IRS Proposes New Section 162(m) Regulations

On Jan. 16, the U.S. Department of the Treasury and the IRS issued proposed regulations to clarify certain provisions of Section 162(m) as amended by the American Rescue Plan Act of 2021 (ARPA). ARPA expanded the definition of covered employee under Section 162(m) for tax years beginning after Dec. 31, 2026. The proposed regulations provide rules for identifying the five highest-paid employees generally and for identifying these individuals in the context of affiliated groups.

Background

Under Section 162(m), a publicly traded company’s deduction for compensation is limited to $1 million per year per covered employee. The Tax Cuts and Jobs Act of 2017 (TCJA) amended Section 162(m) to remove an exception for performance-based compensation and to provide that once an individual is a covered employee, they are always a covered employee. The TCJA also expanded the definition of covered employee to include any individual who serves as CFO at any time during the year. ARPA further expanded the definition of covered employee to include any employee who is among the five highest-paid employees for the tax year other than the principal executive officer (PEO), the principal financial officer (PFO), or the three highest-paid executive officers other than the PEO or PFO, all of whom generally already are covered employees.

Proposed regulations

The long-awaited proposed regulations provide rules for identifying the five highest-paid employees, including in situations where there are affiliated groups. Comments on the proposed regulations are due by March 17. If finalized, the regulations would be effective for tax years beginning after the later of Dec. 31, 2026, or the date they are published in the Federal Register. Following are highlights of the proposed regulations.

Identifying the five highest-paid employees

Identifying the additional group of covered employees (the five highest-paid employees) for a particular tax year is based on employees’ compensation that otherwise would be deductible for that tax year absent any limitation under Section 162(m).

Crowe observation

This approach is much simpler than the approach that is required for determining whether an employee is one of the three highest-paid executive officers, which is based on compensation that is required to be disclosed under the Securities Exchange Act of 1934.

Anyone who is a covered employee for a particular year because they are one of the five executive officers under the SEC rules for that year cannot also be one of the five highest-paid employees for that year for purposes of Section 162(m). However, an employee who is a covered employee for a particular year because they were one of the five executive officers under the SEC rules in a prior year (the once-a-covered-employee, always-a-covered-employee rule) can be one of the five highest-paid employees for the year. The once-a-covered-employee, always-a-covered-employee rule does not apply to the five highest-paid employees.

Affiliated groups 

Any employee of any corporation in the public company’s affiliated group (as defined under the consolidated return rules) may be one of the five highest-paid employees. If an affiliated group has more than one corporation that is publicly traded, each public company will have its own set of five highest-paid employees. An affiliated group that has multiple public companies and at least one nonpublic company will be divided into smaller affiliated groups (as prescribed in the regulations), with each group consisting of one public company and certain affiliated nonpublic companies, if any. When determining whether an employee is one of the five highest-paid employees of a particular public company, only compensation paid by that public company or another member of its smaller affiliated group is considered. Compensation paid by a different public company or a nonpublic company that is part of the same smaller affiliated group with the different public company is not considered.

Employees of a public company or an affiliate of a public company include employees of other entities that function as employees of the public company or affiliate. For example, certified professional employer organization (CPEO) workers who legally are considered employees of the CPEO are treated as employees of a public company if they render services primarily to that public company. Fees paid by a public company to a CPEO for the services performed by CPEO employees are considered compensation paid by the public company to the CPEO employees. Accordingly, the public company’s ability to deduct such payments is limited by Section 162(m).

Looking ahead

The proposed regulations were published just days before President Donald Trump’s inauguration and are subject to recently issued executive orders and other administrative guidance that require review of agency regulations. It is unclear what the result of this review will be and whether the proposed regulations will be finalized, modified, or withdrawn.

Even if the proposed regulations are never finalized, the changes under ARPA are effective for tax years beginning after Dec. 31, 2026. ARPA’s expansion of the Section 162(m) covered employee group will result in additional administrative complexity and could result in additional lost deductions. Public companies should consider whether to identify their five highest-paid employees during 2025 and 2026 and model how deductions might be affected beginning in 2027. If it appears that future deductions might be limited, companies can begin to strategize regarding potential mitigation techniques, such as using deferred compensation to spread deductions over multiple years or pushing deductions into postemployment years when other compensation will be minimal or nonexistent.