IRS proposes rules for determining additional 162(m) “covered employees” beginning in 2027
Background
Section 162(m) limits the amount of compensation public companies can deduct from income taxes to $1 million a year for covered employees. Currently, Section 162(m) covered employees (“current covered employees”) are:
- The CEO or CFO at any time during the tax year;
- The next three highest-paid executive officers during the tax year (based on compensation used to determine proxy named executive officers (NEOs) but ignoring whether such employee was an executive officer as of the last day of the tax year); and
- Anyone who was a covered employee for any tax year beginning after December 31, 2016 (the so-called “once a covered employee, always a covered employee” rule).
Under ARPA, beginning in 2027, covered employees will also include the next five highest-paid employees during a tax year regardless of whether they are officers (“additional covered employees”). Additional covered employees aren’t subject to the “once a covered employee, always a covered employee” rule.
The proposed rules
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Employees would be defined as employees under IRC Section 3401, which generally includes common law employees and officers.
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Additional covered employees would be identified based on compensation that would (but for section 162(m)) be allowable as a deduction in a given year (vs. compensation used to determine NEOs). This means compensation granted prior to 2027 would count if deductible in 2027 or later. Bonuses and full-value stock units are generally deductible at settlement, restricted stock is deductible at vesting and stock options are deductible at exercise.
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An individual who is already a current covered employee under the “once a covered employee, always a covered employee” rule could count as one of the five additional covered employees in any given year (which could reduce the number of additional covered employees for that year).
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To prevent workarounds to avoid the cap:
- As is the case with current covered employees, employees of any corporation in an affiliated group (including foreign corporations) could be additional covered employees regardless of whether they are employees of or perform services for the public company. When affiliated groups contain more than one public company, each public company would have its own list of covered employees and additional rules would apply when calculating compensation.
- Employees would include individuals who are employees of a third-party employer (such as a related but unaffiliated organization, a professional employer organization (“PEO”) or an external manager) if these individuals function as employees of the public company. In these situations, compensation would be the amount paid by the public company to the third party for work that would otherwise have been deductible by the public company (e.g., service fees paid to a PEO or management fees paid to an external manager).
Next steps
Companies should assess their internal systems to ensure they can track compensation using the proposed definition and rank employees by pay. Once the proposed rules are final, companies may want to weigh the pros and cons (and permissibility under IRC Section 409A) of accelerating 2027 payments to 2026 to preserve deductibility.
