3520 / Is there an upper limit on the amount of executive compensation that a publicly-traded corporation may deduct? How did the 2017 Tax Act legislation legislation impact this limit?

Editor’s Note: Under IRC Section 162(m), publicly traded corporations are not permitted to deduct compensation paid to “covered employees” to the extent the employees’ annual compensation exceeds $1 million. Covered employees generally include the CEO, CFO and next three-highest paid employees. For tax years beginning in 2027 and thereafter, the ARPA will require corporations to include the five next most highly compensated employees, increasing the number of covered employees to at least 10. However, under prior law, employees were counted as covered employees permanently once they became subject to the Section 162(m) limits discussed below. With respect to employees who only become covered under Section 162(m) because of the ARPA changes, the employee will not continue to be subject to Section 162(m) if the employee later ceases to qualify as a covered employee (i.e., covered employee status will not be permanent for employees who are not the CEO, CFO or among the top three most highly paid employees).IRS proposed regulations released early in 2025 clarify that the definition of "employee" for this purpose is the Section 3401(c) definition, including common law employees and officers of the corporation.  "Compensation" for this purpose includes any compensation that would be deductible as a business expense absent Section 162(m).IRC Section 162(m) mandates an upper limit on the amount that a publicly-traded corporation may deduct for compensation paid to certain executives, even though it may well otherwise be reasonable.¹ No deduction is permitted for “applicable employee remuneration” in excess of $1 million paid to any “covered employee” by any “publicly-held corporation.”²

Prior to 2018, a “covered employee” was defined as the corporation’s principal executive officer or any other employee who is one of the corporation’s three highest compensated officers (other than the corporation’s principal financial officer).³ This determination is made under the executive compensation disclosure rules of the Securities Exchange Act of 1934.⁴ The 2017 tax reform legislation expanded the definition of “covered employee” to include the chief financial officer and the chief executive officer (if the individual holds one of these positions at any time during the tax year). A covered employee now includes the three (rather than four) most highly compensated officers (other than the CEO and CFO) for the tax year who must be reported on the company’s proxy statement for the tax year (or who would be required to be reported if the company is not required to provide a proxy statement).⁵

---

Planning Point: The IRS proposed regulations provide that the employee need not have served as an executive officer as of the end of the company’s tax year in order to be treated as a covered employee (adopting the rule set forth in Notice 2018-68). Further, executive officers can be covered employees even if their compensation need not be disclosed. In determining the three most highly compensated employees, employers are entitled to rely on a reasonable, good faith interpretation of the statute until further guidance is released. The guidance also clarified that covered employees identified during a tax year that began in 2017 in accordance with pre-tax reform rules will continue to be covered employees for 2018 and beyond.

---

For tax years beginning after 2017, once the employee becomes a covered employee, he or she will stay a covered employee (even if the compensation is eventually paid to a beneficiary after the individual has died, to a beneficiary of a qualified domestic relations order or if the employee is no longer employed by the employer).⁶

The term “covered employee” also means any employee who was a covered employee of any predecessor of a publicly held corporation of the taxpayer for any preceding taxable year beginning after December 31, 2016. The proposed regulations use the term “predecessor of a publicly held corporation” for clarity. An individual who is a covered employee for one taxable year (including a taxable year of a predecessor of a publicly held corporation) remains a covered employee for subsequent taxable years. Specifically, a predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held.

The proposed regulations also provide that the term “predecessor of a publicly held corporation” includes a publicly held corporation that is acquired (as a target corporation), or the assets of which are acquired, by another publicly held corporation (the acquiror corporation) in certain transactions. The covered employees of the target corporation in those transactions are also covered employees of the acquiror corporation. With respect to asset acquisitions, if an acquiror corporation or one or more members of an affiliated group (acquiror group) acquires at least 80 percent of the operating assets (determined by fair market value on the date of acquisition) of a publicly held target corporation, then the target corporation is a predecessor of the acquiror corporation or group. For acquisitions of assets that occur over time, only acquisitions that occur within a 12-month period are taken into account to determine whether at least 80 percent of the target corporation’s operating assets were acquired.