IRS proposes rules to implement Section 162(m) expansion

The IRS recently released proposed regulations (REG-118988-22) to implement the expansion of covered employees subject to Section 162(m), which is scheduled to take place in 2027.

Section 162(m) limits a public company’s annual compensation deduction to $1 million for each covered employee. The American Rescue Plan Act (ARPA) expanded the definition of covered employee for tax years beginning after Dec. 31, 2026.

Under current law, the term “covered employee” includes the company’s principal executive officer (PEO) and principal financial officer [PFO) as well as the three highest-paid officers for the taxable year, other than the PEO and PFO (original covered employees). The highest-paid officers are determined based on the SEC proxy disclosure definition of compensation. Anyone treated as an original covered employees for any taxable year beginning after Dec. 31, 2016, remains an original covered employee in all future taxable years, regardless of whether the officer is still employed or an officer in the future taxable year — that is, once an original covered employee, always an original covered employee, meaning taxpayers can have more than five covered employees. 

Effective for taxable years beginning after Dec. 31, 2026, ARPA amends the definition of covered employee to add the top five highest-paid employees during the taxable years (ARPA five). The ARPA five are in addition to the original covered employees, so most publicly held companies will have a minimum of 10 covered employees during a taxable year. However, unlike the original covered employees, an employee who is part of the ARPA five for a taxable year would not automatically be a covered employee for future taxable years — the ARPA five are determined separately for each taxable year.

The proposed regulations would clarify several aspects of determining who is included in the ARPA five. The ARPA five may include any service provider who is an employee within the meaning of Section 3401(c), which includes common law employees and officers. This would mean that while the original covered employees are limited to executive officers, the ARPA five could include service providers who are not officers. Also, if the publicly held corporation is a member of an affiliated group, all employees of the affiliated group may be part of the publicly held corporation’s ARPA five group. 

The determination of who are the top five paid employees would be based on the aggregated amount of compensation otherwise deductible by the publicly held corporation (and its affiliated group) during the taxable year for compensation paid to the employee. This differs from how the top three paid officers are determined for purposes of the original covered employees, which is based on SEC compensation for the taxable year. Employees of affiliated foreign entities may be part of the ARPA five and special rules apply for determining the compensation for these employees. 

The proposed regulations would include a new concept where an individual service provider of an unaffiliated organization who performs substantially all the individual’s services for the publicly held corporation would be treated as an employee of the publicly held corporation when determining the ARPA five and nondeductible compensation under Section 162(m). This appears to be an anti-abuse rule that addresses, for example, situations where a publicly held corporation might move its employees to an unaffiliated employee leasing company (or similar organization) to avoid the application of Section 162(m).

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