IRS issues Final Regulations on TCJA changes to Section 162(m) $1 million compensation deduction limitation

Since 1993, Internal Revenue Code (IRC) Section 162(m) has imposed a $1 million deduction limitation on compensation paid to certain “covered employees” of publicly held corporations. The Tax Cuts and Jobs Act of 2017 (TCJA) significantly altered these rules, effective for tax years beginning after Dec. 31, 2017, by:

  • Eliminating the prior law exceptions for commissions and for “qualified performance-based compensation.” 
  • Treating the principal financial officer as a “covered employee.”
  • Eliminating the “employment on the last day of the corporation’s tax year” requirement for “covered employee” status.
  • Establishing that once a “covered employee,” the individual remains subject to the $1 million deduction limitation indefinitely.
  • Expanding the “publicly held corporation” standard to include companies required to report under Section 15(d) of the Securities Exchange Act of 1934 (the Exchange Act), foreign private issuers, or private companies with registered debt offerings.
  • Providing certain limited grandfathering relief for arrangements in place under a written binding contract in place as of Nov. 2, 2017.

In 2018, the IRS issued Notice 2018-68, which provided interim guidance on the TCJA changes until Proposed Regulations were issued in late December 2019. 

The IRS has now finalized these regulations. The Final Regulations generally follow the Proposed Regulations, with certain modifications and clarifications based on public comments.

“Publicly held corporation”

  • Any corporation (including an S corporation) that as of the last day of its tax year is required to (1) register its securities under Section 12 of the Exchange Act (i.e., to list securities for trading on a national exchange, or, where assets exceed $10 million, to register securities held by 2,000 or more persons or 500 or more non-accredited investors), or (2) file reports under Section 15(d) of the Exchange Act (i.e., private foreign issuers of ADRs traded in the U.S. or certain issuers of public debt). 
    • These determinations are to be made as of the last day of the corporation’s tax year. (If registration or the filing requirement is suspended as of the last day of such year, Section 162(m) is not applicable.) 
    • Applies to publicly traded partnerships that are treated as corporations for federal tax purposes (e.g., under IRC Section 7704).
    • Applies to “foreign private issuers” required to register securities under Section 12 of the Exchange Act or file reports under Section 15(d) of the Exchange Act, even if the reports are not required to provide a summary compensation table. In the process of preparing the Final Regulations, the IRS considered but determined not to provide a safe harbor for use by foreign private issuers that are not required to disclose the compensation of their officers.
  • The requirements apply separately to a subsidiary (and its covered employees) of a publicly held corporation that is itself a publicly held corporation. The Final Regulations provide that where a covered employee of a publicly held corporation that is a member of an affiliated group also provides services to and is compensated by one or more other group members, the compensation from all group members is to be aggregated, and any compensation deduction amount disallowed under Section 162(m)(2) is to be prorated among the group members in proportion to the respective compensation paid by each. However, and conversely, if more than one of the group members compensating a covered employee is a publicly held corporation, the deduction disallowance is to be calculated separately for each.
  • A corporation that owns a disregarded entity is treated as the issuer of any securities issued by the disregard.

“Covered employee”

  •  Principal executive officer or principal financial officer at any time during the corporation’s tax year (or an individual acting in such capacity). 
  • Based on the SEC disclosure rules, the three highest-paid executive officers for the corporation’s tax year, other than the PEO or PFO (regardless of whether the officer is employed on the last day of the corporation’s tax year, and even if the officer’s compensation is not required to be reported to shareholders under the Exchange Act).
    • As the SEC disclosures are based on the corporation’s fiscal year, where a corporation’s fiscal and tax year differ, the determination of the three highest-paid executive officers is based upon the SEC rules, but using the tax year-end as the fiscal year-end for such purpose.
  • Once a “covered employee,” the individual remains subject to the $1 million deduction limitation indefinitely. 

Predecessor corporations

  • “Covered employee” includes any employee who was a covered employee of a “predecessor corporation” for any preceding tax year beginning after Dec. 31, 2016. The following would be considered a “predecessor corporation”:
  • A publicly held corporation that goes private and then again becomes public within 36 months of the due date of the last income tax return filed when it was publicly held.
  • A publicly held corporation acquired via a stock sale or an 80% or greater assets sale (based on fair market value of the assets as of the sale date). The Final Regulations clarify that for this purpose, the test is to be based on gross operating assets, rather than net operating assets as was the case under the Proposed Regulations. 
  • A publicly held corporation that is acquired or is the transferor in an IRC Section 368(a)(1) reorganization.
  • A subsidiary spun off to its shareholders by a publicly held corporation.

Partnership-level compensation

  • A publicly held corporation that holds a partnership interest is required to take into account its distributive share of the partnership’s compensation deduction for compensation paid by the partnership to the publicly held corporation’s covered employee, and combine that amount with the corporation’s own compensation payments to such covered employee.

Elimination of IPO transition rule

  •  The prior-law transition rule that deferred the applicability of IRC Section 162(m) to corporations undergoing an IPO is no longer available.

Modification of grandfather rule

  • Accelerated vesting will not be treated as a material modification that would otherwise preclude grandfathering of an arrangement under a written binding contract in place as of Nov. 2, 2017.
  • Under the Final Regulations, a publicly held corporation’s right to recover compensation upon the occurrence in the future of a condition beyond its control does not affect the determination of the compensation amount subject to a written binding contract in place as of Nov. 2, 2017.
  • The Final Regulations provide new rules clarifying the determination of grandfathered amounts under account balance and nonaccount balance nonqualified deferred compensation plans.
  • Under the Final Regulations, the grandfathered amount payable under a plan or arrangement is to apply only to the amounts paid under the specific grandfathered plan or arrangement. The Preamble to the Final Regulations provides as an example that if all or some of a grandfathered amount were forfeited, the unpaid amount under that grandfathered arrangement could not be used as a grandfathered amount under a different arrangement for the same covered employee.
  • The Final Regulations clarify that if compensation from the exercise of a nonqualified stock option or stock appreciation right (SAR) is grandfathered and the exercise period under the option or SAR is extended, the compensation from the exercise will be grandfathered (1) if the extension occurs when the option or SAR is “underwater,” or (2) if the extension is to a date that is no later than the earlier of the latest date upon which the option or SAR would have expired under its original terms, or the 10th anniversary of the original grant date.

Effective Date

The Final Regulations will generally be effective for the 2021 tax year; however, they can be applied to tax years beginning after Dec. 31, 2017, provided that they are applied in their entirety and in a consistent manner for all subsequent years.

What does CohnReznick think?

The changes to Section 162(m) under the Tax Cuts and Jobs Act were very significant, especially the elimination of the exception for qualified performance-based compensation. With limited additional rules and clarifications reflecting public comments, the Final Regulations generally follow the Proposed Regulations. 


Dana Fried, JD, LLM, Managing Director, National Tax Services


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