The Internal Revenue Service (IRS) recently published proposed regulations implementing amendments made to Section 162(m) of the Internal Revenue Code (Section 162(m)) by the Tax Cuts and Jobs Act of 2017 (TCJA).While generally consistent, the proposed regulations expand on initial Section 162(m) guidance provided by the IRS in Notice 2018-68 (described here).In large part, the newly proposed regulations are detailed and technical, and we summarize them below. Publicly held companies that already exceed or that may soon exceed the Section 162(m) deduction limit will need to carefully consider the impact of amended Section 162(m).

Companies that have recently experienced an initial public offering (IPO) or companies contemplating an IPO should be aware of the potential future application of amended Section 162(m). Most notably, the proposed regulations eliminate a previously popular transition rule for private companies that become publicly held. Preexisting regulations provided an IPO exception allowing a transition period under Section 162(m) for a company that becomes publicly traded. The proposed regulations do not provide a similar IPO transition exception and, therefore, companies seeking to have an IPO may want to consider (1) examining future deductibility of executive compensation for corporate income tax purposes and (2) assessing the level of remuneration provided to their executive management team in advance of an IPO.

The newly proposed regulations are subject to a 60-day comment period.Once adopted in final form, the Section 162(m) regulations generally will apply to taxable years beginning on or after the date of their publication.Taxpayers may rely on the proposed regulations until the final regulations become effective.

Background on Section 162(m)

Section 162(m) imposes a $1 million cap on the deductibility of compensation paid to certain executives ("covered employees") by a publicly held corporation. Prior to passage of the TCJA, Section 162(m) included an exclusion from the $1 million cap for commission-based and qualified performance-based compensation.

For tax years beginning after December31, 2017, the TCJA amended Section 162(m) to expand the scope of public companies subject to its deduction limitation, cover more executive officers and eliminate the exception for commission-based and qualified performance-based compensation.

The TCJA, however, provided a "grandfather rule" for compensation paid under a "written binding contract" in effect on, and not "materially modified" after, November2,2017. Compensation covered by the grandfather rule is subject to the old Section 162(m) rules.

Notice 2018-68 provided initial guidance on the TCJA's expanded definition of Section162(m) covered employees and notably gave a narrow construction to the grandfather rule. The Notice did not address certain situations, such as the impact of the new rules on companies newly public as a result of an initial public offering or spinoff that have benefitted from transition relief.

Proposed Section 162(m) regulations

The IRS has now proposed new regulations to implement the TCJA's amendments to Section162(m), effective for taxable years beginning after December 31, 2017, and to supersede Notice 2018-68. Except for certain payments covered by the grandfather rule, the proposed regulations state that no deduction is allowed to "any publicly held corporation for compensation paid to any covered employee to the extent that the compensation for the taxable year exceeds $1,000,000."The primary topics covered by the proposed regulations include:

  • definition of publicly held corporation
  • definition of covered employees
  • compensation subject to the deduction limitation
  • operation of the grandfather rule and
  • elimination of IPO relief.

The proposed regulations also include many new examples illustrating these rules.

Publicly held corporation

Following the TCJA, a publicly held corporation for purposes of Section 162(m) is any corporation that, as of the last day of its taxable year, either (1) is an issuer of a class of securities (not just common equity securities) that is required to be registered under Section 12 of the Securities Exchange Act of 1934 (Exchange Act) or (2) is required to file reports under Section15(d) of the Exchange Act.This definition covers a corporation whose only publicly traded security is debt.

Under the proposed regulations, a publicly held corporation includes any of the following entities that meet the registration or reporting conditions:

  • an S corporation, including an S corporation owning a qualified subchapter S subsidiary (QSub) that meets the registration or reporting conditions
  • a foreign private issuer (ie, a non-governmental foreign issuer meeting a threshold level of US connections)
  • a publicly held subsidiary corporation
  • a publicly traded partnership treated as a corporation under the Internal Revenue Code
  • an affiliated group of corporations (determined by an 80 percent ownership test) that includes one or more publicly held corporations (with each publicly held member of the group also separately subject to Section 162(m)) and
  • a corporation owning a disregarded entity (ie, as sole owner) that meets the registration or reporting conditions.

The proposed regulations contain additional guidance regarding the application of Section162(m) to affiliated groups of corporations, including:

  • A privately held parent corporation of a publicly held subsidiary corporation will be treated as part of a publicly held affiliated group.
  • A privately held foreign subsidiary of a domestic publicly held corporation will be treated as part of a publicly held affiliated group.
  • Rules for proration of a Section 162(m) deduction disallowance where a covered employee receives compensation from more than one member of the affiliated group.

Covered employee

Under the proposed regulations, a covered employee for the taxable year of a publicly held corporation means each of the following:

  • each person serving at any time during the taxable year as the principal executive officer (PEO) or principal financial officer (PFO)
  • the three highest compensated executive officers (other than the PEO or PFO), regardless of whether serving at the end of the taxable year or whether the executive officer's compensation is subject to disclosure for the last completed fiscal year under the executive compensation disclosure rules of the Exchange Act and
  • each individual who was a covered employee of the publicly held corporation (or any predecessor of the publicly held corporation) for any taxable year beginning after December 31, 2016 ("once a covered employee, always a covered employee"). For a taxable year beginning in 2017, covered employee status is determined under the pre-TCJA Section 162(m) rules.

The proposed regulations include additional guidance for determining a publicly held corporation's covered employees, including:

  • Only executive officers as defined by the Exchange Act may qualify as covered employees for purposes of Section 162(m)
  • If a publicly held corporation has a taxable year different from its fiscal year, its three highest compensated executive officers are to be determined by applying the executive compensation disclosure rules under the Exchange Act as if the taxable year is a fiscal year
  • A covered employee of a publicly held corporation for any taxable year beginning after December 31, 2016 who separates from service remains a covered employee for any post-separation compensation received from that corporation and
  • Rules for identifying the predecessor of a publicly held corporation under various circumstances, including a publicly held corporation that goes private and then again becomes publicly held; a publicly held corporation acquired in a merger or whose assets are acquired by another publicly held corporation; a publicly held corporation that distributes another publicly held corporation in a spinoff; or a publicly held corporation acquired by a private company that subsequently becomes publicly held.


Under amended Section 162(m), compensation potentially subject to the deduction limitation includes commission-based and performance-based compensation, which can no longer be excluded unless covered by the grandfather rule discussed below. Compensation means the aggregate amount allowable as a deduction for the taxable year (without regard to Section 162(m)) for remuneration for services performed by a covered employee in any capacity (including as a director or consultant), whether or not the services were performed during the taxable year.

The proposed regulations include a number of clarifications of the compensation subject to Section 162(m):

  • Compensation includes remuneration for the covered employee's services that is paid to another person, such as a beneficiary after the covered employee's death.
  • Compensation includes remuneration paid for a covered employee's services in a capacity other than as an employee, such as director's fees paid for continued board service following the executive officer's retirement from employment.
  • Subject to a special transition rule, a publicly held corporation that is a partner of a partnership that pays compensation to a covered employee of the corporation must treat as compensation for purposes of Section 162(m) its share of the partnership's deduction for the compensation paid to the covered employee.
  • The proposed regulations eliminate transition relief previously available for corporations that become publicly held as a result of an initial public offering or spinoff. Section 162(m) will apply to compensation paid to a covered employee in the taxable year during which the corporation's registration statement becomes effective, including compensation paid before the corporation became publicly held. This new rule applies to any corporation that becomes publicly held on or after December 20, 2019.

Grandfather rule

The proposed regulations continue to narrowly interpret the grandfather rule provided by the TCJA. Under the grandfather rule, the Section 162(m) amendments do not apply to compensation provided pursuant to a written binding contract that was in effect on November 2, 2017 and that has not been materially modified after that date. Grandfathered compensation will remain subject to Section162(m) as in effect prior to the TCJA amendments, including the exclusion of the PFO from treatment as a covered employee and the exclusion of compensation-based or qualified performance-based compensation from the Section 162(m) deduction limitation.

Consistent with Notice 2018-68, the proposed regulations provide that compensation is grandfathered only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the compensation under a written contract as in effect on November 2, 2017 if the employee performs services or satisfies applicable vesting conditions. Any amount of compensation that exceeds the amount that applicable law obligates the corporation to pay under the contract as in effect on November 2, 2017 is not grandfathered and is subject to amended Section162(m).

The proposed regulations provide guidance on the definitions of "written binding contract" and "material modification" for purposes of amended Section 162(m), including:

Written binding contract

  • A written binding contract does not exist with respect to any amount of compensation that the employer has a discretionary right under applicable law to eliminate ("negative discretion"). Only the amount that the employer is obligated by applicable law to pay under the terms of the contract as in effect on November 2, 2017 will be treated as subject to a written binding contract. The proposed regulations clarify that in situations where a contract purports to provide the employer with negative discretion that extends beyond what would be permitted under applicable law, the negative discretion is taken into account only to the extent that applicable law permits. A corporation must analyze other applicable in each instance.
  • If a written binding contract is renewed after November 2, 2017, amended Section162(m) will apply to any payments made after the renewal date. For example, a contract that can be terminated after November 2, 2017 by the employer without the employee's consent (eg, by giving notice of non-renewal) will be treated as renewed as of the earliest date such termination could be effective. If the contract is not terminated, payments made after the deemed renewal date are not grandfathered.
  • An employer's obligation or discretion to clawback compensation paid in a taxable year upon a future event that is objectively outside of the employer's control is disregarded in determining whether the compensation is grandfathered. However, if the event occurs, then only the amount that the employee is nevertheless entitled to retain under applicable law remains grandfathered, whether or not the employer exercises the clawback.
  • If a written binding contract in effect on November 2, 2017 provides for severance, only the compensation that the employer would be obligated to pay under the contract if employment was terminated on November 2, 2017 may be grandfathered. For example, if the contract provides as of November 2, 2017 for severance equal to the sum of the employee's annual base salary and the prior year's discretionary bonus, upon a subsequent termination of employment for which severance is payable, only the amount of annual base salary in effect on November 2, 2017 would be grandfathered. The discretionary bonus component of severance would not be grandfathered.

Material modification

  • A material modification of a contract occurs if it is amended to increase the amount of compensation payable to the employee. The modified contract is treated as a new contract, and all amounts received by the employee under the contract following its modification after November 2, 2017 are not grandfathered and instead are subject to amended Section 162(m).
  • If a contract is modified after November2, 2017 to increase compensation by more than a reasonable cost of living adjustment, then it will be treated as materially modified, and all payments of compensation under the contract after the date of the modification (not just the increased compensation) are not grandfathered. However, if the increase in compensation is limited to a reasonable cost of living adjustment, then the increase will not be treated as a material modification, although the adjustment amount itself will not be grandfathered.
  • A material modification includes the modification of a contract in effect on November 2, 2017 to accelerate the payment of compensation, unless the payment is discounted to reasonably reflect the time value of money.
  • If a contract in effect on November 2, 2017 is amended to defer the payment of compensation, any increase in the payment amount will not be a material modification as long as the additional amount reflects only a reasonable rate of interest or the rate of return on a predetermined actual investment.However, the additional amount itself generally will not be grandfathered.
  • If a grandfathered amount is subject to a substantial risk of forfeiture (ie, vesting), a modification of the contract that results in the lapsing of the substantial risk of forfeiture is not a material modification. For example, accelerated vesting of equity-based compensation, such as a stock option or restricted stock, under a contract in effect on November 2, 2017 does not constitute a material modification of that contract.
  • The proposed regulations include coordinating rules for nonqualified deferred compensation arrangements under Section 409A. Section 409A permits payment of deferred compensation to be further deferred to the extent that the corporation reasonably anticipates that, if the payment were made as originally scheduled, it would not be deductible under Section 162(m).Due to the new definitions of "covered employee" (ie, the new "once a covered employee, always a covered employee" rule), such delayed payments may never become payable. The proposed regulations therefore allow for certain amendments to be made to such arrangements to avoid this result without having those amendments being treated as a "material modification," provided such amendments are made by December 31, 2020.

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.