Seyfarth Synopsis: On January 16, 2025, the IRS issued proposed regulations under Section 162(m) of the Internal Revenue Code of 1986 (the “Code”), which limit the amount of compensation a publicly held corporation may deduct for wages paid to its “covered employees” to $1 million per year. Section 162(m) has been amended over the years to expand the definition of a “covered employee,” which originally was limited to a corporation’s principal executive officer (“PEO”), principal financial officer (“PFO”), and its next three most highly compensated executive officers. Most recently, in 2021 the American Rescue Plan Act of 2021 (“ARPA”) amended the definition of “covered employee” to include, for tax years beginning after December 31, 2026, the corporation’s five highest compensated employees other than its PEO, its PFO and its next three most highly compensated executive officers. The proposed regulations provide guidance on determining and applying Section 162(m) to these next five most highly compensated employees.

Background

In 2017, as part of the Tax Cuts and Jobs Act, Section 162(m) was amended to, among other things, (i) eliminate the exception for “performance-based compensation,” (ii) broaden the definition of “publicly held corporation” by including certain companies with registered debt subject to the reporting requirements of Section 15(d) of the Securities Exchange Act of 1934 (the “Exchange Act”) and certain foreign private issuers, and (iii) expand the definition of “covered employee” by providing that a person considered a covered employee in one year would continue to be considered a covered employee in all future years (often referred to as the “once a covered employee, always a covered employee” rule).

In 2021, ARPA further expanded the definition of “covered employee” with new Section 162(m)(3)(C), which added any employee who is among the five highest compensated employees for the corporation’s tax year, other than the PEO, the PFO, or the three highest compensated executive officers for the tax year other than the PEO and the PFO (the “High Five”). This change is effective for tax years beginning after December 31, 2026.

The proposed regulations provide guidance on how to determine and apply Section 162(m) to the High Five, including the following:

Determining the High Five: 

  • The term “employee” is to be determined under Section 3401(c) of the Code.
  • Employees include common law employees and certain employees providing services to the corporation through a “professional employer organization.”
  • A person is considered an employee if the person is an employee on any day in the year, regardless of whether the person is employed on the last day of the year.

Compensation:  Unlike the determination of the three most highly compensated executive officers other than the PEO and PFO, which is based on total compensation required to be disclosed under the Exchange Act (i.e., in the  company’s proxy statement), the High Five are determined based on compensation subject to Section 162(m)’s deduction limit in accordance with current Treas. Reg. § 1.162-33(c) (generally, compensation that would, but for Section 162(m), be allowable as a deduction). The proposed regulations note “[t]he Treasury Department and the IRS expect this approach to be easily administrable.” However, there likely will be disconnects between the compensation amounts for the three most highly compensated executive officers other than the PEO and PFO and the High Five in light of the significant differences between how compensation is determined for the two groups. Also, the determination of the High Five could be significantly impacted by the form or method in which compensation is paid, such as vesting, deferred payments, option exercises, etc., and would not include amounts for which there is no corporate tax deduction (because compensation would be measured based on current year deductibility).

Affiliated Groups:

  • If an employee of a publicly held corporation is paid by more than one member of a corporation’s affiliated group, then compensation from all affiliated group members is aggregated for purposes of determining whether the employee is one of the High Five, without regard to whether employee performs services for the publicly held corporation directly subject to Section 162(m).
  • The proposed regulation also addresses application of Section 162(m) to an affiliated group that includes more than one publicly held corporation, providing that the affiliated group is divided into smaller affiliated groups, each consisting of a publicly held corporation and certain affiliated non-publicly held corporations, if any, and that each publicly held corporation affiliated group then would have its own High Five.

Some Special Considerations:

  • The High Five Already May be Covered Employees. The proposed regulations clarify that a covered employee by reason of being one of the High Five also may be a covered employee because of the once a covered employee, always a covered employee rule. To the extent there is overlap in any year, there will be fewer covered employees in that year.
  • Once a Covered Employee, Always a Covered EmployeeRule Does Not Apply to the High Five. As expected, the proposed regulations confirm the High Five should be determined annually, and employees may become covered or cease to be covered from one year to the next.

Comments on the proposed regulations are due by March 17, 2025. Please contact the employee benefits attorney at Seyfarth Shaw LLP with whom you usually work if you have any questions regarding the proposed regulations.