Covered Employee | Practical Law

Covered Employee | Practical Law

Covered Employee

Covered Employee

Practical Law Glossary Item 3-569-8266 (Approx. 4 pages)

Glossary

Covered Employee

On December 22, 2017, Congress passed and President Trump signed the Tax Cuts and Jobs Act (the Act) which significantly reforms the U.S. Tax Code (the Code), effective for taxable years beginning after December 31, 2017.
Among other changes, the Act:
  • Broadens Section 162(m)'s definition of covered employee.
  • Establishes an excise tax on tax-exempt organizations for certain compensation paid to employees, as defined in the Act.
In many cases, the application of the changes made to Section 162(m) by the Act was unclear and commenters requested guidance. On August 21, 2018, the Internal Revenue Service (IRS) and the Treasury Department issued Notice 2018-68 to clarify certain aspects of the amendments, including the amended rules for identifying covered employees. On December 31, 2018 the IRS issued Notice 2019-9 to clarify amended rules as they pertain to tax-exempt organizations under Section 4960.
Section 162(m)
Section 162(m) (26 U.S.C. § 162(m)) generally limits to $1 million the amount of compensation a public company may deduct in any taxable year for compensation paid to any of its covered employees.
The definition of covered employee for purposes of Section 162(m) is as follows:
For taxable years beginning on or before December 31, 2017 (pre-tax reform definition):
  • Anyone serving as the chief executive officer (CEO) as of the last day of the taxable year.
  • The three most highly compensated officers, excluding the CEO and the chief financial officer (CFO), whose compensation is required to be reported to shareholders under the Securities and Exchange Commission's (SEC's) executive compensation disclosure rules.
  • For companies that may elect to disclose executive compensation under the reduced disclosure requirements of Item 402(m) of Regulation S-K (17 C.F.R. § 229.402(m)), such as smaller reporting companies and emerging growth companies:
    • anyone serving as the CEO as of the last day of the taxable year; and
    • the two most highly compensated officers whose compensation is required to be reported to shareholders under the SEC's executive compensation disclosure rules, excluding the CEO (a CFO can be a covered employee on the basis of his or her compensation).
    • up to two additional individuals for whom disclosure would have been provided pursuant to the immediately preceding bullet but for the fact that the individual was not serving as an executive officer at the end of the last completed fiscal year.
For taxable years beginning after December 31, 2017 (post-tax reform definition):
  • Anyone who served as the CEO or CFO at any time during the taxable year (broadening the definition to pick up CFOs and individuals who served as CEO or CFO at any time during the year).
  • The three most highly compensated officers, other than the CEO and the CFO, whose compensation is required to be reported to shareholders under the SEC's executive compensation disclosure rules (or who would be required to be reported for a company not required to make such a report to shareholders).
  • Anyone who was a covered employee of the taxpayer, or any predecessor, for any taxable year beginning after December 31, 2016. This means that once an individual becomes a covered employee for any taxable year beginning after December 31, 2016, that individual will remain a covered employee for all future years, including after termination of employment or death.
  • The Act clarifies that compensation does not fail to be compensation with respect to a covered employee because the compensation is includible in the income of, or paid to, another individual (for example, a beneficiary).
Notice 2018-68 clarifies that under the post-tax reform definition:
  • The term covered employee for a taxable year includes any employee who is among the three highest compensated executive officers for the taxable year (other than the PEO and PFO, or an individual acting in that capacity) regardless of whether:
    • the executive officer is serving at the end of the corporation's taxable year; or
    • the executive officer's compensation is subject to disclosure for the last completed fiscal year under the SEC's executive compensation disclosure rules.
  • The term covered employee includes any individual who was a covered employee of the corporation (or any predecessor) for any taxable year beginning after December 31, 2016. However, for taxable years beginning before January 1, 2018, covered employees are determined under the pre-amendment rules. This means that individuals who are determined to be covered employees for the taxable year beginning in 2017 under the pre-amendment rules will continue to be covered employees in future taxable years.
  • A corporation's status as a smaller reporting company or an emerging growth company is not relevant for purposes of determining a corporation's covered employees.
Tax-Exempt Organizations
Under Section 4960 (26 U.S.C. § 4960), a tax-exempt organization is subject to a 21% excise tax on:
  • Compensation that exceeds $1 million paid to any of its covered employees for a taxable year.
  • Any excess parachute payments (under a new definition that relates only to separation pay) to its covered employees, subject to certain limited exceptions.
For purposes of this provision, a covered employee is an employee (including any former employee) of the tax-exempt organization if the employee:
  • Is one of the five most highly compensated employees of the organization for the taxable year.
  • Was a covered employee of the organization, or any predecessor, for any taxable year beginning after December 31, 2016. This means that once an individual becomes a covered employee for any taxable year beginning after December 31, 2016, that individual will remain a covered employee for all future years, including after termination of employment or death.