17 December 2019

IRS and Treasury propose to expand scope of IRC Section 162(m) limit on deductions for executive compensation

The IRS and Department of the Treasury have released proposed regulations (REG-122180-18) that would significantly expand the scope of IRC Section 162(m) so that the limit on executive compensation deductions would apply to more taxpayers and types of compensation. While the regulations are generally proposed to be effective upon publication of the final rule, several specific provisions are proposed to be effective on earlier dates, including tax years beginning on or after the publication date in the Federal Register of these proposed regulations (expected to occur December 20, 2019).

The proposed regulations would permit taxpayers to rely on the proposed regulations pending finalization, but only if they apply the proposed regulations in their entirety.

Background

IRC Section 162(m) imposes a $1-million limit on the deduction that a "publicly held corporation" is allowed for compensation paid to a "covered employee." IRC Section 162(m) was originally enacted as part of the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), effective for tax years beginning on or after January 1, 1994. Comprehensive final regulations were published in 1995 (1995 Regulations).

As originally enacted, IRC Section 162(m) defined a "covered employee" as the CEO and the next four highest-compensated officers whose compensation was required to be reported to shareholders under the Securities Exchange Act of 1934 (Exchange Act). When the SEC rules were later amended to require disclosure for the CEO, the CFO, and the three highest-compensated officers other than the CEO and the CFO, the IRS concluded that there would be only four "covered employees" in most cases: the CEO and the three highest-compensated officers other than the CEO and the CFO.1 For all "covered employees," the 1995 Regulations imposed a "last day" requirement: compensation paid to an individual who was no longer a covered employee on the last day of the corporation's tax year (such as severance and other deferred compensation payments) was not subject to the $1 million deduction limit.

Only publicly held companies that were required to register their common stock under Section 12 of the Exchange Act were subject to IRC Section 162(m) as it was originally enacted — it did not apply to companies that registered debt, voluntarily registered their common stock, or were foreign private issuers traded on US exchanges via American Depository Receipts (ADRs). Moreover, IRC Section 162(m) originally contained a significant exception for performance-based compensation, including cash and stock-based compensation, contingent upon the attainment of objective performance goals and meeting other requirements, as well as for most stock options and stock appreciation rights.

The TCJA made several amendments to IRC Section 162(m) to expand its applicability, including:

  • Eliminating the exception for performance-based compensation
  • Expanding the definition of "covered employee" to include the CFO, plus any individual who had ever been a covered employee of the publicly held corporation or any predecessor for any tax year beginning after December 31, 2016 (thus, under the TCJA amendments, once an individual is identified as a covered employee, the deduction limitation applies to the compensation paid to that individual, even after the individual no longer holds that position or has separated from service)
  • Expanding the definition of "publicly held corporation" to include certain companies to the extent those companies must report under Section 15(d) of the Exchange Act, including foreign private issuers or private companies that have registered debt offerings

All of these amendments were generally effective for tax years beginning after December 31, 2017, but a grandfather rule provides that any compensation paid under a written binding contract that was in effect on November 2, 2017, and not materially modified on or after that date, remains subject to IRC Section 162(m) as it existed before the TCJA amendments.

In August 2018, the IRS and Treasury released Notice 2018-68, with guidance on a limited number of issues arising under the TCJA amendments. Regarding the definition of "covered employee," the notice confirmed that the "last day" rule that applied under the 1995 Regulations was eliminated, so the compensation of a covered employee may be subject to IRC Section 162(m) in some cases, even though it is not subject to disclosure under the SEC rules. The notice also clarified various aspects of the grandfather rule, generally applying analogous transition rules from the 1995 Regulations. (See Tax Alert 2018-1679 for a more detailed description of Notice 2018-68.)

Proposed regulations

Rather than amending the 1995 Regulations to reflect the TCJA amendments, the new proposed regulations provide a separate, comprehensive set of rules. (The 1995 Regulations will continue to apply to grandfathered amounts.) The proposed regulations include: (1) rules on the TCJA amendments (only some of which were contained in Notice 2018-68); (2) new rules completely unrelated to the TCJA amendments; and (3) certain existing rules carried over from the 1995 Regulations. The proposed regulations also include more than 80 examples. Given the comprehensiveness of the proposed regulations, this Alert focuses on the most significant provisions that are likely to affect many taxpayers.

Publicly held corporation definition

  1. Determination of a 'publicly held' corporation subject to IRC Section 162(m)

Proposed rules

Like the 1995 Regulations, the proposed regulations look to the last day of the corporation's tax year to determine its status as a publicly held corporation. However, the proposed regulations reflect the TCJA amendments, under which a corporation is considered publicly held if any of its securities must be registered under Section 12 of the Exchange Act or the corporation must file reports under Section 15(d) of the Exchange Act. Under the proposed regulations, a corporation is not considered publicly held while its obligation to file reports under Section 15(d) is suspended. The proposed regulations also clarify that a subsidiary of a publicly held corporation is itself a publicly held corporation and separately subject to IRC Section 162(m) under the affiliated group rules discussed later.

Implications

The relief from IRC Section 162(m) for periods of "suspended" reporting under the SEC rules will be met favorably by many otherwise "private" companies that have public debt issuances. However, the proposed rule raises some technical questions about how these taxpayers may plan for the application of IRC Section 162(m) in tax years when the applicable SEC reporting is not suspended. Careful study of the examples on affiliated groups and the separate application of IRC Section 162(m) to affiliates that are public issuers will be merited. The examples help to clarify many of the issues that have arisen under the amended definition of "publicly held corporation."

  1. Foreign private issuers

Proposed rules

Citing the TCJA amendments and legislative history, the proposed regulations reject a commenter's suggestion to exempt foreign private issuers from IRC Section 162(m). The proposed regulations do, however, recognize that a safe harbor for these corporations may be appropriate, given that they are not subject to the SEC executive compensation disclosure rules and thus may incur undue burdens identifying their covered employees.

Implications

Because a foreign private issuer and its affiliates are subject to IRC Section 162(m), a US affiliate filing a US federal income tax return may find that compensation for its employees is subject to the $1 million deduction limitation if those employees would be covered employees. Foreign private issuers should consider whether to comment on the proposed regulations to suggest possible safe harbors for identifying covered employees because this determination is not being made for SEC purposes.

  1. Affiliated groups and disregarded entities

Proposed rules

The proposed regulations generally retain the 1995 Regulations' rules for affiliated groups of corporations. Under those rules, a publicly held corporation includes an affiliated group of corporations as defined in IRC Section 1504 (without regard to IRC Section 1504(b)), but each publicly held subsidiary and its subsidiaries (if any) are separately subject to IRC Section 162(m). The proposed regulations include a new rule under which IRC Section 162(m) would apply to a privately held parent corporation with a publicly held subsidiary. The proposed regulations would also expand on the 1995 Regulations' rules for prorating the deduction disallowance among the members of an affiliated group.

The proposed regulations include a new rule for disregarded entities. If a disregarded entity owned by a privately held corporation is an issuer of securities required to be registered under Section 12(b) or 15(d) of the Exchange Act, the proposed regulations would treat the otherwise privately held corporation as a publicly held corporation for purposes of IRC Section 162(m). The proposed regulations include a similar rule for QSubs (certain wholly owned subsidiaries of S corporations).

Implications

Taxpayers should carefully consider how the proposed rules for affiliated groups and disregarded entities would apply to their compensation arrangements and consider whether it would be beneficial to comment on the proposed regulations.

Covered employee definition

Proposed rules

The proposed regulations generally follow the methodology for identifying covered employees that was set forth in Notice 2018-68. The IRS and Treasury declined to adopt some comments requesting simplification.

Notice 2018-68 did not address how to identify the three most highly compensated executive officers if the corporation's fiscal year and tax year do not align, such as when the corporation has a full 12-month fiscal year but a short tax year. Under the proposed regulations, the SEC executive compensation disclosure rules would apply as if the relevant tax year (a short tax year, for example) were the corporation's fiscal year. This rule is proposed to apply to tax years beginning on or after the publication of the proposed regulations in the Federal Register (which is expected to occur on December 20, 2019).

Notice 2018-68 also did not address how to identify the predecessor of a publicly held corporation for purposes of the rule that treats an individual as a covered employee if the individual was a covered employee of the publicly held corporation or any predecessor corporation for any tax year beginning after December 31, 2016. The proposed regulations supply rules for a variety of corporate transactions: reorganizations, divisions, stock acquisitions, and asset acquisitions. These rules are proposed to apply to corporate transactions for which all events necessary for the transaction occur on or after the date the final regulations are published in the Federal Register. The proposed regulations also would treat a corporation as its own predecessor if it goes from being publicly held to being privately held and then back to being publicly held again within a three-year period (if corporation becomes publicly held again on or after the final regulations are published in the Federal Register).

The proposed regulations would also treat employees of disregarded entities and QSubs as covered employees of their corporate owners if those employees are executive officers of the corporate owner under the SEC rules.

Implications

The proposed regulations' rules for identifying covered employees and adoption of the standards in Notice 2018-68 will create significant administrative complexity. Even for taxpayers that are filing a summary compensation table under SEC rules, relying on a summary compensation table to identify covered employees is not foolproof. The proposed regulations retain the principles set forth in Notice 2018-68 that a departing executive who has never appeared on a summary compensation table (as a result of SEC rules limiting reporting for former executives) might nonetheless be a covered employee for purposes of IRC Section 162(m). Such a fact pattern may arise more often than expected in the context of transactions.

Further, for any tax year that does not align with the corporation's fiscal year, a special application of the SEC executive compensation disclosure rules would be needed, in many cases requiring the involvement of separate securities and tax law specialists. The rules for predecessor corporations would add further complexity to the TCJA-imposed burden of tracking former covered employees indefinitely. The IRS and Treasury may believe that the TCJA amendments leave them with little choice but to apply IRC Section 162(m) in this manner, but taxpayers should consider whether to comment on these rules and suggest simpler alternatives.

'Applicable employee remuneration' definition

  1. General rule

Proposed rules

The proposed regulations define "applicable employee remuneration" (referred to in the regulations as "compensation" for simplicity) as: (1) the aggregate amount allowable as a deduction under chapter 1 of the Code for the tax year; (2) determined without regard to IRC Section 162(m); (3) for compensation for services performed by a covered employee, (4) whether or not the services were performed during the tax year. The proposed regulations reiterate that compensation includes an amount that is includible in the income of, or paid to, a person other than a covered employee, including after the death of the covered employee.

Implications

Employers subject to IRC Section 162(m) will have the additional administrative burden of tracking the deductibility of the compensation to be paid to previously employed covered employees.

  1. Partnerships' payment of compensation

Proposed rules

Among the most significant new rules in the proposed regulations are the rules for partnerships. These rules are unrelated to the TCJA amendments and were not in the 1995 Regulations.

The proposed regulations would apply IRC Section 162(m) to compensation payments made to a covered employee by a partnership to the extent the IRC Section 162 deduction for that compensation is allocated to a publicly held corporation (or its affiliate) based on the corporation's interest in the partnership. This result is contrary to four private letter rulings2 and would effectively subject certain real estate investment trusts (REITs) and businesses with so-called Up-C partnership structures (in which a publicly held corporation holds an interest in a lower-tier operating partnership) to IRC Section 162(m) for the first time. This proposed regulation would have a special grandfather rule: it would not apply to compensation paid under a written binding contract in effect on the date the proposed regulations are published in the Federal Register and that is not materially modified after that date.

The proposed regulations would also apply IRC Section 162(m) to a "publicly traded partnership," as defined in IRC Section 7704. The Preamble explains that, because a publicly traded partnership generally is treated as a corporation for purposes of the Code, IRC Section 162(m) applies to a publicly traded partnership that is treated as a corporation, just as it would apply to a corporation.

Finally, the Preamble to the proposed regulations notes the possibility that a taxpayer might attempt to use a partnership to circumvent IRC Section 162(m) and cites the anti-abuse rules under Treas. Reg. Section 1.701-2 and other federal income tax principles as possible impediments.

Implications

The new rule for partnership compensation deductions that are allocated to publicly held corporations is a dramatic departure from the 1995 Regulations and has the potential to significantly affect a large number of taxpayers that were not previously subject to IRC Section 162(m). Many REITs and other businesses with "Up-C" partnership structures have taken the position that IRC Section 162(m) does not apply to their compensation deductions based on a technical analysis of the 1995 Regulations and the four private letter rulings, none of which has been revoked.

If the proposed rule goes into effect, a publicly held corporation with an interest in a lower-tier partnership will need to find a way to identify compensation payments made to its corporate covered employees by the partnership. It is not clear whether the IRS anticipates making changes to Form 1065, Schedule K-1, or has some other reporting requirement in mind.

In contrast to the change for "Up-C" and REIT structures, the proposed regulations' application of IRC Section 162(m) to publicly traded partnerships may not be as broad. Because of the IRC Section 7704(c) exception for passive-type income, many would-be publicly traded partnerships are not treated as corporations. Accordingly, many publicly traded partnerships with passive-type income will be treated as partnerships and therefore will not be considered publicly held corporations for the purposes of IRC Section 162(m). On the other hand, the new rule could very significantly affect an entity that is treated as a corporation under IRC Section 7704.

  1. Compensation paid to independent contractors

Proposed rules

Under the proposed regulations, IRC Section 162(m) would not be limited to compensation paid to a covered employee for services as an employee, but instead would also include compensation for services the individual rendered as an independent contractor. Additionally, the Preamble to the proposed regulations asserts that this has been the rule since the enactment of IRC Section 162(m) in 1993. To reach that conclusion, the IRS and Treasury rely heavily on the OBRA '93 legislative history, which states: "If an individual is a covered employee for a tax year, the deduction limitation applies to all compensation not explicitly excluded from the deduction limitation, regardless of whether the compensation is for services as a covered employee and regardless of when the compensation was earned." House Conf. Rep. 103-213, 585 (1993).

Implications

Many tax practitioners, including those specializing in IRC Section 162(m) since its enactment, historically have believed that IRC Section 162(m) did not apply to amounts paid to a covered employee for services rendered as an independent contractor (for example, fees for serving on the board of directors). These practitioners interpreted the legislative history previously quoted as being limited to compensation earned by an employee before becoming a covered employee. As a result, commenters can be expected to resist the assertion that this part of the proposed regulations merely clarifies a long-standing rule.

Transition rules

  1. IPO transition rule

Proposed rules

The 1995 Regulations provide a transition rule for a corporation that becomes publicly held. While this rule was not limited to initial public offerings (IPOs), it is commonly known as the "IPO transition rule." The Preamble to the proposed regulations explains that the rationale for this rule was tied to the performance-based compensation exception, which the TCJA eliminated. Under the proposed regulations, the IPO transition rule would not apply to corporations that become publicly held corporations on or after the date the proposed regulations are published in the Federal Register. Instead, the proposed regulations would subject a privately held corporation that becomes publicly held to IRC Section 162(m) for the tax year ending on or after the date that its registration statement becomes effective under either the Securities Act or the Exchange Act.

Implications

The application of the IPO transition rule was one of the issues on which Notice 2018-68 requested comments. While some commenters advocated for its preservation, Treasury and the IRS did not adopt these comments. If the regulations are finalized as proposed, corporations will need to anticipate IRC Section 162(m) as a more immediate consequence of going public rather than benefitting from a transition period lasting several years. This change is proposed to be effective for IPOs that occur on or after publication of the proposed regulations, which is expected to be December 20, 2019.

  1. Grandfathering

Proposed rules

The proposed regulations retain all the grandfather rules from Notice 2018-68, including some of the same examples.

Notice 2018-68 made clear that compensation was not grandfathered to the extent the corporation was not obligated under applicable law to pay it as of November 2, 2017. Stated differently, compensation for which the corporation retained negative discretion (that is, the legal right not to pay it) was not grandfathered. Notice 2018-68 did not address discretionary claw backs — compensation that the corporation can require the covered employee to repay only if certain circumstances arise. Under the proposed regulations, otherwise grandfathered payments do not lose their grandfathered status so long as the corporation's right to demand repayment is based on conditions objectively outside the corporation's control and the conditions giving rise to the corporation's right to demand repayment have not occurred.

Notice 2018-68 included numerous examples, but those examples focused on defined contribution plans. The proposed regulations clarify that the same basic rule applies to both defined contribution plans and defined benefit plans: only the amount of compensation that the corporation is obligated to pay under applicable law on November 2, 2017, is grandfathered. To illustrate the application of this rule, the proposed regulations include new examples involving defined benefit plans and other types of arrangements, such as "linked plans" (nonqualified deferred compensation plans linked to qualified retirement plans) and severance agreements, as well as earnings on grandfathered amounts.

Under the TCJA, an otherwise grandfathered amount loses its grandfathered status if the written binding contract is materially modified on or after November 2, 2017. Drawing heavily from the 1995 Regulations, Notice 2018-68 addressed several material modification issues. The proposed regulations retain all the rules from Notice 2018-68. One issue Notice 2018-68 did not address, however, was whether acceleration of vesting would be considered a material modification. Under the proposed regulations, the acceleration of vesting would not be treated as a material modification.

Notice 2018-68 also did not address how to identify the grandfathered amount when compensation is paid in a series of payments rather than as a lump sum. Under the proposed regulations, the grandfathered amount would be recovered first, and non-grandfathered amounts would be recognized only after the grandfathered amount has been fully recovered.

Implications

Many taxpayers were disappointed by the narrow scope of the grandfather rules in Notice 2018-68. The importance of grandfathering will diminish even further as employers' contractual obligations in effect as of November 2, 2017, are satisfied. Nevertheless, employers that believe they still have grandfathered amounts will need to consider whether the positions they have taken are consistent with the rules in Notice 2018-68 and the proposed regulations, or whether they may rely on other authorities to support their positions. Taxpayers that have been reluctant to make any changes to compensation arrangements they believe to be grandfathered may be comforted by the proposed rule that would not treat acceleration of vesting as a material modification. The rule for allocating grandfathered amounts is also generally taxpayer-favorable, as it will have the effect of delaying the application of the TCJA amendments to IRC Section 162(m).

Increased complexity for corporate transactions

The proposed regulations' definition of "publicly held corporation" and the rules for identifying the covered employees of a "predecessor" would increase the complexity of applying the deduction limit in corporate transactions. The entities potentially subject to the deduction limit would expand, and the number of covered employees that would need to be taken into account would significantly increase. These issues would not be limited to situations in which public companies engage in corporate transactions with other public companies. Consideration would also need to be given to whether private companies might have latent covered employees because the companies were publicly held within the past three years and are either joining a public company's affiliated group or are becoming publicly held themselves. Applying the deduction limit to short tax years, which arise often in corporate transactions, may prove to be challenging as covered employees for the short tax year (in addition to the covered employees for prior years) would need to be identified.

Applicability dates

Although the proposed regulations are generally proposed to apply to tax years beginning on or after the regulations are finalized, there are special applicability dates for certain rules. Where relevant, the special applicability date for each newly proposed rule is identified in the prior discussion, along with the description of the rule. In addition, the rules contained in Notice 2018-68, all of which are retained in the proposed regulations without substantive changes, are proposed to apply to tax years beginning on or after September 10, 2018.

Deadline for comments

Comments are due 60 days after the proposed regulations are published in the Federal Register (February 18, 2020, if publication occurs on December 20, 2019, as expected). A public hearing will be held on March 9, 2020.

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Contact Information
For additional information concerning this Alert, please contact:
 
Compensation and Benefits Group
Christa Bierma (christa.bierma@ey.com)
Catherine Creech (catherine.creech@ey.com)
Stephen Lagarde (stephen.lagarde@ey.com)
Andrew Leeds (andrew.leeds@ey.com)
Bing Luke (bing.luke@ey.com)
Helen Morrison (helen.morrison@ey.com)
Rachael Walker (rachael.walker@ey.com)

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ENDNOTES

1 Notice 2007-49. With regards to smaller reporting companies (and emerging growth companies), the SEC rules allow for reduced disclosure, generally consisting of three individuals: the CEO and the two highest-compensated officers other than the CEO; for smaller reporting companies, the IRS confirmed in CCA 201543003 that the CFO would be considered a "covered employee" subject to IRC Section 162(m) if the CFO's compensation is required to be disclosed as one of the two highest-compensated officers.

2 PLR 200837024, PLR 200727008, PLR 200725014, and PLR 200614002. Since 2010, this has been an issue on which the IRS will not issue rulings; taxpayers and their advisors, however, have come to their own views based upon the statutory and regulatory rules in effect.

Document ID: 2019-2229