The 2017 tax reform (known as the TCJA) significantly amended IRC Section 162(m). Arrangements that were in effect pre-TCJA and subject to (or potentially subject to) Section 162(m) often include certain language to avoid significant Section 409A tax penalties for employees and related payroll and deduction exposures for employers. Ironically, certain TCJA changes to Section 162(m) result in this same language creating 409A tax exposures for arrangements subject to the new law. The U.S. Department of the Treasury and the IRS provide relief if certain actions are taken no later than Dec. 31, 2020 – a deadline that is fast approaching.
Congress added Section 162(m) to the IRC via the Omnibus Budget Reconciliation Act of 1993. Section 162(m) limits an employer’s compensation deduction to $1 million per year for each covered employee of a publicly held corporation. As enacted, employers could use various loopholes to avoid the deduction limit – including delaying payment of compensation earned by a covered employee until the related deduction was attributable to a taxable year when the individual no longer was a covered employee.
The TCJA eliminated this loophole by treating a covered employee for any taxable year beginning with 2017 as a covered employee for all time, even with respect to payments beyond the individual’s death. Moreover, effective beginning with the 2018 tax year, the TCJA expands the definition of covered employee (previously the principal executive officer (PEO) and the three highest-compensated officers other than the PEO, based on holding that position at year-end) to include anyone who is the PEO or principal financial officer (PFO) at any time during the taxable year, along with the three highest-compensated officers during the taxable year other than the PEO and PFO. Thus, for a given taxable year, the deduction limitation applies with respect to compensation of not only the five covered employees meeting this definition for a taxable year but to anyone who met that definition in a prior taxable year.
Other significant Section 162(m) changes include expanding the definition of a publicly held corporation to include certain nonpublicly traded companies and removing the exemption for compensation meeting various performance-based requirements. The TCJA permits grandfathering of compensation subject to a written binding contract in effect on Nov. 2, 2017, and not materially modified after this date. Specific complex rules apply for this determination, but even grandfathered arrangements are exempt from Section 162(m) only if exempt under pre-TCJA Section 162(m).
Proposed regulations under Section 162(m) released on Dec. 20, 2019, provide significant guidance on the various TCJA changes and include relief in connection with Section 409A’s intersection with Section 162(m).