Section 162(m) of the Internal Revenue Code, as amended (the “Code”), is a section of the law that limits the deductibility of compensation expenses paid by publicly traded employers to $1 million for any covered employee.
Code Section 162(m) was amended at the end of last year pursuant to the Tax Cuts and Jobs Act. Compensation for 2018 was largely set at that point and many changes were not possible. As employers look to adjust and set compensation for the next year, this alert is intended to highlight some of the primary changes and planning opportunities. As summarized below, the main changes to Code Section 162(m) that we’ll highlight include:
- The expanded definition of public company
- The modified scope of covered employees
- The elimination of the performance-based compensation and commission exceptions
- The grandfathering rule
1. Confirm if you’re now a public company.
Section 162(m) provides that a publicly held corporation (which will be subject to the deductibility cap) includes an issuer (broadly defined) of securities which are required either: (i) to be registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”); or (ii) to file reports under Section 15(d) of the Exchange Act. The latter prong was added under the December 2017 amendments to the Code.
- Section 12 Analysis. In general, an entity would be required to list securities under Section 12(b) if it lists securities on a national exchange, such as the New York Stock Exchange or the Nasdaq Global Market. An entity also would also be required to list securities under Section 12(g) once it has at least $10 million in assets and 2,000 record holders or 500 non-accredited record holders. There is an exemption in Rule 12g3-2(b) for certain foreign private issuers issuing ADRs in the U.S.
In general, an entity will qualify as a foreign private issuer under Rule 3b-4 of the Exchange Act if either: (A) 50% or less of its outstanding voting securities are held by U.S. residents, or (B) none of the following apply: (i) a majority of its executive officers OR directors are U.S. citizens or residents; (ii) more than 50 percent of its assets are in the Unites States; and (iii) the business is administered principally in the U.S.
Entities listed on foreign exchanges should consider reviewing the Rule 12g3-2(b) information requirements to ascertain that it continues to comply. In addition, such entities should be sure to confirm that there are no other foreign (or U.S.) publicly traded entities in the controlled group.
- Section 15(d) Analysis. Section 15(d) applies to companies that have issued equity or debt securities under a registration statement under the Securities Act of 1933, as amended (the “Securities Act”), but have not otherwise listed such securities on a national exchange in the U.S. The registration statement can be for debt or equity securities.
SEC filings may reflect whether an entity or its affiliates are/ever have been subject to the reporting requirements of Section 15(d) of the Exchange Act.
- Conclusion and Warning: Under the amended Section 162(m) definition of a publicly held corporation, an organization will not be considered a publicly held corporation to the extent it is not required to be registered under Section 12 of the Exchange Act or file reports under Section 15(d) of the Exchange Act. However, remember that both listed corporations and certain unlisted corporations that register debt or equity securities with the SEC, including foreign companies publicly traded through ADRs, are probably subject to the §162(m) limitations. In fact, the Joint Explanatory Statement of the Committee of Conference (which explains the Tax Cuts and Jobs Act) states a clear intent that ALL foreign companies publicly traded through ADRs be subject to Section 162(m). Section 162(m) as amended, is not so broad, and whether and when the Treasury Department will provide for regulations covering all foreign companies are unclear. It is certainly possible that the Treasury Department takes this legislative intent into account in its interpretation of the rules. Accordingly, a foreign organization should be prepared to address these issues if the Treasury Department takes a broader view of the new law.
- To the extent that an entity has current SEC reporting obligations under the Exchange Act, such reports can be found on SEC Edgar, the SEC’s electronic reporting database.
2. Confirm whose compensation deductibility will be limited.
- To the extent an entity is subject to Section 162(m), the December 2017 amendments to the Code make it easier to determine which employees are covered by the rule. The new definition of a covered employee is now analogous to named executive officers (“NEOs”) whose compensation is required to be reported under the Exchange Act.
- This definition includes a company’s principal executive officer (“PEO” or more commonly referred to as the “CEO”) and principal financial officer (“PFO” or more commonly referred to as the “CFO”) at any time during the applicable year (or an individual acting in the capacity of a PEO or PFO, as applicable), and the three highest compensated executive officers who are not the PEO or PFO.
- To determine who the three highest compensated executive offers are, Section 162(m) expressly refers to those employees that would be required to be reported under the Exchange Act (in Rule 3b-7). The company has some latitude to conclude who the appropriate executive officers are, but the key for applying this rule to subsidiaries is to determine whether the executive officers of the subsidiary performs policy making functions for the registrant.
- Under the revised rules, once an employee becomes a covered employee (starting with 2017), they remain a covered employee indefinitely; in other words, once covered employee status is attained, that status is permanent.
- For example, if an individual was the PEO of a publicly held corporation for all of 2018 and, in 2020, remains employed by the corporation, but is no longer the PEO (and is not either the PFO or one of the three most highly compensated officers) compensation paid to her in 2020 will remain subject to the $1 million deduction limit.
- Practical Implications: This means that companies will need to keep a permanent record of their covered employees and will need to track any compensations that is paid in future years (e.g. deferred compensation, options, etc.)
- Under the revised rules, a company will have at least five covered employees for any tax year—the PEO, the PFO, and the three other most highly compensated officers. However, the number of covered employees is potentially unlimited, because part-year PEOs and PFOs as well as former covered employees remain included in the scope of covered employees.
- Note, an individual's status as a covered employee is relevant only if compensation is paid with respect to the individual that would otherwise be deductible by the company in that tax year.
3. Reconsider what counts toward the $1 million limit.
- Perhaps the most important change to 162(m) concerns the elimination of the performance-based compensation and commission exclusions from the $1 million compensation limit. Under prior law, performance-based compensation and commissions were carved out of the definition of “applicable employee remuneration” (which is relevant for the $1 million cap); however, the new tax act removed these exclusions.
- Note also that it is expected that companies will continue to favor this type of compensation as a matter of good compensation policy to align pay with performance. It is likely Institutional Shareholder Services (and similar organizations) will also consider this alignment when making their voting recommendation.