The IRS and Treasury Department have released proposed regulations (REG-118988-22) under IRC Section 162(m), concerning the deduction limitation for covered employee compensation over $1m for publicly held corporations. The proposed regulations are intended to implement changes that were made by the American Rescue Plan Act (ARPA) and expand the scope of covered employees. The statutory changes apply to tax years beginning after December 31, 2026.

Comments must be received by March 17, 2025.

Background

Section 9708 of the ARPA expanded IRC Section 162(m)'s $1m deduction limitation. Before the change, covered employees included (1) anyone serving as CEO or CFO during the year, (2) the next three highest compensated officers, and (3) any individual who was a covered employee in any previous tax year beginning after December 31, 2016.

Section 9708 of the ARPA expanded the scope of covered employees to include an additional five highest compensated employees — not limited to officers — who are not already treated as covered employees under (1) or (2) (although these may include individuals included in (3)). In contrast to the permanency of covered employee status for the existing group of covered employees, this new group of covered employees will not permanently retain that status for subsequent tax years if subject to IRC Section 162(m) solely on this basis.

Proposed regulations

The proposed regulations provide guidance on implementing the IRC Section 162(m) expansion. For purposes of identifying the additional five highest compensated employees, "employee" would be defined by IRC Section 3401(c). Under this provision, as interpreted by Treas. Reg. Section 31.3401(c)-1, the term employee would include common law employees and officers of the corporation. Thus, under IRC Section 162(m), the additional covered employees would not be limited to executive officers. The definition of "employee" also would include persons who are employees of a separate employer, but provide substantially all of their services during the tax year for the publicly held corporation (including its affiliated group).

The determination of the five highest compensated employees would be based on the employee's compensation that would otherwise be deductible for tax purposes without considering IRC Section 162(m). This determination would take into account all companies in the publicly held corporation's affiliated group, regardless of whether the employee is employed by or performs services for the publicly held corporation. If the affiliated group were to include more than one publicly held corporation, the proposed regulations would subdivide the larger group, generating a subgroup for each publicly held corporation and allocating compensation and the potential deduction limitation among members of the subgroups.

Under the proposed regulations, employees of an unrelated company who provide substantially all of their services for the publicly held corporation would be treated as employees of the publicly held corporation. Thus, their compensation would be defined as the amount that would otherwise be deductible to the corporation to obtain their services.

An affiliated group would include a foreign corporation. The proposed regulations would explicitly define compensation as including a publicly held corporation's pro rata share of compensation paid by a controlled foreign corporation that is a member of its affiliated group. According to the Preamble, this explicit addition reflects a substantive rule dating back to the 1995 regulations.

Implications

The proposed regulations give much-needed clarity on applying IRC Section 162(m) limitations to the "ARPA 5" highest compensated employees.

Publicly held corporations will need to accurately identify which employees will be subject to IRC Section 162(m) in any given year. These employees will not retain permanent IRC Section 162(m) status for future years solely by being a member of the "ARPA 5."

The use of otherwise deductible compensation to identify the highest compensated employees differs from the determination of the three highest compensated officers, which uses the SEC-proxy-disclosure definition of compensation. For publicly held corporations that maintain highly variable compensation programs (e.g., commission-type incentive plans or nonqualified stock options), the definition of compensation may make it difficult to project who may be part of the "ARPA 5" in future tax years.

While the application of this expansion will not apply until tax years beginning after December 31, 2026, employers may need to consider the potential application of IRC Section 162(m) in preparing financial statements. For example, deferred tax assets for employee compensation may need to be adjusted in the interim period including the issuance date of these regulations if existing deferred tax assets are projected to be further limited under these new regulations.

The proposed regulations introduce a new concept that would apply beyond just the "ARPA 5" by applying IRC Section 162(m) to employees of other companies who provide substantially all their services for the publicly held corporation during the tax year. The Preamble states this rule is intended, in part, to prevent avoidance through use of third-party payors (an example in the proposed regulation involves a temporary executive staffing arrangement), but it raises questions as to how this concept might apply in practice.

The rule seems to assume that employees of an entity rendering entity-level services to a publicly held corporation are personally rendering services for the publicly held corporation rather than their employer. The employer, in turn, receives payment from the publicly held corporation in exchange for the individual's services rather than the services of the employing entity. Because the proposed regulation articulates these as factual inputs rather than conclusions reached by applying the rule, this concept may be difficult to apply in practice.

In addition, the Preamble refers to these employees as someone who "functions as an employee of the publicly held corporation" without explaining the difference between someone who functions as an employee and someone who actually is a common law employee (a status that is based on a multi-factor facts-and-circumstances test). Moreover, the "substantially all" threshold is not defined. Companies with highly-compensated individuals providing services in this manner may need to revisit their IRC Section 162(m) analysis if this proposed rule is retained in final regulations and may wish to comment on the proposed regulations.

The Preamble includes a footnote that "disallowed amounts generally may not be capitalized," a nod to chronic questions concerning whether and to what extent each provision applies when both IRC Section 162(m) and a capitalization requirement apply to an amount. This seems to say that a capitalization requirement is not an exception to IRC Section 162(m), but ambiguity remains as to the order in which the rules apply. These issues cross jurisdictions within IRS Chief Counsel, and as a result, may be addressed in future guidance outside the IRC Section 162(m) space.