The IRS recently published proposed changes to regulations under Section 162(m) of the Internal Revenue Code (IRC), to implement a feature of the American Rescue Plan Act of 2021 (ARPA) that expands the number of executives subject to the regulation. The regulations effectively add the next 5 highest paid employees to those whose compensation is not deductible in excess of $1M.

Background of Existing Regulation

The existing 162(m) regulation limits the deductibility of compensation exceeding $1,000,000 to certain highly paid “covered employees” at publicly traded companies for tax purposes. The definition of “covered employees” includes the CEO, CFO and next three highest paid officers; generally, the “Named Executive Officers.” There is an additional “once a covered employee, always a covered employee” requirement that limits deductibility for any employee who has been a Named Executive Officer since 2017.

What’s Changing under the Proposed New Rules

Beginning after December 31, 2026, the ARPA amended the regulation to cover additional employees. The new regulations will include the next five highest compensated employees of the company in addition to the Named Executive Officers. The next five highest compensated employees are not limited to officers of the company, as with the original five. Additionally, the next five highly compensated employees may change each year and are not subject to the “once covered, always covered” concept.

The definition of “Employee” includes individuals who are employed directly by the company at any time during the year, and those employed by a subsidiary of the publicly traded company, and contractors. The regulation is concerned with preventing companies from avoiding the expanded coverage by employing highly compensated individuals through a subsidiary.

If a former Named Executive Officer subject to the "once covered, always covered" rule is among the five highest-paid employees, then that employee can count as one of the five additional. If this is the case, the Company would lose its tax deduction for fewer than five additional employees.

The compensation used to identify covered employees is the amount of compensation that would otherwise be deductible by the company in the reporting year, whether or not it is for services performed by the employee during the taxable year. This is not the same method that is used for identifying the Named Executive Officers under the Exchange Act, but it is already tracked by companies in this way and therefore should not be burdensome.

Comment Period for the Proposed Rules

The IRS has requested comments for a public hearing on the proposed regulations. Comments must be submitted by March 17, 2025.

Thinking Ahead

• Companies should develop a way to track and identify “highest paid employees” under the different methodology to obtain next five. This includes monitoring subsidiary and foreign employees
• Companies should consider whether any compensation can be timed to be deductible prior to the regulations taking effect in January 2027
• Industries where there are very highly compensated employees who are not officers are likely to be impacted the most (e.g., financial services, entertainment, highly-compensated sales force)