This installment of the overview of the Proposed Regulations under Code Section 162(m) focuses on the definition of what is “applicable employee remuneration.” As a reminder, Code Section 162(m) generally limits the compensatory deduction to the first $1 million of “applicable employee remuneration” paid by a publicly held corporation to each covered employee.
General Definition of “Applicable Employee Remuneration”
Code Section 162(m)(4) defines the term “applicable employee remuneration” with respect to any covered employee for any taxable year as the aggregate amount allowable as a deduction for such taxable year (determined without regard to Code Section 162(m)) for compensation for services performed by the covered employee (whether or not during the taxable year). The proposed regulations reflect the amendments made to Code Section 162(m) by the Tax Cuts and Jobs Act (“TCJA”). As a note to the reader, the proposed regulations use the term “compensation” instead of “applicable employee remuneration.”
Section 13601(a) of TCJA amended the Code’s definition of applicable employee remuneration to eliminate the exclusions that had been available for qualifying commissions and performance based compensation paid to covered employees. In addition, Section 13601(d) of TCJA added a special rule for amounts paid to a covered employee’s beneficiaries, which provides that compensation will be “applicable employee remuneration” even if it is includible in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.
Application of Code Section 162(m) to Covered Employees Performing Services for Partnerships
The proposed regulations also address the issue of compensation paid by a partnership to a covered employee of a publicly held corporation, which has been the subject of a “no-rule” position for private letter rulings since Revenue Procedure 2010-3 was released in 2010. Prior to the adoption of this position on issuing rulings, the IRS had released multiple private letter rulings stating that, when a publicly held corporation is a partner in a partnership, Code Section 162(m) does not apply to the corporation’s distributive share of the partnership’s deduction for compensation paid by the partnership for services performed for it by a covered employee of the corporation.
The proposed regulations highlight that the language in Code Section 162(m)(1) is broad and does not limit the application of Code Section 162(m) to deductions for compensation paid only by the publicly held corporation. Also covered is any deduction for compensation paid to the corporation’s covered employees by another party to the extent the corporation is allocated a share of the otherwise deductible item. In other words, the publicly held corporation’s share of the partnership’s deduction is subject to the limitations of Section 162(m) even though the corporation did not directly pay the compensation to the covered employee.
In an effort to balance the impact on taxpayers that relied on prior guidance with the desire to curb potential abusive practices, the proposed regulations provide transition relief for current compensation arrangements involving partnerships and publicly held corporations. The rule covering compensation paid by a partnership will apply to any deduction for compensation that is otherwise allowable for a taxable year ending on or after December 20, 2019, but the rule will not apply to compensation paid pursuant to a written binding contract that was in effect on December 20, 2019 that is not materially modified after that date.
Compensation for Services in a Capacity other than an Executive Officer
In response to a comment, the proposed regulations also confirm that, if a covered employee separates from service as an executive officer and subsequently performs services as a director of the publicly held corporation, the compensation paid to the individual as a director will be considered applicable employee remuneration for purposes of Code Section 162(m)(4).
The author reminds us that, dating back to the 1993 proposed regulations under Code Section 162(m), the deduction limit has applied to any compensation that could otherwise be deducted in a taxable year, except for the specific types of payments set forth as exclusions in Code Section 162(m)(4). These exclusions have never included compensation earned by a covered employee through a non-employee position, such as director fees.
As we noted in “Overview of Proposed Regulations Under Code Section 162(m) – Who is a Covered Employee“, the amended definition of “covered employee” under TCJA is very broad and includes any individual who was a covered employee of the publicly held corporation (including any predecessor entity) for any taxable year beginning after December 31, 2016. A covered employee remains such even after a separation from service. Accordingly, if such a covered employee returns to provide services to the publicly held corporation in any capacity then any deduction for the compensation paid to that covered employee remains subject to Code Section 162(m).
Next week, we will look more closely at the grandfathering rules applicable to the amended Code Section 162(m) deduction limitation.