United States: Who Are Your Section 162(m) "Covered Employees" After Mergers, Acquisitions And Other Transactions?

Section 162(m) of the Internal Revenue Code (the “Code”) limits the deductibility of compensation paid by public companies to certain of their executives in any year to $1 million.

The 2017 Tax Cuts and Job Act (the “TCJA”) amended Section 162(m) to expand the number of executives at a public company1 whose compensation may be non-deductible by reason of its provisions (“Covered Employees”).  On December 16, 2019, the Internal Revenue Service (“IRS”) issued proposed regulations under Section 162(m) as amended by the TCJA (the “Proposed Regulations”).2 

This alert memorandum discusses newly proposed IRS rules under which a public company can effectively inherit Covered Employees – employees whose compensation above $1 million, including base salary, cash and equity incentive awards, retention awards and severance benefits, will be non-deductible – in connection with mergers, acquisitions and other transactions.  The impact of these rules, if adopted as proposed, could be financially significant to some acquisitions, and the potential accumulation by acquisitive public companies of numerous Covered Employees could have ongoing notable financial impact.

Background

For nearly twenty-five years, Section 162(m) contained an exception for “qualified performance-based compensation”; however, this exception was eliminated by the TCJA.  The TCJA also expanded the group of executives whose compensation is subject to the deductibility limitation.  Covered Employees include the CEO, CFO and three other most highly compensated executive officers of the company.  However, under the TCJA, once an executive officer qualifies as a Covered Employee, he or she will continue to be treated as a Covered Employee indefinitely, even after ceasing to serve as an executive officer or separating from the company.3 

Predecessor Corporations and M&A Transactions

Under Section 162(m) as amended by the TCJA, Covered Employees include any employee who was a covered employee of any “predecessor” of the taxpayer for any preceding taxable year beginning after December 31, 2016.  The Proposed Regulations explain that an individual who is a Covered Employee of a predecessor of a public company for a taxable year is a Covered Employee of the public company for subsequent taxable years.  This aspect of the rule functions cumulatively so as to include any predecessor of a predecessor of a public company and so on.

The Proposed Regulations set forth how the predecessor rule applies in the context of merger and acquisition transactions.  Under the Proposed Regulations, target companies will generally be considered predecessors of an acquiror.  Thus, Covered Employees of any company acquired by a public company may become Covered Employees of the acquiring public company forever, significantly expanding the scope of Covered Employees at acquisitive public companies and requiring the acquiror to carefully track Covered Employees of the target for purposes of Section 162(m).  These provisions are proposed to apply to corporate transactions effectuated on or after the date of publication of final regulations in the Federal Register.4

Affected Transactions

The predecessor rule in the Proposed Regulations is broadly applicable across several types of corporate transactions (“Affected Transactions”).  Affected Transactions under the Proposed Regulations include the following transactions involving public companies5:

  • Corporate Reorganizations.The Proposed Regulations provide that predecessors include public companies whose stock or assets are acquired in tax-free corporate reorganizations6, such as mergers or certain other acquisitions of corporations for stock of the acquiring corporation.Accordingly, for example, if public company A acquires public company B in a stock-for-stock reverse subsidiary merger, the Covered Employees of company B become Covered Employees of company A forever.Incentive, severance and other compensation payable to the former Covered Employees of company B following the acquisition would be subject to Section 162(m)’s $1 million deductibility limitation.The same limitation would apply to those company B Covered Employees if years later company A were acquired in an Affected Transaction by public company X.
  • Corporate Divisions.The Proposed Regulations also apply to spin-offs.Under the Proposed Regulations, Covered Employees of a publicly held distributing corporation that commence employment with the spun-off company within the period beginning 12 months before, and ending 12 months after, the spin-off are Covered Employees of the spun-off company.
  • Stock Sales.The Proposed Regulations provide that Covered Employees of a public company target that becomes part of a public company acquiror’s affiliated group, for example through a tender offer, will become Covered Employees of the acquiror.
  • Asset Sales.Under the Proposed Regulations, if a public company acquiror acquires at least 80% of the operating assets (determined by fair market value on the date of acquisition) of a public company target, and the Covered Employees of the target commence employment with the acquiror (or an affiliate) within the period beginning 12 months before, and ending 12 months after, the date of the transaction, those employees will become Covered Employees of the acquiror.For asset sales that occur over time, only assets acquired within a 12-month period are taken into account in determining whether the 80% threshold has been met.Such 12-month period includes any continuous period that ends or begins on any day during which the acquiror has an arrangement to purchase (directly or indirectly) the target’s assets.

The Proposed Regulations also contain guidance regarding the application of the predecessor rule to companies that are not public at the time of the transaction.  In particular:

  • Target is Not a Public Company.If the target was previously public, but is not a public company at the time of the transaction, the target will nonetheless be a predecessor to the acquiror if the acquiror is a public company at the time of the transaction and the transaction takes place during a taxable year ending before the 36-month anniversary of the due date for the target’s US federal income tax returns for the last taxable year for which the target was previously publicly held.
  • Acquiror is Not a Public Company.If the target is a public company, but the acquiror is not, the target will still be considered a predecessor of the acquiror if the acquiror becomes a public company for a taxable year ending before the 36-month anniversary of the due date for the target’s US federal income tax return for its last taxable year in which the transaction is taken into account.
  • Neither Corporation is a Public Company.If the target was previously publicly held, but neither the target nor the acquiror is publicly held at the time of the transaction, the target is a predecessor if the acquiror becomes a public company for a taxable year ending before the 36-month anniversary of the due date for the target’s US federal income tax return for the last taxable year for which the target was previously publicly held.

Key Takeaways

  • We expect that accounting for a target’s Covered Employees will become a common part of the diligence process and representation and warranty requests for transactions involving public companies.
  • If in connection with an Affected Transaction a public company becomes obligated to pay Covered Employees of the target substantial incentive, retention or severance compensation in the year or two after the acquisition occurs (e.g., a retention bonus or a change in control payment), these payments will largely no longer be deductible. Currently, Section 162(m) deductibility limits usually do not impact post-closing compensation paid to Covered Employees of a target.To the extent the parties to the transaction agree to allocate the cost of such liabilities to the sellers/target via a purchase price adjustment (e.g., through a company transaction expense, transaction tax benefit and/or indebtedness concept), acquirors may want to consider how the loss of any deduction is accounted for (if at all) in such adjustment.
  • Acquisitive companies, or companies that acquire acquisitive companies, should be prepared for the possibility that the number of their Covered Employees will grow substantially as a result of the Proposed Regulations.

Footnotes

1 The  TCJA also expanded the definition of  “publicly held corporation” to include (a) corporations with any class of securities (as opposed to a class of common equity securities) required to be registered under section 12 of the Securities Exchange Act of 1934 (“Exchange Act”) and (b) corporations required to file reports under section 15(d) of the Exchange Act. Most significantly this will expand the scope of Section 162(m) to cover issuers of publicly traded debt and foreign private issuers who offer or list their securities in the United States and, as a result, are required to register their securities under section 12 of the Exchange Act.

2 The Proposed Regulations are available at https://www.govinfo.gov/content/pkg/FR-2019-12-20/pdf/2019-26116.pdf.  The Proposed Regulations confirm and, in part, expand, previous IRS guidance issued in August 2018.  For a discussion of the IRS guidance contained in Notice 2018-68, see our alert memorandum “Tax Reform: IRS Issues Guidance on Section 162(m)”, available at https://www.clearygottlieb.com/eform-irs-issues-guidance-on-section-162m-pdf.pdf

3 For example, post-separation severance and deferred compensation payouts to Covered Employees would be subject to the deduction limitation.  Prior to the TCJA, if an individual was not an executive officer as of the end of the relevant taxable year, he or she could not qualify as a Covered Employee and therefore such payments would not be subject to the limitation.

4 Until the effective date under final regulations, taxpayers may rely upon the Proposed Regulations or a “reasonable good faith interpretation” of the term “predecessor.”

5 The Proposed Regulations provide an extensive set of examples intended to illustrate the application of the proposed predecessor rules to various types of corporate transactions.

6 As defined in Section 368(a)(1) of the Code.

To view original article, please click here.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions