, or the assets of which are acquired, by another publicly-held corporation in the following transactions:
- Reorganizations described in section 368(a)(1);
- Corporate divisions, e.g., where public distributing corporation distributes controlled corporation thus becoming publicly-held in a section 355(a)(1) transaction;
- Stock acquisitions; or
- Asset acquisitions of at least 80% of the fair market value of operating assets. The final regulations clarify that this test is based on gross as opposed to net operating assets.
In the case of a deemed asset acquisition under sections 336(e) or 338, the corporation is treated as the same corporation before and after the election.
In addition, the regulations provide that these rules are applied cumulatively such that a predecessor includes predecessors of prior predecessors.
Applicable employee remuneration
Similar to the proposed regulations, the final regulations use the term ‘compensation’ instead of ‘applicable employee remuneration’ wherever possible for simplicity.
The final regulations adopt the position in the proposed regulations that section 162(m) is not limited to deductions for compensation paid by the publicly-held corporation, it would also cover deductions for compensation paid to the corporation’s covered employees to the extent the corporation is allocated a share of the deduction from a lower-tier partnership. Accordingly, section 162(m) applies in the case of a publicly-held corporate partner’s allocated distributive share of the partnership’s compensation deduction even though the corporation did not pay the compensation to the covered employee. The final regulations provide additional limited transition relief for this rule such that compensation includes a publicly-held corporation’s distributive share of a partnership’s deduction for compensation paid by the partnership after Dec. 18, 2020 (the date the final regulations were released). It should be noted that this rule does not apply to compensation paid pursuant to a written binding contract in effect on Dec. 20, 2019 (the date the proposed regulations were published) that is not materially modified after that date.
Further, the final regulations retain the position from the proposed regulations that compensation earned by a covered employee, through a non-employee position, such as director, is within the scope of section 162(m).
Limited transition relief
In the case of a privately-held corporation that becomes publicly held, section 162(m) applies to the deduction for any compensation that is otherwise deductible for the taxable year ending on or after the date the corporation becomes publicly held (i.e., the date its registration statement becomes effective). The final regulations clarify that a subsidiary member of an affiliated group may rely on transition relief in the 1995 regulations only if it became a separate publicly held corporation (e.g., in a spin-off) on or before Dec. 20, 2019, whereas members of an affiliated group that includes a publicly-held corporation are otherwise considered publicly held and may not avail themselves of this transition relief.
The final regulations consistently follow prior guidance in the proposed regulations and Notice 2018-68 with respect to the application of the grandfather rule and include illustrative examples with a notable departure: the final regulations provide that the corporation’s right to recover compensation does not affect the determination of the amount of compensation the corporation has a written binding contract to pay under applicable law as of Nov. 2, 2017, regardless of whether the corporation exercises its discretion to recover any compensation in the future. Under the proposed regulations such right would have been disregarded.
Amendments under the TCJA generally apply to tax years beginning after Dec. 31, 2017, however they do not apply to remuneration paid pursuant to a written-binding contract in effect on Nov. 2, 2017 that is not materially modified thereafter. The grandfather rule continues to rely on state law in making the written-binding contract determination and whether the corporation may exercise negative discretion. Treasury and IRS considered comments on applying a safe harbor based upon generally accepted accounting principles but did not adopt that in the proposed or final regulations.
The final regulations expand detailed provisions explaining the application of the grandfathered status of account and nonaccount balance plans, and earnings on those plans, as well as severance arrangements and trimmed some examples after adding clarifying text to the regulations.
The regulations retain the prior clarification that the lapse of the substantial risk of forfeiture is not considered a material modification in certain circumstances. The final regulations also provide ordering rules for mixed payments, i.e., payments consisting of grandfathered and non-grandfathered amounts which allocate the grandfathered amount to the first otherwise deductible payment under the plan to taxable years ending on or after Dec. 20, 2019.
Coordination with section 409A
The final regulations recognize that further coordination between sections 162(m) and 409A is necessary and provide that until such guidance is issued taxpayers may continue to rely on the preamble to the proposed regulations.
Overall, the regulations are consistent with and closely track guidance from the proposed regulations and Notice 2018-68 that many companies have already analyzed for purposes of reporting prior periods. The final regulations are generally effective (other than with respect to certain definitions (i.e., covered employee, predecessor and compensation limited transition relief and grandfather rule described above) as of the date of publication in the Federal Register and apply to tax years beginning on or after that date but may be relied upon (if relied upon in their entirety) for taxable years beginning after Dec. 31, 2017.