Unlike any of the prior definitions of covered employee subject to the $1 million deduction limitation, the ARPA expansion brings non-officers into the definition of covered employees .(Photo: Shutterstock)
On December 16, 2019, the Internal Revenue Service (IRS) released proposed regulations (REG-122180-18) under Internal Revenue Code (IRC) section 162(m), which is the tax provision that generally imposes a $1 million annual limit on deductions by a publicly held corporation for compensation paid to certain top executives.
John Schultz is a Managing Director with the Compensation and Benefits group of Alvarez & Marsal. He specializes in compensation and benefits planning and consulting. A couple of years before that, in 2017, the Tax Cuts and Jobs Act (TCJA) amended section 162(m) by expanding the definition of publicly held corporation and covered employees, and by eliminating the almost universally utilized performance-based compensation exception. Under the TCJA, the definition of a covered employee was revised to include the CEO, CFO, and the three highest paid officers (previously the CFO was excluded from the covered employee definition). Additionally, once designated as a covered employee, an officer will always be a covered employee for TCJA purposes (including at subsequent employers).
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The American Rescue Plan Act of 2021 (ARPA) was signed by President Joe Biden on March 11, 2021. In addition to many other provisions, the ARPA also included an amendment to section 162(m), which expands the definition of a covered employee. Effective December 31, 2026, the definition of a covered employee will be revised to include an additional five highest-paid employees (regardless of whether they are officers), significantly expanding the group of employees subject to the $1 million deduction limitation. These five highest-paid employees are in addition to the expanded definition of covered employees per the TCJA.
Jeff Swerdlow is a Senior Director with the Compensation and Benefits group of Alvarez & Marsal. He brings experience assisting public, privately held, private equity and non-profit organizations.
Unlike any of the prior definitions of covered employee subject to the $1 million deduction limitation, the ARPA expansion brings non-officers into the definition of covered employees. This change brings the base number of covered employees to ten (it could be more than ten if the company is required to include certain legacy covered employees).
However, these new five employees will not be subject to the TCJA "once a covered employee, always a covered employee" rule. This means that while the CEO, CFO, and the next three highest-paid officers will always be considered a covered employee (since subject to the "once a covered employee…" rule), the additional group of five employees is more likely to change from year to year. Therefore, the five additional covered employees added by the ARPA revisions will need to be evaluated annually and could change with each tax year.
Because of this potential year-over-year shifting of the next five highest-paid covered employees, corporations can plan ahead for payments to this expanded group of top-paid employees and maneuver around the $1 million pay deduction limit. For example, companies may look to defer compensation payments to a later year after the recipient is no longer in the next five highest-paid group (e.g., after separation from service) or provide additional compensation in the current year (e.g., increasing bonus payments) to manage which employees are included in the expanded group.
Sarah Rumsey is a Senior Associate with the Compensation and Benefits group of Alvarez & Marsal. She focuses on executive compensation, equity incentive plan design, HR due diligence, executive employment agreement review and compensation benchmarking. However, tracking of this expanded top five highest compensated employee group could be tricky and will likely take some administrative work. Further, questions remain about whether or not the IRS will continue to utilize the Securities and Exchange Commission definition of compensation for purposes of determining the highest-paid officer and highest-paid employee groups or opt to take a different approach.
While the effects of the ARPA will not be felt until 2027, the delayed implementation should not lull companies into a false sense of security. Deferred tax planning and reviewing compensation arrangements should take place sooner rather than later, as the impact of the ARPA could negatively impact future compensation deductions if sufficient planning is not done.
Deferred compensation may become more useful than ever to help ensure companies can continue to deduct compensation for highly compensated employees that may otherwise be subject to the expanded covered employee rule. Lastly, companies will want to develop administrative tracking measures for the two groups of covered employees as they will have one group of permanent covered employees and another group of current covered employees that are subject to annual change.
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