Section 162(m) of the Internal Revenue Code prohibits a publicly held corporation from taking compensation-related tax deductions with respect to the compensation of a “covered employee” to the extent the compensation exceeds $1 million in a tax year. The definition of “covered employee” under Section 162(m) was expanded by the Tax Cuts and Jobs Act (TCJA) in 2017 and was expanded further by the American Rescue Plan Act (ARPA) in 2021. ARPA expanded the list of covered employees to include the company’s five most highly compensated employees, effective for tax years beginning after December 31, 2026. On January 14, 2025, prior to the presidential administration transition, the US Department of the Treasury and the Internal Revenue Service (IRS) released proposed regulations (Proposed Regulations) implementing the ARPA amendments to Section 162(m).
This blog post discusses the impact of the Proposed Regulations on ARPA’s requirement that a publicly held corporation expand the group of covered employees by adding its five most highly compensated employees. As discussed below, if finalized, these Proposed Regulations are likely to pose complex and difficult implementation issues for affected companies.
It is not clear whether the new presidential administration will finalize the Proposed Regulations, but, even if they do not, ARPA’s statutory requirement to add five additional employees to the Section 162(m) group will go into effect in 2027. Public companies need to start planning soon to determine how the new law and these Proposed Regulations might apply to them. Companies may want to submit comments suggesting changes to these Proposed Regulations. The deadline for comments is March 17, 2025.
ARPA Change to Section 162(m)
Under Section 162(m) as presently in effect, a publicly held corporation’s group of covered employees is comprised of three categories: (1) the chief executive officer (CEO) and the chief financial officer (CFO), (2) the company’s three highest paid executive officers for the taxable year (other than the CFO and the CEO), and (3) any individual who was a covered employee under either of the two preceding categories in any year after 2016 (known as the “once-covered-always-covered” rule). Because of the once-covered-always-covered rule, the group of covered employees under this definition will grow over time.
ARPA amended Section 162(m), effective for tax years after December 31, 2026, to expand the group of Section 162(m) covered employees to include the publicly held corporation’s five highest paid employees during the year (other than an employee who is already a covered employee by reason of being the CFO, CEO, or among the three top-paid executive offers during that year).
The “ARPA five group” includes high paid employees who are not necessarily officers of the corporation. The ARPA five group is redetermined every year, and there is not a separate once-covered, always-covered rule applicable to the ARPA five group. Accordingly, the ARPA group will never include more than five employees in any year although the ARPA five group may include individuals who would otherwise be covered employees under the “once covered, always covered” rule. Consequently, once this expanded list under ARPA becomes effective, a publicly held corporation’s covered employees in any year will be comprised of the following:
- Any individual who was the company’s CEO or CFO at any time during the year
- The company’s three highest paid executive officers (other than the CEO and CFO in that year) as identified under proxy reporting rules
- Any individual who was a covered employee under either (1) or (2) in any year beginning before the current year and after 2016; and
- The ARPA-mandated list of five additional employees (which may not overlap with individuals who are in group (1) or (2) but may overlap with individuals who are in group (3))
Highlights of the Proposed Regulations
The Proposed Regulation provides rules for identifying employees in the ARPA five group.
Defining “Employee”
The Proposed Regulations define an “employee” as any employee of the publicly held corporation, or any of its affiliates, regardless of whether the individual performs services for the publicly held corporation. The Proposed Regulation applies the definition of “employee” under Code Section 3401(c), which includes the corporation’s officers (whether or not they are its common law employees). The preamble explains that this definition is used is to prevent “avoidance” of Code Section 162(m) by the use of third-party payors.
In addition, the Proposed Regulations define an “employee” for this purpose to include an employee of an unaffiliated entity who is not an employee or an officer of the publicly held corporation but who performs “substantially all” of the individual’s services “during the relevant taxable year” for the publicly held corporation.
Defining “Compensation”
The Proposed Regulations define “compensation” for the ARPA five group as the aggregate amount of compensation paid to an employee by all members of the affiliated group that is allowed as a tax deduction for remuneration for services under chapter 1 of the Internal Revenue Code (determined without the deduction cap of Code Section 162(m)(1)), without regard to the whether the services are performed during such taxable year.
This definition departs from the definition of “compensation” used or purposes of identifying the corporation’s three highest paid executive officers (group (2) referenced above). For this purpose, Code Section 162(m)(3) defines compensation on the basis of total compensation required to be disclosed in the proxy or Form 10-K under the Exchange Act for named executive officers.
This tax deduction-based definition of compensation may produce a mismatch between the year in which services are performed and the year in which the deduction is denied. For example, an employee with significant deferred compensation paid as a lump sum may be among the ARPA five highest compensated employees in the year in which the deferred compensation is paid, based on the amount of compensation that is otherwise deductible in that year. This could happen for a retiring employee with a significant lump sum supplemental executive retirement plan (SERP) payment, or an employee who in a single year exercises stock options earned over many years.
The tax deduction-based definition of compensation may pose significant implementation issues, since tax deductions are typically not recorded for all payors in an affiliated group, on the basis of service providers.
Allocation Among Affiliated Group Members
In determining the ARPA five group, the publicly held corporation must identify the highest paid employees within its affiliated group, without regard to whether the individual is an employee of, or performs services for, the publicly held corporation. If an employee receives compensation from more than one member of the affiliated group, the Proposed Regulations provide rules for allocating the cap among the amounts paid by each member. If an affiliated group includes more than one publicly held corporation, the Proposed Regulations provide that the ARPA five group will be identified separately for each such corporation and its affiliates and provide rules for identifying the respective affiliates for each such publicly held corporation. An affiliated group containing more than one publicly held corporation will accordingly be divided into separate subgroups, each with its own group of five highest paid employees.
Foreign Affiliates
The Proposed Regulations provide that an employee’s compensation includes compensation received from any controlled foreign corporation that is a member of the affiliated group. The preamble to the Proposed Regulation takes the position that this provision merely clarifies a provision that existed as far back as the 1995 regulations. Public comments are specifically requested on how these rules should apply to controlled foreign corporations.
Nonemployee Service Providers
The Proposed Regulations define an “employee” for this purpose to include an individual who is the employee or officer of an unrelated company and who performs “substantially all of the individual’s services during the relevant taxable year for the publicly held corporation.” The Proposed Regulations define compensation as the aggregate amount allowed as a tax deduction to the publicly held corporation (without regard to Code Section 162(m)(1)) “to obtain the services performed by such individual, whether or not the particular services that give rise to the deduction were performed during the relevant taxable year.”
This rule raises several issues. First, it apparently lacks statutory authority. Section 162(m) caps the deduction for compensation paid by a public company to its employees. The employees of a corporation include its common law employees, and by statute for certain purposes may include its officers who are not its common law employees. However, the Proposed Regulations cover services performed on behalf of the publicly held corporation by employees of an unrelated company, even if those individuals are neither employees nor officers of the publicly held corporation. There is no apparent statutory authority for this expansion of the term “employee” of the publicly held corporation.
Second, the Proposed Regulations describe this rule in a conceptually muddled way. Although the individual performing the work is the common law employee of the service-provider entity (and not an employee of the publicly held corporation), the Proposed Regulations describe the arrangement as one in which the individual provides services “to” the client publicly held corporation. Under the Proposed Regulations’ assumptions (i.e., the individual is the employee of the entity and not an employee or even an officer of the publicly held corporation), in many situations the individual provides services “to” the service-provider entity that in turn renders services to the publicly held corporation.
Under the Proposed Regulations, the payments made by the publicly held corporation are not in any way limited to the compensation actually paid to the individual for the individual’s services. There is no definition of “substantially all” services, nor is it clear how the publicly held corporation is to determine whether an unrelated company’s employee devoted “substantially all” of such employee’s time to services performed on behalf of corporation.
There is also a mismatch in the timing rules. The limitation applies with respect to an individual who performs “substantially all” of the individual’s services during the “relevant taxable year” on behalf of the publicly held corporation, but the deduction cap applies “whether or not” the related services “were performed during the taxable year.” This raises questions as to how to apply these rules when services are performed in one year, but compensation is paid and deducted in a different year.
Transition Rule
The ARPA deduction cutback, like the TCJA deduction cutback, does not apply compensation payable under a written binding contract that was in effect on November 2, 2017, and that is not modified in any material respect on or after that date (grandfathered compensation). For purposes identifying the ARPA five group of employees, however, grandfathered compensation is not disregarded. In some situations—for example, in the case of a former employee with a large grandfathered SERP benefit paid as a lump sum—this would mean that individuals identified as being in the ARPA five high paid group have compensation that is significantly shielded from the deduction cutback.
Planning for the Expansion of Section 162(m)
As the effective date of ARPA’s expansion of Section 162(m) approaches, companies should begin evaluating their employee tracking and reporting practices and consider whether awards will be (or in some instances have been) granted to individuals who could be covered employees under the new rules. It may be possible to reduce the number of new employees included under the ARPA five group if those individuals are already covered employees under the “once-covered-always-covered” rule. To the extent new individuals must be counted, companies should be mindful of considering the compensation received by any employee within the affiliated group from any member of the affiliated group. Companies should also be mindful of compensation paid to unrelated third parties for services performed by third-party employees who might perform “substantially all” their services to the third-party entity on behalf of the publicly held corporation.
Companies should also consider how the new rule may potentially affect future tax deductions for equity grants. Awards granted this year may vest after the effective date of the expanded list of “covered employees”—i.e., in 2027 or later, and absent any future changes in law, more equity awards to more service providers may not be deducible at the time of grant.
From a financial accounting perspective, companies should implement robust forecasting practices to identify future tax deductions. The expansion of the covered employees list means for many companies that less of the executive compensation they pay will be tax-deductible. This, coupled with the increased complexity in tracking covered employees, should be considered by companies when reviewing recordkeeping practices.
Next Steps
Public comments and requests for a public hearing on the Proposed Regulations must be received on or before March 17, 2025 (60 days after publication of the Proposed Regulations in the Federal Register). Morgan Lewis stands ready to assist clients with submitting individual comments or anonymized comments that Morgan Lewis submits on our clients’ behalf. Morgan Lewis will continue to monitor developments related to the Proposed Regulations and their potential impact on executive compensation agreements and arrangements.
Now is the time to develop strong methodologies and procedures for tracking and forecasting covered employees under the new rules as well as plan for the changes to deductibility. If you have questions about the expansion of Section 162(m), tracking covered employees, or any of the information in this post, please contact the authors or your usual Morgan Lewis contacts.