United States: IRS Provides Guidance On New Definition Of "Covered Employee" Under Code Section 162(M)

On August 21, 2018, the IRS issued initial guidance (Notice 2018-68) to assist companies in determining how the changes made to Internal Revenue Code 162(m) by the Tax Cuts and Jobs Act of 2017 affect the deductibility of their compensation arrangements. The guidance focused on two aspects: (1) determining who is a "covered employee" under the new Code Section 162(m) rules and (2) defining when an arrangement is considered "grandfathered" such that the arrangement may continue to be governed by the old (pre-tax reform) Code Section 162(m) rules. This article focuses on determining who is a covered employee. A subsequent article will focus on the guidance on grandfathered arrangements.


As a refresher, Code Section 162(m) limits the deduction that a publicly held corporation can take with respect to compensation paid to each of its "covered employees" to $1 million per year. Among other changes to Code Section 162(m), the Tax Cuts and Jobs Act significantly expanded the definition of "covered employee." Under pre-tax reform rules, a company (other than a smaller reporting company or emerging growth company) would generally have a maximum of four covered employees each year: its CEO and three highest paid officers (excluding the CFO) who were employed as of the last day of the year, as reported in the company's proxy statement. (Smaller reporting companies and emerging growth companies may have been subject to slightly different rules.) In contrast, the Tax Cuts and Jobs Act revised the rules so that a company's covered employees for any tax year starting on or after January 1, 2018, will include anyone who:

  1. served as its Principal Executive Officer ("PEO") or Principal Financial Officer ("PFO") for any portion of the year;
  2. was one of its top three highest paid officers for the year;
  3. was one of its covered employees for any prior tax year beginning after December 31, 2016.

New Guidance

The new guidance focused on how companies need to determine their top three highest paid officers each year. Perhaps surprisingly, the notice clarified that a company's top three highest paid officers for 162(m) covered employee purposes means "any employee who is among the three highest compensated executive officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity), regardless of whether the executive officer is serving at the end of the publicly held corporation's taxable year, and regardless of whether the executive officer's compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules." Said another way, this means that a company's "top three" officers for 162(m) covered employee purposes may be different from the officers that are actually reported in the company's Summary Compensation Table for such year.

To illustrate this point, the new guidance provides the following example:

Facts. Corporation Z is a calendar year taxpayer and a publicly held corporation within the meaning of section 162(m)(2)...Employees D, E, and F were, respectively, the first, second, and third most highly compensated executive officers of Corporation Z for 2018 other than the PEO and PFO, and all three retired before the end of 2018. Employees G, H, and I were, respectively, Corporation Z's fourth, fifth, and sixth highest compensated executive officers other than the PEO and PFO for 2018, and all three were serving at the end of 2018. Corporation Z disclosed [in its SEC filings] the compensation of Employee A for serving as the PEO, Employees B and C for serving as the PFO, and Employees G, H, and I pursuant to Item 402 of Regulation S-K. Corporation Z also disclosed the compensation of Employees D and E pursuant to Item 402 of Regulation S-K.

Conclusion: Three Highest Paid Executive Officers. Even though the SEC rules require Corporation Z to disclose the compensation of Employees D, E, G, H, and I for 2018, Corporation Z's covered employees for 2018 under section 162(m)(3)(B) are Employees D, E, and F, because these are the three highest compensated executive officers other than the PEO and PFO for 2018.

The guidance also clarified that smaller reporting companies and emerging growth companies need to follow the same process as larger reporting companies for determining their 162(m) covered employees. So, even though smaller reporting companies and emerging growth companies only need to report on their PEO and "top two" paid officers for SEC reporting purposes, they still need to include their PEO, PFO, and "top three" paid officers on their 162(m) covered employee list each year.

Practical Tips

Based on this new guidance, here are some practical tips for creating your list of covered employees:

  • You need to update your list of covered employees each tax year, including any short tax years.
  • You only add individuals to your covered employee list, never subtract, because once an individual is on your covered employee list, he or she forever remains a covered employee, even after termination of employment or death.
  • Your list of covered employees should start with anyone who was a covered employee under pre-tax reform rules for your 2017 tax year (i.e., any tax year that began after December 31, 2016, but before January 1, 2018).
  • You will then add the following individuals to your list each tax year, beginning with your first tax year that begins on or after January 1, 2018:
    • all individuals who served as your PEO or PFO for any portion of the year (including any individual who acted in such capacity without the formal title for any portion of the year); and
    • your top three highest paid officers for the year, regardless of whether they are employed on the last day of the year, calculated according to Item 402 of Regulation S-K of the Securities Exchange Act of 1934 (i.e., the Summary Compensation Table disclosure rules).

      To get to this list, you should rank, by pay, all officers who were employed on the last day of the year, and all officers who terminated employment at any point during the year, and select the three highest-paid individuals from that list. As noted above, these individuals may be different from the individuals who are listed in your Summary Compensation Table for the year.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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