Pension & Benefits News IRS final regs address the deduction limit for compensation in excess of $1,000,000
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Wednesday, January 27, 2021

IRS final regs address the deduction limit for compensation in excess of $1,000,000

By Pension and Benefits Editorial Staff

The IRS has issued final regulations under Code Sec. 162(m), which for federal income tax purposes limits the deduction for certain employee remuneration in excess of $1,000,000. These final regulations implement the amendments made to Code Sec. 162(m) by the Tax Cuts and Jobs Act (TCJA, P.L. 115-97).

The final regulations provide guidance related to the limitation on the deduction for employee compensation in excess of $1 million. Specifically, the regulations address:

  • what constitutes a publicly held corporation for purposes of Code Sec. 162(m)(2);
  • the definition of a covered employee for purposes of Code Sec. 162(m)(3);
  • the definition of compensation for purposes of Code Sec. 162(m)(4);
  • the application of Code Sec. 162(m) to a taxpayer’s deduction for compensation for a tax year ending on or after a privately held corporation becomes public; and
  • what constitutes a binding contract and material modification for purposes of the grandfather rule in Code Sec. 162(m)(4)(B).

The IRS has adopted the proposed regulations with a small number of modifications.

The Tax Cuts and Jobs Act. The TCJA modified the definitions of “covered employee,” “compensation,” and “publicly held corporation” for purposes of the limitation on the deduction for excessive employee compensation paid by publicly held corporations.

Publicly held corporations. The TCJA expanded the definition of publicly held corporation to include: (1) corporations with any class of securities and (2) corporations that are required to file reports under section 15(d) of the Exchange Act. The final regulations adopt the proposed regulation’s stance that a corporation is publicly held if, as of the last day of its tax year, its securities are required to be registered under section 12 of the Exchange Act or the corporation is required to file reports under section 15(d).

Under the regulations, a publicly held corporation includes an affiliated group of corporations (affiliated group) that includes one or more publicly held corporations. In addition, a subsidiary corporation that meets the definition of publicly held corporation is separately subject to Code Sec. 162(m) compensation limitations. Furthermore, an affiliated group includes a parent corporation that is privately held if one or more of its subsidiary corporations is a publicly held corporation. The regulations provide further clarification for affiliated groups where certain members are not publicly held. In the case where a covered employee of two or more members of an affiliated group is paid by a member of the affiliated group that is not a publicly held, the compensation is prorated for purposes of determining the deduction.

Covered employees. Under the TCJA, a covered employee is the principal executive officer (PEO), the principal financial officer (PFO), or one of the three other highest compensated executives. The final regulations adopt the proposed regulation’s stance that there is no requirement that an employee must an executive officer at the end of the tax year to be a covered employee. The definition applies regardless of whether the executive officer is serving at the end of the publicly held corporation’s tax year. Covered employees may include employees who have left the corporation. Furthermore, the definition applies regardless of whether the executive officer’s compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules.

The term “covered employee” includes any employee who was a covered employee of any predecessor of the publicly held corporation for any preceding taxable year beginning after December 31, 2016. The regulations provide rules for determining the predecessor of a publicly held corporation for various corporate transactions.

Applicable employee compensation. The final regulations define compensation as the aggregate amount allowable as a deduction for services performed by a covered employee, without regard for Code Sec. 162(m). Compensation includes payment for services performed by a covered employee in any capacity, including as a common law employee, a director, or an independent contractor. The regulations clarify that compensation also includes an amount that is includible in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.

Privately held corporations that become publicly held. In instances where a privately held corporation becomes public, Code Sec. 162(m) applies to the deduction for any compensation that is otherwise deductible for the tax year ending on or after the date that the corporation becomes a publicly held corporation. In addition, the regulations provide that a corporation is considered to become publicly held on the date that its registration statement becomes effective either under the Securities Act or the Exchange Act.

Grandfather rules. The amendments made by the TCJA to Code Sec. 162(m) do not apply to any compensation paid under a written binding contract that is effect on November 2, 2017 and is not materially modified after that date. A contract is binding when it obligates a publicly held company to pay the compensation if the employee performs services or satisfies requirements in the contract. Under the final regulations:

  • The TCJA amendments apply to any amount of compensation that exceeds the amount that applicable law obligates the corporation to pay under a written binding contract that was in effect on November 2, 2017.
  • A provision in a compensation agreement that purports to give the employer discretion to reduce or eliminate a compensation payment (negative discretion) is taken into account only to the extent the corporation has the right to exercise that discretion under applicable law, such as state contract law.
  • Under an ordering rule, the grandfathered amount is allocated to the first otherwise deductible payment paid under the arrangement, then to the next otherwise deductible payment, etc. For tax years ending before December 20, 2019, the final regulations allow the grandfathered amount to be allocated to the last otherwise deductible payment or to each payment on a pro rata basis.
  • A material modification occurs when a contract is amended to increase the amount of compensation payable to the employee. However, a modification that defers compensation is not a material modification if any compensation that exceeds the original amount based on a reasonable rate of interest or a predetermined actual investment.

The final regulations depart from the proposed regulations with respect to the recovery of compensation. Under the proposed regulations, a corporation’s right to recover compensation is disregarded in determining the grandfathered amount only if the corporation recovery right or obligation depends on a future condition that is objectively outside of the corporation’s control. However, the final regulations recognize that a recovery right is a contractual right that is separate from the corporation’s binding obligation to pay the compensation. Accordingly, 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 November 2, 2017.

The final regulations also clarify the application of the grandfather rule to compensation payable under nonqualified deferred compensation (NQDC) plans. Specifically, the grandfathered amount is the amount that the corporation is obligated to pay under the terms of the plan as of November 2, 2017. The regulations also provide rules for calculating the grandfather amount for account balance plans, and analogous rules for nonaccount balance plans when:

  • the corporation is obligated to pay the employee the account balance that is credited with earnings and losses and has no right to terminate or materially amend the contract;
  • the terms of a plan that is a written binding contract as of November 2, 2017, provide that the corporation may terminate the plan and distribute the account balance to the employee; or
  • the plan provides that the corporation may not terminate the contract, but may discontinue future contributions and distribute the account balance.

However, the corporation may instead elect to treat the account balance as of the termination or freeze date as the grandfathered amount regardless of when the amount is paid and regardless of whether it has been credited with earnings or losses prior to payment.

In addition, the final regulations provide that all compensation attributable to the exercise of a non-statutory stock option or a stock appreciation right (SAR) is grandfathered if the option or SAR is grandfathered and the extension satisfies IRS Reg. §1.409A-1(b)(5)(v)(C)(1).

Effective/applicability dates. Generally, these final regulations apply to taxable years beginning on or after the date that they are published as final in the Federal Register. The final regulations include special applicability dates for certain provisions. However, taxpayers may choose to apply these final regulations to a taxable year beginning after December 31, 2017. Taxpayers that elect to apply the final regulations before the effective date must apply the final regulations consistently and in their entirety to that taxable year and all subsequent taxable years.

Source: 85 FR 86481.

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