December 22, 2020
Final IRC Section 162(m) regulations have few changes
The IRS published final regulations under IRC Section 162(m) (TD 9932), incorporating Tax Cuts and Jobs Act (TCJA) statutory amendments and making certain other changes to existing rules. The final rules generally follow the proposed rules previously published in December 2019, but there are a few key changes:
The final regulations also include other, less significant new rules and clarifications.
The final regulations generally apply to tax years beginning on or after the date the regulations are published in the Federal Register, although a taxpayer may choose to apply them to tax years beginning after December 31, 2017, if the taxpayer applies them in their entirety and in a consistent manner. There are special applicability dates for some rules, most of which were included in the proposed regulations.
IRC Section 162(m) imposes a $1 million limit on the deduction that a "publicly held corporation" is allowed for compensation paid with respect 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 IRC Section 162(m) was originally enacted as part of the Omnibus Budget Reconciliation Act of 1993 (OBRA 1993), effective for tax years beginning on or after January 1, 1994.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As originally enacted, IRC Section 162(m) defined a "covered employee" as the CEO and the next four highest-compensated officers whose compensation was required to be reported to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 (such as severance and deferred compensation) paid to an individual who was no longer a covered employee on the last day of the corporation's tax year 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to register their common stock under Section 12 of the Exchange Act were subject to IRC Section 162(m) as it was originally enacted.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:
All of these amendments were generally effective for tax years beginning after December 31, 2017, but under a grandfather rule any compensation paid pursuant to 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 prior to 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. With respect to the definition of "covered employee," the Notice confirmed that the "last day" rule that applied under the 1995 Regulations was eliminated and, therefore, 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).
Rather than amending the 1995 Regulations to reflect the TCJA amendments, the proposed regulations provided a separate, comprehensive set of rules (see Tax Alert 2019-2229). (The 1995 Regulations continue to apply to grandfathered amounts.) The proposed regulations included: (1) rules related to 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 included more than 80 examples.
Analysis of the Final Regulations
The following sections of this Alert highlight the key rules and definitions set forth in the proposed regulations that were either retained or modified in the final regulations.
Definition of publicly held corporation
Like the 1995 Regulations, the proposed regulations looked to the last day of the corporation's tax year to determine its status as a publicly held corporation. The proposed regulations, however, reflected the TCJA amendments under which a corporation is considered publicly held if any of 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) of the Exchange Act. Under the proposed regulations, a corporation was not considered publicly held while its obligation to file reports under Section 15(d) was suspended. The proposed regulations also clarified that a subsidiary of a publicly held corporation was itself a publicly held corporation and separately subject to IRC Section 162(m) under the affiliated group rules discussed below.
Citing the TCJA amendments and legislative history, the proposed regulations rejected a commenter's suggestion that foreign private issuers be exempt from IRC Section 162(m). The proposed regulations did, 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.
The proposed regulations generally retained the 1995 Regulations' rules for affiliated groups of corporations. Under those rules, a publicly held corporation included 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) were separately subject to IRC Section 162(m). The proposed regulations included 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 also expanded on the 1995 Regulations' rules for prorating the deduction disallowance among the members of an affiliated group.
The proposed regulations included a new rule for disregarded entities. If a disregarded entity owned by a privately held corporation was an issuer of securities required to be registered under Sections 12(b) or 15(d) of the Exchange Act, the proposed regulations treated the otherwise privately held corporation as a publicly held corporation for purposes of IRC Section 162(m). The proposed regulations included a similar rule for QSubs (certain wholly owned subsidiaries of S corporations).
The final regulations retain the rules from the proposed regulations. Under a new rule, consistent with the proposed rule for QSubs, a real estate investment trust (REIT) that owns a qualified real estate investment trust subsidiary (QRS) is a publicly held corporation if the QRS issues securities required to be registered under Section 12(b) of the Exchange Act or is required to file reports under Section 15(d) of the Exchange Act. There is no safe harbor for identifying covered employees of foreign private issuers in the final regulations because none was proposed by commenters.
The final regulations modify an example involving the application of IRC Section 162(m) in the case of an individual who is a covered employee for only two of the three publicly held corporations in an aggregated group but who is paid compensation by all three. (This was Example 2 in the proposed regulations, but it is Example 20 in the final regulations.) The aggregate compensation paid by the three corporations is $3 million, and the final regulations conclude that the total deduction disallowance is $1 million, as one might expect. The example in the proposed regulations had concluded that the aggregate deduction disallowance was $1.6 million, which resulted from an allocation method that required double counting of amounts over the $1 million limit. This change was made in response to a comment criticizing the double counting.
Definition of covered employee
The proposed regulations generally followed 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 did 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 be applied as if the relevant tax year (a short tax year, for example) were the corporation's fiscal year. This rule was proposed to apply to tax years beginning on or after the publication of the proposed regulations in the Federal Register (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 supplied rules for a variety of corporate transactions: reorganizations, divisions, stock acquisitions and asset acquisitions. These rules were proposed to apply to corporate transactions for which all events necessary for the transaction occurred on or after the date the final regulations were published in the Federal Register. The proposed regulations also would treat a corporation as its own predecessor if it went from being publicly held to being privately held and then back to being publicly held again within a three-year period (if the corporation became publicly held again on or after the final regulations were published in the Federal Register). For the period prior to publication of the final regulations, the proposed regulations permitted reliance on the proposed rule, or any reasonable, good faith interpretation of the term "predecessor," and defined certain examples of what would not represent a reasonable, good faith interpretation.
The proposed regulations also treated employees of disregarded entities and QSubs as covered employees of their corporate owners if those employees were executive officers of the corporate owners under the SEC rules.
The final regulations retain the rules from the proposed regulations, with certain minor additions and clarifications. The final regulations provide rules for identifying the covered employees of a REIT that owns a QRS. The final regulations also clarify that for purposes of determining the predecessor of a publicly held corporation in the context of an asset acquisition the 80% threshold for operating assets refers to gross operating assets and not net operating assets.
Definition of applicable employee remuneration
The proposed regulations provided that "applicable employee remuneration" (referred to in the proposed and final regulations as "compensation" for simplicity) meant: (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) regardless of whether the services were performed during the tax year. The proposed regulations reiterated 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.
Among the most significant new rules in the proposed regulations were the rules for partnerships. These rules were unrelated to the TCJA amendments and were not in the 1995 Regulations. The proposed regulations would have applied 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 was allocated to a publicly held corporation (or its affiliate) based on the corporation's interest in the partnership. This result was contrary to four private letter rulings2 and would effectively subject "Up-REITs" and businesses with so-called "Up-C" partnership structures (in which a publicly held REIT or corporation, as applicable, holds an interest in a lower-tier operating partnership) to IRC Section 162(m) for the first time. This part of the proposed regulations had a special grandfather rule under which IRC Section 162(m) would not apply to compensation paid pursuant to a written binding contract in effect on the date the proposed regulations were published in the Federal Register (December 20, 2019) and not materially modified after that date.
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. What's more, the preamble to the proposed regulations asserted that this has been the rule since the enactment of IRC Section 162(m) in 1993. To reach that conclusion the IRS and Treasury relied 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).
The final regulations retain the rules from the proposed regulations but provide additional transition relief for a publicly held corporation's distributive share of a partnership's compensation deductions. In addition to grandfathering compensation paid pursuant to a written binding contract in effect on December 20, 2019 (and not materially modified after that date), compensation paid on or before December 18, 2020, is not subject to the partnership rule. This date corresponds to the date the final regulations were available on the IRS website, which precedes the Federal Register publication date.
Some practitioners had wondered whether the final rules would be expanded even further to apply IRC Section 162(m) to compensation paid by a partnership's corporate subsidiaries (commonly found in an "Up-REIT" structure where the operating partnership holds a taxable REIT subsidiary). The Preamble, however, affirms that, "[a]ssuming the partnership is respected for U.S. federal income tax purposes, [IRC S]ection 162(m) generally would not apply to compensation paid to a publicly held corporation's covered employee by a corporate subsidiary of a partnership for services performed as an employee of the subsidiary because, in this circumstance, the corporate subsidiary would not be a member of the publicly held corporation's affiliated group."
IPO transition rule
The 1995 Regulations provided 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 explained 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 became publicly held corporations on or after the date the proposed regulations were published in the Federal Register (December 20, 2019). Instead, the proposed regulations specified that a privately held corporation that became publicly held would be subject to IRC Section 162(m) for the tax year ending on or after the date that its registration statement became effective under either the Securities Act or the Exchange Act.
The final regulations retain the rules from the proposed regulations and clarify that a subsidiary that was a member of an affiliated group may continue to rely on the transition rule if it became a separate publicly held corporation on or before December 20, 2019.
The proposed regulations retained 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 with respect to which the corporation retained negative discretion (that is, the legal right not to pay) was not grandfathered.
Notice 2018-68 did not address discretionary clawbacks — compensation that the corporation could require the covered employee to repay only if certain circumstances arise. Under the proposed regulations, otherwise grandfathered payments would not lose their grandfathered status so long as the corporation's right to demand repayment was based on conditions objectively outside the corporation's control and the conditions giving rise to the corporation's right to demand repayment had not occurred. If the conditions did occur, however, then only the amount the corporation was obligated to pay under applicable law (taking into account the occurrence of the condition) would remain grandfathered.
Notice 2018-68 included numerous examples that focused on defined contribution plans. The proposed regulations clarified that the same basic rule applied to both defined contribution plans and defined benefit plans: only the amount of compensation that the corporation was obligated to pay under applicable law on November 2, 2017, was grandfathered. To illustrate the application of this rule, the proposed regulations included 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 there is a material modification of the written binding contract on or after November 2, 2017. Drawing heavily from the 1995 Regulations, Notice 2018-68 addressed a number of material modification issues. The proposed regulations retained 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 was not 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 was fully recovered.
The final regulations generally retain the rules from the proposed regulations, but those rules are expressed using fewer illustrative examples and more operative rules. In addition, there are four key changes to the proposed rules.
First, the final regulations have a different rule for clawbacks. As the Preamble explains, "After further consideration, the Treasury Department and the IRS recognize that the corporation's right to recover compensation is a contractual right that is separate from the corporation's binding obligation under the contract (as of November 2, 2017) to pay the compensation. Accordingly, these 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, whether or not the corporation exercises its discretion to recover any compensation in the event the condition arises in the future."
Second, the final regulations include a new rule under which the grandfathered amount is not required to be reduced for losses after November 2, 2017. Tracking grandfathered amounts is simpler under this rule because it is unnecessary to distinguish investment gains and losses from new plan benefits if the value of the grandfathered benefit falls after November 2, 2017.
Third, the final regulations require the grandfathered amount to be determined on a plan-by-plan basis. Thus, for example, if a participant's grandfathered benefit under one plan is forfeited, the grandfathered amount does not become available under another plan — the grandfathered amount associated with the forfeited compensation is simply lost.
Finally, the final regulations add a rule that extending the exercise period for a grandfathered stock option or stock appreciation right is not a material modification and does not cause a loss of grandfathering, provided that the extension complies with Treas. Reg. Section 1.409A-1(b)(5)(v)(C)(1). A common example is an employer allowing a stock option to be exercised for a short time after an employee separates from service, even though the original terms of the stock option called for the exercise period to end upon separation from service.
Although the final regulations generally 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 discussion above along with the description of the rule. In addition, the rules contained in Notice 2018-68, nearly all of which were retained in both the proposed and final regulations without substantive changes, apply to tax years beginning on or after September 10, 2018.
The following chart summarizes the final applicability dates:
Taxpayers likely will be disappointed by the modest changes to the proposed rules. Commenters had suggested numerous changes that would have narrowed the scope of IRC Section 162(m), thereby allowing taxpayers greater compensation deductions. Nearly all those suggestions were rejected.
The most important change in the final regulations is the additional transition relief for a publicly held corporation's distributive share of a partnership's compensation deductions. As proposed, this rule would have applied retroactively once the final regulations were published. The proposed regulations were published in the Federal Register on December 20, 2019, and this rule was proposed to apply to tax years ending on or after that date (2019 in the case of a calendar year taxpayer). This put some taxpayers in an awkward position, because they had to file tax returns without knowing whether this rule would be included in the final regulations and applied retroactively as proposed. In many cases, however, this was a moot point, thanks to the special grandfather rule for amounts paid pursuant to a written binding contract in effect on December 20, 2019. Thus, many taxpayers had been expecting 2020 to be the first year the new partnership rule would have any practical effect. The additional transition relief for amounts paid on or before December 18, 2020, likely will allow those taxpayers to avoid applying the partnership rule for one more year. In many cases, this will mean one more year of avoiding the $1 million deduction limit entirely.
Other favorable changes in the final regulations were more modest. These changes include the simplified approach for calculating grandfathered amounts subject to pre-TCJA rules, making it unnecessary to track losses on amounts deferred as of November 2, 2017; the more reasonable approach to clawbacks; and the clarification that extending the exercise period for a grandfathered stock option or stock appreciation right is not a material modification and does not result in a loss of grandfathering.
If there is a silver lining for tax professionals, it is that the final rules are by and large familiar. Indeed, some of the most important rules in the final regulations were carried forward from Notice 2018-68, which was released more than two years ago.
1 Notice 2007-49. With regard 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. 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, but taxpayers and their advisors have come to their own views based upon the statutory and regulatory rules in effect.