Today’s installment of our overview of the Proposed Regulations under Code Section 162(m) highlights the expansion of who is a “covered employee.” As a reminder, Code Section 162(m) generally limits the compensatory deduction to the first $1 million of compensation paid by a publicly held corporation to each “covered employee.”
General Expansion of the Term “Covered Employee.” The Amendment expanded the definition of a “covered employee” to include (i) any employee who is the principal executive officer (PEO) or the principal financial officer (PFO) of a publicly held corporation at any time during the taxable year, or an individual acting in such a capacity, (ii) any employee whose compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 (the “Exchange Act”) by reason of such employee being among the three highest compensated officers for the year, other than the PEO and PFO, and (iii) any individual who was a covered employee of a publicly held corporation (or a predecessor) for any taxable year beginning after December 31, 2016.
The Proposed Regulations confirm that a covered employee includes any employee who is among the highest compensated executive officers for the taxable year, regardless of whether the officer is employed by the corporation on the last day of the year and regardless of whether the individual’s compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules. Thus, a corporation’s status as a smaller reporting company or an emerging growth company (which are allowed to disclose the compensation for a small number of executive officers) is not relevant for determining whether an employee is a “covered employee.”
Once a Covered Employee, Always a Covered Employee. The Proposed Regulations clarify that an individual who is a covered employee for years starting in 2017 remains a covered employee of the publicly held corporation for all subsequent taxable years, even after the individual has separated from service. Accordingly, any deduction for compensation paid to a covered employee after separation from service or paid to a person other than the covered employee after the death of the covered employee would be subject to Code Section 162(m). Moreover, if, after separation from service, the covered employee returns to provide services to the publicly held corporation in any capacity, including as an employee, a director, or an independent contractor, any deduction for compensation paid to such individual would be subject to the $1 million deduction limit.
Only Executive Officers are Covered Employees. The Proposed Regulations provide that only an executive officer of a publicly held corporation may qualify as a covered employee under Code Section 162(m). Whether an individual is an executive officer is determined under the Exchange Act rules.
As noted in last week’s installment, a “publicly held corporation” includes the parent corporation of a disregarded entity or a qualified subchapter S corporation (“QSub”) if such entity issues securities required to be registered under Section 12 of the Exchange Act or is required to file reports under Section 15 of the Exchange Act (generally publicly traded debt). The Proposed Regulations provide that the PEO and PFO of the disregarded entity/QSub are generally not treated as a PEO or PFO of the corporate owner. However, consistent with the definition of executive officer under the Exchange Act which treats executive officers of subsidiaries as executive officers of the registrant if the executive office performs policy making functions for the registrant, an executive officer of a disregarded entity/QSub will be treated as an executive officer of its corporate owner if the executive officer performs policy making functions for the corporate owner during the taxable year. The Proposed Regulations include several examples illustrating how to determine whether employees of a disregarded subsidiary are treated as covered employees of its corporate owner.
Covered Employees of a Predecessor Employer. As noted above, a covered employee includes an individual who was a covered employee of a publicly held corporation (or any predecessor) for a taxable year after December 31, 2016. In the context of corporate acquisitions, covered employees of a publicly held corporation that is acquired by another publicly held corporation will be treated as covered employees of the acquirer corporation. The Proposed Regulations contain numerous examples illustrating when a publicly held corporation is treated as a “predecessor” in the context of corporate reorganizations, corporate divisions, stock acquisitions and asset acquisitions. The Proposed Regulations also provide that a publicly held corporation is a “predecessor” if it was a publicly held corporation, became privately held, and then becomes a publicly held corporation within 36 months of the private transaction.
Next week, we will look more closely at what “compensation” is subject to Code Section 162(m) deduction limitation.
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