On Jan. 14, 2025, IRS released proposed regulations, REG-118988-22, to provide proposed guidance on the ARPA amendments to section 162(m). Section 162(m) disallows a deduction by any public corporation for compensation paid in excess of $1 million if it is paid to a “covered employee” during the taxable year. Originally added to the Internal Revenue Code (Code) in 1993, section 162(m) underwent significant amendment under the Tax Cuts and Jobs Act in 2017. Those amendments were aimed at expanding the reach of section 162(m). Among other changes, the definition of covered employee was modified to include not just the CEO, CFO, and the top three highest paid officers, but also anyone who, in 2017 or later, had ever been in one of those top five spots, even if they were not any longer (the “once covered, always covered” rule). As a result of this rule, the number of officers identified by a publicly held corporation as covered employees has likely grown over time. In 2021, the ARPA further expanded section 162(m), specifically increasing the number of individuals that fell within the definition of covered employee, effective for tax years beginning after 2026.
Section 162(m), as amended by ARPA, provides that after 2026, covered employees will include not only CEO, CFO, top three highest paid officers and once covered, always covered individuals, but also “the 5 highest compensated employees” during the taxable year. The proposed regulations provide that for purposes of determining the five highest compensated employees, the term employee means an employee as defined in section 3401(c). In general, under section 3401(c) and the regulations, the term employee includes a common law employee and an officer of a corporation. Therefore, under the new proposed regulations, the new category of covered employees that includes the five highest compensated employees can include both officers and other employees.
While the amendments to section 162(m) provide that the five highest compensated employees are determined each taxable year, the proposed regulations clarify that individuals who are already on the once covered, always covered list of covered employees (but who are not in the current year’s CEO, CFO or top three highest paid officer spots) can fill one or more of the five highest compensated employees spots. Prior to publication of the proposed regulations, it was unclear whether the five highest compensated employees would have to be identified in addition to the covered employees in the “once covered, always covered” category, which could have resulted in an even longer list of covered employees whose compensation over $1 million would be subject to a deduction disallowance for a taxable year. An individual that is a covered employee during a taxable year due to being one of the five highest compensated employees is only a covered employee for that year; they do not become designated as a once covered, always covered employee only by virtue of holding one of these spots. However, an employee already in the once covered, always covered group remains in that group even if the employee is later not included as one of the five highest paid employees under ARPA.
Compensation used to determine whether an individual is one of the five highest compensated employees means compensation that would be deductible for the taxable year, notwithstanding the limitation of section 162(m). This generally means compensation reported in box 1 of Form W-2, Wage and Tax Statement (perhaps with some timing differences). This is different than compensation required to be used for determining the three highest compensated officers, which is the total compensation required to be disclosed under the Exchange Act for executive officers. The preamble to the proposed regulations indicates that because the five highest compensated employees may not necessarily be officers subject to Securities and Exchange Commission (SEC) disclosure, this approach is expected to be more administrable.
An “employee” of a publicly held corporation includes an individual who is an employee of a related but unaffiliated entity or a third-party (e.g., a professional employer organization) but functions as an employee of the public corporation. This rule also applies regardless of how the amounts are paid or denominated and regardless of whether the individual is paid by the publicly held corporation or the third-party.
The current section 162(m) regulations set forth extensive rules and examples of how the affiliated group rules apply with respect to identifying covered employees and applying the deduction limitation under section 162(m). These rules continue to apply to the existing covered employee categories, and the proposed regulations broaden the reach of these rules as they apply to identifying the five highest compensated employees and determining compensation paid to such employees. The preamble to the regulations provides that the affiliation rules have been expanded to prevent companies from moving highly paid employees to related companies in order thwart Congress’ intent to expand the number of covered employees subject to section 162(m).
For an affiliated group with one publicly held corporation, an employee of any member of an affiliated group is eligible to be one of the five highest compensated employees of the public corporation regardless of whether the individual is an employee of the public corporation itself or performs services for the public corporation itself. In addition, if an employee has compensation from more than one member of the affiliated group, the compensation from each affiliated group is added together in determining the total compensation paid to the individual employee for the five highest compensated group. For an affiliated group with more than one public corporation, the group of employees eligible to be the five highest compensated employees is determined separately with respect to each publicly held corporation in the group. In this situation, the proposed regulations provide rules for which members of the affiliated group each publicly held corporation should take into account in determining its five highest compensated employees and its deduction disallowance under section 162(m).
The proposed regulations also clarify that the definition of compensation includes amounts paid by a controlled foreign corporation (CFC) that is a member of an affiliated group with a publicly held corporation, to the extent that the compensation expense is allocable to the publicly held corporation. Comments are requested on the application of this rule to CFCs and whether the proposed rules should apply to CFCs that are not members of an affiliated group.
Comments are requested on all parts of the proposed regulations by March 17, 2025.
The proposed regulations generally apply to compensation that is otherwise deductible for taxable years beginning after the later of Dec. 31, 2026, or the date of publication of the final regulations. Companies that are or may become subject to the section 162(m) rules should be considering the ARPA changes to section 162(m), and whether there is any proactive planning that can be done to minimize the impact of the new rules.
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