On January 14, 2025, the Department of the Treasury and the Internal Revenue Service issued proposed regulations (Proposed Regulations) relating to the expansion of the definition of “covered employees” under Internal Revenue Code (Code) section 162(m). The Proposed Regulations provide guidance on and implement the amendments made to section 162(m) as part of the American Rescue Plan Act of 2021 (ARPA).
Key points covered by the Proposed Regulations include defining a covered employee to include employees of affiliates, using deductible compensation as the measure to determine the next five highest compensated employees, and clarifying the interaction of the “once covered, always covered” rule with the expanded list of covered employees under ARPA.
Comments and requests for public hearings must be received no later than March 17, 2025, and the regulations are proposed to be effective as of the later of December 31, 2026 or the date of publication of the final regulations.
Current Law
Code section 162(m) limits a public company’s annual compensation deductions to $1 million for each of its “covered employees,” which includes the CEO, the CFO, and the next three highest-paid officers during the taxable year. Once an individual is designated as a covered employee for tax years beginning after December 31, 2016, that covered employee status extends to all future years, even after a termination of employment (the Once Covered, Always Covered Rule).
Code section 162(m) was further amended in 2021 by ARPA to broaden the definition of “covered employee” for taxable years beginning after December 31, 2026. The amendment expanded covered employees to include the next five highest-compensated employees for the taxable year in addition to the CEO, CFO and next three highest-paid officers.
Proposed Regulations
The Proposed Regulations provide guidance on determining the additional group of employees constituting the next five highest-compensated employees under Code section 162(m).
Definition of Employee
The Proposed Regulations provide that an “employee” generally includes common law employees and corporate officers based on the definition in Code section 3401(c). The Proposed Regulations provide that the term “employee” also includes an individual who is an employee of a person other than the publicly held corporation (e.g., a related but unaffiliated organization, or a professional employer organization (PEO)), but performs substantially all of their work for the publicly held corporation.
Definition of Compensation
The next five highest compensated employees in a given year are determined based on their relative compensation to other employees. The Proposed Regulations define “compensation” as the amounts that would, but for Code section 162(m), be allowable as a deduction for a given year. While the IRS considered determining the next five highest compensated employees using the same approach currently used to determine the three-highest paid employees after the CEO and CFO (by measuring compensation on the same basis as the SEC proxy disclosure rules), the IRS commented that the statute did not support applying the SEC rules to the next five determination. The IRS also stated that their proposed approach should simplify administration because companies already track compensation for determining their own tax liability for the taxable year.
The Proposed Regulations also provide that compensation paid to an employee by each member of a publicly held corporation’s affiliated group (including foreign corporations to the extent the compensation is allowable as a deduction for US tax purposes) is aggregated when determining whether the employee is one of its five highest compensated employees. The Proposed Regulations include specific rules to address situations involving multiple publicly held corporations and controlled foreign corporations in an affiliated group.
Interaction with Once Covered, Always Covered Rule
As outlined above, the “Once Covered, Always Covered Rule” provides that once an individual is designated as a covered employee, that covered employee status extends to all future years, even after termination of employment.
An individual who is already a covered employee by previously serving as a covered employee may also qualify as one of the next five highest compensated employees (such as an individual who was one of the three highest paid officers in a given year, but dropped out of the top three in a later year). In this situation, the individual would not add to the corporation’s overall number of covered employees because they would occupy one of the five additional slots.
The Once Covered, Always Covered Rule does not apply to the five additional employees who become covered as a result of ARPA. Accordingly, the group of five additional employees is redetermined each year.
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