IRS Issues Proposed Regulations Under Code Section 162(m)

December 31, 2019

On December 20, 2019, the Internal Revenue Service (IRS) issued proposed regulations under Internal Revenue Code section 162(m). This section limits the annual compensation expense deduction available to publicly traded companies to $1 million for certain “covered employees.” Once finalized, the proposed regulations will implement the amendments made to Code section 162(m) by the Tax Cuts and Jobs Act (2017 Tax Act).


Prior to the 2017 Tax Act, Code section 162(m) limited the annual compensation deduction expense available to publicly traded companies to $1 million per “covered employee” (i.e., the CEO and the next three highest paid employees, other than the CFO). Compensation in excess of $1 million was available for a deduction only if it met the exception requirements for certain commission and performance-based compensation paid to the “covered employee.”

2017 Tax Act Modification of 162(m) Deduction Limit

The 2017 Tax Act modified the Code section 162(m) deduction limit in several significant ways.

  • The exception for commission and performance-based compensation was repealed.
  • The definition of “covered employee” was expanded to cover CFOs.
  • The categories of public companies subject to the deduction limit was expanded. Previously, Code section 162(m) applied only to companies with a registered class of securities. It now also applies to any company that is required to file public reports with the Securities and Exchange Commission (SEC).
  • Beginning with those persons who are covered employees for 2017, once an individual becomes a covered employee, he or she remains a covered employee forever.

The new rules became effective for tax years beginning after Dec. 31, 2017. However, the 2017 Tax Act provided that compensation paid pursuant to a “written binding contract” in effect on Nov. 2, 2017, and not materially modified thereafter, is grandfathered and can continue to qualify for the performance-based compensation exception, assuming all other Code section 162(m) requirements are met.

IRS Notice 2018-68

In 2018, the IRS provided initial guidance regarding covered employees and the application of the grandfathering rules.

Proposed Regulations Summary

Following is a chart summarizing the key aspects of the proposed regulations:

Publicly Held Companies
Topic Summary Notes
General Rule
  • Companies with class of securities required to be registered under Section 12 of ’34 Act
  • Companies required to file reports under Section 15(d) of ’34 Act
  • Must be required to register/file reports at year-end to be covered
  • Generally, covers companies on national stock exchanges and those that offer to sell their securities under ’33 Act
Publicly Traded Subsidiaries
  • Considered a separate entity for purposes of rule
  • Example: Subsidiary with public debt
  • Results in multiple groups of covered employees – each entity evaluated independently
Foreign Private Issuers
  • Generally, foreign issuer with (i) more than 50 percent of voting stock held by U.S. residents and (ii) either a majority of officers and directors citizens/residents, more than 50 % percent of assets located in U.S. or business is principally located in U.S.
  • Expands coverage of rule to firms that do not file traditional SEC executive compensation disclosures
Publicly Traded Partnerships (PTPs)
  • Partnerships may issue equity interests registered under Section 12 of ’34 Act
  • Example: Master Limited Partnerships (MLP) common to energy sector
  • PTPs treated as corporations covered by rule

  • PTPs exempt from corporate status not covered by rule
Affiliated Groups
  • Affiliated Corporations under IRC 1504 considered part of publicly held company
  • Generally covers parent-subsidiary groups with stock ownership of 80 percent voting power and 80 percent value of assets
  • Private parent companies with public subsidiaries covered by rule

  • Also covers foreign subsidiaries
Disregarded Entities
  • Entities owned by a single owner considered disregarded for tax purposes
  • DEs may issue registered securities or file reports
  • Corporations that own DEs treated as issuing securities issued by DE and covered by rule
  • Generally, S corporations that are wholly-owned by another S corporation
  • Q-Subs may issue registered securities or file reports
  • Owner of Q-Sub that issue registered securities or that file reports covered by rule
Covered Employees
General Rule
  • CEO & CFO at any time during tax year
  • Three highest executive officers required to be reported in proxy
  • Was a covered employee in prior years
  • Any officer whose compensation was among three highest, even if not required to be reported in proxy
  • Eliminates requirement that executive be employed at year-end to be covered

  • Proposed rules generally follow 2018 Notice
Incongruent Tax v. Fiscal Year
  • SEC disclosure rules based on fiscal year; usually matches tax year, but not always
  • Compensation measured based on tax year as the fiscal year
Executive Officers Only
  • SEC disclosure rules only apply to executive officers
  • Only executive officers covered by 162(m)
Separation from Service
  • Once a covered employee, always a covered employee
  • Post-employment compensation covered by rule

  • Ex. Executive retirement payments
Predecessor Companies
  • Companies that go private and then become public again within 36 months or private transaction
  • Public companies acquired by stock, asset, reorganizations or divisions
  • Covered employee including covered employees of “predecessor” firms
Disregarded Entities
  • Executive officers of DEs may be considered executive officers of publicly held parent
  • Evaluated based on policy making function with regard to parent
  • Executive officers of Q-Subs may be considered executive officers of publicly held parent
  • Evaluated based on policy making function with regard to parent
General Rule
  • Compensation paid pursuant to a written binding contract in effect on Nov. 2, 2017 eligible for grandfathering unless materially modified
  • Reject proposed safe-harbor for amounts accrued under GAAP
  • Binding contract status determined according to state law

  • Treasury requests comments regarding other potential safe-harbor standard
Negative Discretion
  • Regulations suggest that compensation only grandfathered to extent negative discretion limited to “floor”
  • Ex. Compensation may not be reduced to less than $x
  • Relief also provided to the extent that state law may limit negative discretion

  • State law standard is ambiguous – presumably “bad faith” reductions prohibited
  • Compensation subject to mandatory clawback does not eliminate grandfathering for compensation retained
  • Discretionary clawback right limits grandfathering to amounts company entitled to recover under state law and past practice
  • State law and past practice is ambiguous – presumably “excessive” clawbacks prohibited

  • If “bad behavior” does not occur, disregard discretionary clawback authority

  • If “bad behavior” occurs look to state law and past practice to determine grandfathered amount
Defined Benefit Plans
  • Amount accrued as of Nov. 2, 2017 grandfathered
  • Subsequent earnings only grandfathered if company obligated to pay under the plan as in effect Nov. 2, 2017
  • Subsequent increases attributable to pay increased/years of service accruals not grandfathered
  • Earnings paid during 12 months post termination and prior to payout eligible for grandfathering
  • May qualify for grandfathering if based on compensation elements (base/bonus/etc.) company obligated to pay per contract
  • Grandfathered amount measured as of Nov. 2, 2017
  • Each component of severance analyzed independently

  • Ex. Multiple of base grandfathered/multiple of discretionary bonus not grandfathered
Loss of Grandfathering
  • Grandfathering lost if contract materially modified after Nov. 2, 2017
  • Material modification generally = increase in/acceleration of compensation payable
  • Grandfathering lost only with regard to amounts paid post material modification

  • Modification of one contract ≠ modification of other contracts unless pay under others increased as result
Supplemental Agreements
  • Treated as materially modifying grandfathered arrangement if additional compensation paid on substantially same elements/conditions
  • Additional equity grants ≠ supplemental agreement to base salary
  • Reasonable COLAs ≠ material modification

  • Increases in excess of COLAs = material modification
Accelerated Vesting
  • Permitted without loss of grandfathering for options, SARs and restricted stock
  • Permitted for cash-based awards
  • Unexpected positive news for employers, though shareholder pressure may limit application
  • Grandfathered if based on pre-determined investment and amounts deferred as of Nov. 2, 2017
  • Examples suggest choice between investments permitted

  • Change in investment line-up may eliminate grandfathering
Contract Extensions
  • Company discretion to terminate results in loss of grandfathering as of first date contract may be terminated
  • Executive right to extend does not eliminate grandfathering
  • Ex. Employment term auto renewals unless either party provides notice of non-renewal = new contract as of renewal date
Right to Future Plan Participation
  • Amounts payable under plan executive had a contractual right to participate in as of Nov. 2, 2017 eligible for grandfathering
  • Applicable even if participation does not begin until after Nov. 2, 2017
Accelerating Payment Timing
  • Acceleration = material modification unless amount discounted for time value of money
  • Ability to accelerate payments limited due to IRC 409A
Deferring Grandfathered Payments
  • May defer amounts owed under grandfathered contracts without losing grandfathering on principal deferred
  • Earnings on post-Nov. 2, 2017 deferrals not eligible for grandfathering
  • COLA adjustments do not eliminate grandfathering for amounts paid pursuant to contracts in effect on or before Nov. 2, 2017
  • Oddly, the actual amount of the COLA is subject to new rules
  • Ex. $2M base salary + $40K COLA / base remains grandfathered, COLA included under new rules
Covered Compensation, Newly Public Companies & Effective Dates
Covered Compensation
  • Generally, all compensation paid to a covered employee that is deductible (without regarding to 162(m) limits)
  • Includes amounts paid to beneficiaries upon death
    Partnership Income
  • Compensation paid by a publicly held company’s partner to which a portion is allocated to the public company covered by rule
    Director/Other Fees
  • Covered by rule and aggregated with compensation for services as an employee
  • Expansive definition that follows tax rules for includible compensation
  • Partnership income often the result of joint ventures
Newly Public Companies
  • Transition relief formerly available for newly public companies (IPOs, spin-offs, etc.)
  • Proposed regulations do not provide any transition relief for newly public companies
Effective Dates
  • Generally applicable to tax years beginning on or after date of publication of Final Rule in Federal Register
  • Covered Employees – effective for tax years ending on or after Sept. 10, 2018
  • Predecessor Company – effective for companies that go private for tax years beginning after Dec. 31, 2017 and becomes public again on or after date of publication of Final Rule in Federal Register
  • Compensation – Rules re: partnership applies to compensation allowable for tax years ending on or after date of publication of Proposed Rule in Federal Register

  • Newly Public Companies – elimination of transition relief only applicable to companies that become public on or after date of publication of Proposed Rule in Federal Register


For further information about the proposed regulations under Internal Revenue Code section 162(m), please contact one of the authors or any other member of McGuireWoods’ employee benefits team