Who Qualifies as a 162(m) Covered Employee?

Internal Revenue Code Section 162(m) limits the tax deduction for publicly held corporations to $1 million per year for compensation paid to each covered executive. The purpose of this rule is to prevent the subsidization of what is considered excessive executive pay through corporate tax deductions. Understanding the specific definitions of who is a covered employee and what constitutes a publicly held corporation is necessary for tax planning.

Defining a Publicly Held Corporation

A “publicly held corporation” is any corporation that issues a class of securities required to be registered under Section 12 of the Securities Exchange Act of 1934. It also includes any corporation required to file reports under Section 15(d) of that act. This encompasses companies whose stock is traded on a national securities exchange and are subject to SEC reporting requirements.

The Tax Cuts and Jobs Act of 2017 (TCJA) broadened this definition to include companies with publicly traded debt securities, not just equity. This change brought many privately held corporations with public debt under the purview of Section 162(m). The updated definition also includes certain foreign private issuers that meet the registration or reporting thresholds.

This expansion means a wider array of business structures now fall under the deduction limitation. For instance, entities like real estate investment trusts (REITs) can be considered publicly held if a subsidiary issues securities meeting the registration requirements. A corporation’s status is determined on the last day of its taxable year, and if it meets the definition on that day, the deduction limit applies for the entire year.

Identifying a Covered Employee

The definition of a “covered employee” was substantially revised by the TCJA and encompasses several specific individuals. The first group includes any person who served as the Principal Executive Officer (PEO) or the Principal Financial Officer (PFO) at any point during the taxable year.

Beyond the PEO and PFO, the definition includes the three other most highly compensated executive officers for the taxable year. The identification of these individuals is based on total compensation required to be reported under SEC disclosure rules, such as in a proxy statement. These individuals are identified regardless of whether they are serving as an officer on the last day of the company’s taxable year.

The TCJA established the “once a covered employee, always a covered employee” provision. Once an individual is identified as a covered employee for any taxable year beginning after December 31, 2016, they retain that status for all future years. The $1 million deduction limit will apply to all compensation paid to that individual by the corporation indefinitely, including payments to their beneficiaries after death.

Furthermore, the definition of a covered employee will be expanded for taxable years beginning after December 31, 2026. In addition to the existing group, the term will also include the five highest-compensated employees for the taxable year. This new group is determined annually, and the “once a covered employee, always a covered employee” rule will not apply to them.

Determining Applicable Employee Remuneration

The $1 million deduction limit applies to “applicable employee remuneration,” which includes nearly all forms of compensation paid to a covered employee for services performed. The aggregate amount includes salary, bonuses, commissions, non-cash benefits, and the value of property transferred, such as stock awards, when they become taxable to the executive.

The TCJA eliminated the exception for “performance-based compensation,” which previously exempted awards like stock options and performance bonuses from the limit. This change applies to arrangements entered into or materially modified after November 2, 2017. Now, these awards are included in the total remuneration subject to the cap for the tax year in which the compensation is deductible, regardless of when the services were performed.

The rules also address complex arrangements to ensure the limitation cannot be easily circumvented. For example, those involving partnerships are structured to ensure a corporation’s distributive share of a partnership’s compensation deduction is counted toward the limit.

Grandfathered Arrangements and Transition Rules

Despite the TCJA’s changes, a grandfather rule exempts certain pre-existing arrangements. This transition provision applies to compensation paid pursuant to a “written binding contract” that was in effect on November 2, 2017. For these arrangements, the pre-TCJA rules, including the performance-based compensation exception, may still apply if the contract has not been materially modified.

A “written binding contract” is one that is enforceable under applicable law and obligates the corporation to pay compensation if the employee performs the services or satisfies vesting conditions. The corporation must not have the right to cancel or terminate the contract unilaterally without substantial penalty. If the company retains discretion to reduce or eliminate the compensation, the contract is not considered binding.

A “material modification” is any change that increases the amount of compensation payable. Examples include increasing a salary, granting a larger bonus than required, or accelerating the vesting of a stock award. A material modification breaks the contract’s grandfathered status, making all future payments subject to the new rules. A change is not considered material if it does not enhance the compensation’s value, such as an administrative change to a payment schedule.