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Section 162(m) Toolkit
Practical Law Toolkit w-000-6179 (Approx. 6 pages)
Section 162(m) Toolkit
by Practical Law Employee Benefits & Executive Compensation
| Maintained • USA (National/Federal) |
Resources to assist employers and practitioners in complying with Section 162(m) of the Internal Revenue Code. Section 162(m) generally limits to $1 million the deduction that a public company can claim in any tax year for compensation paid to each of certain executive officers.
Section 162(m) of the Internal Revenue Code (26 U.S.C. § 162(m)) ("Section 162(m)") prohibits public companies from deducting more than $1 million per year in compensation paid to covered employees. On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the TCJA) which significantly reformed the U.S. Tax Code, including Section 162(m). The TCJA made two primary changes to Section 162(m) that substantially impact how public companies design their executive compensation arrangements:
- The elimination of the performance-based compensation exception to the $1 million deduction limit.
- The expansion of the individuals who are covered employees.
Prior to the enactment of the TCJA, to ensure maximum deductibility of compensation paid to covered employees, most public companies designed their executive compensation arrangements to comply with the performance-based compensation exception to the greatest extent possible. This included complying with onerous documentary and procedural requirements such as:
- Establishing objective performance goals in advance and only paying incentive compensation if the performance goals are attained.
- Including in plans a list of business criteria on which performance goals can be based and having them approved by shareholders every five years.
- Having the compensation committee certify the achievement of performance goals before any amounts are paid.
Many of the provisions included in plans to comply with the performance-based compensation exception, particularly those related to tying pay to performance, are preferred by shareholders and other stakeholders who will likely continue to look for them in new plans. Nonetheless, since the enactment of the TCJA, many companies have been:
- Eliminating or diminishing certain onerous provisions to the extent no longer required under Section 162(m).
- Increasing the compensation committee's discretion.
The TCJA is generally effective for taxable years beginning after December 31, 2017. However, for purposes of the performance-based compensation exception, the TCJA includes a transition rule for written binding contracts that were in effect before November 2, 2017. Arrangements that qualify under the transition rule can continue to operate in the same manner, and compensation will continue to qualify as performance-based compensation, provided that the requirements of the exception are met and the arrangement is not materially modified.
Following the enactment of the TCJA, the IRS received many comments requesting guidance on the application of the changes made by the TCJA to Section 162(m). On August 21, 2018, the IRS and the Treasury Department issued Notice 2018-68 (the Notice) which provides initial guidance on certain aspects of the Section 162(m) amendments, including the amended rules for identifying covered employees and the operation of the transition rule. For information on the Notice, see Legal Update, IRS Issues Initial Guidance on the Application of Section 162(m) After Tax Reform. Further guidance was issued in the form of proposed regulations in December 2019, incorporating and expanding on the guidance provided in the Notice. For information on the proposed regulations, see Legal Update, IRS Issues Proposed Regulations Addressing Changes Made to Section 162(m) by the Tax Cuts and Jobs Act. In December 2020, the IRS issued final regulations addressing the application of the changes made to Section 162(m), which retained the basic approach of the proposed regulations, with a few clarifications and a few changes. See Legal Update, IRS Issues Final Regulations Addressing Changes Made to Section 162(m) by the Tax Cuts and Jobs Act.
For more information on the TCJA generally, see Legal Update, Tax Reform is Enacted With Significant Implications for Executive Compensation and Employee Benefits.
Because of the TCJA's transition rule, the performance-based compensation exception remains relevant for grandfathered plans.
In March 2021, in response to the COVID-19 pandemic, Congress passed and the President signed the American Rescue Plan Act of 2021 (ARPA-21), economic stimulus legislation which includes numerous employee benefits and executive compensation (EBEC) provisions. Among the EBEC provisions is an expansion of the definition of "covered employee" under Section 162(m) effective for taxable years beginning after December 31, 2026. ARPA-21 adds another layer of complexity for employers subject to Section 162(m) that must keep track of their covered employees and ensure that they properly apply the $1 million deduction limit.
This Section 162(m) Toolkit contains continuously maintained resources to help companies:
- Understand the tax implications of Section 162(m).
- Track their covered employees.
- Draft compensation plans and policies that comply with Section 162(m).
- Avoid common Section 162(m) pitfalls.
- Adopt procedural safeguards to increase Section 162(m) compliance.