Skip to main content
Article | Insider

IRS issues final 162(m) regulations

Executive Compensation|Health and Benefits

By Gary Chase and Steve Seelig | February 17, 2021

Corporations will need to continue monitoring certain compensation that will be paid in future years to preserve grandfather treatment.

The IRS has issued final regulations implementing the amendments to Internal Revenue Code section 162(m) made by the 2017 Tax Cuts and Jobs Act (TCJA), with only minor substantive changes to the proposed guidance.1 Section 162(m) limits the allowable deduction for compensation paid to covered employees of publicly held corporations to $1 million per year. The heavy lifting for corporations will remain in preserving grandfather treatment for certain compensation that will be paid in future years, and to track “covered employees” who may receive compensation in future years (including when a corporation acquires new employees in a merger or acquisition).

The final regulations are generally applicable to tax years beginning on or after December 30, 2020, and taxpayers generally have the option to apply them to tax years beginning after December 31, 2017. However, the final regulations also include special applicability dates for certain provisions that require compliance prior to December 30, 2020.

Because most long-term incentive compensation cycles that were open during 2017 have already paid out, it will be less important for corporations to monitor grandfather treatment, except for unexercised stock options and stock appreciation rights (SARS) that tend to have longer (e.g., 10-year) life spans. Nonqualified deferred compensation (NQDC) — such as excess 401(k), supplemental executive retirement plans and deferred stock units — will also need continued monitoring to support the continuation of grandfathered treatment.

Final regulations

The changes made to 162(m) by the TCJA meant that publicly held corporations have three main tasks in determining whether compensation paid is subject to the $1 million tax-deduction limitation (the $1 million pay cap), which are described below.

  1. 01

    Determine if the payee is a covered employee

    The TCJA introduced the “once a covered employee, always a covered employee” rule — that is, starting in 2017, an employee who is a covered employee for any year will remain a covered employee for any future year in which compensation is paid by the corporation, even following retirement or death. This is the case even if an employee was a covered employee at certain entities acquired via a merger or acquisition.

    Determining newly covered employees each year: The final regulations continue to define a covered employee as any employee who is the principal executive officer or principal financial officer (or acting as such) of a publicly held corporation at any time during the taxable year. Covered employees also include any executive officer whose total compensation for the company’s taxable year places him or her among the three highest compensated officers for the taxable year, determined under the proxy disclosure rules, regardless of whether the corporation’s fiscal year and taxable year end on the same date. However, because the employee is not required to be an executive officer at the end of the taxable year, this group may be different from the executive officers disclosed on the proxy. Special rules exist where the company’s fiscal year differs from its taxable year.

    Tracking covered employees in future years: The final regulations require companies to track their own covered employees into future years when compensation is paid, including years beyond retirement and death. They also include detailed rules on tracking covered employees who were employed at predecessor employers acquired by public corporations, including stock-related transactions, asset purchases involving at least 80% of gross operating assets, certain changes from private to public status and purchases of publicly traded partnerships. Companies must closely monitor acquisitions that take place after the grandfather date, since these events may add to their cadre of covered employees.

    Applying the rules to unusual corporate structures: The final regulations retain the guidance on those entities that are considered publicly held corporations for purposes of 162(m) and continue to focus on two possible scenarios:

    1. A corporation’s securities are required to be registered under section 12.
    2. A corporation is required to file reports under section 15(d) of the Exchange Act of 1934.

    Whether a corporation is considered to be publicly held is determined as of the last day of the corporation’s taxable year.

    In the final regulations, publicly held corporations continue to include S corporations that issue registered securities or have issued publicly traded debt, wholly owned subsidiary corporations of publicly held corporations that meet (2) above, foreign private issuers that meet (1) or (2) above, a publicly traded partnership that meets (1) or (2) above, and certain affiliated groups and disregarded entities where the parent is private and the subsidiary is publicly traded. Applying these rules can be complicated, particularly when compensation is paid to a covered employee by more than one entity within the affiliated group.

    Stand-alone private corporations that become public would be subject fully to the 162(m) deduction limits. A special transition rule exists for corporations that became publicly held on or before December 20, 2019, so they would be exempt from the 162(m) deduction limits. The final regulations clarify that the transition rule also applies to a subsidiary of an affiliated service group that becomes a separate publicly traded organization (e.g., as part of a spin-off transaction). Generally, the transition period ends either on the first shareholder meeting at which directors are elected after the close of the third calendar year following the year in which an initial public offering (IPO) occurs or the first calendar year following the year in which a company becomes public without an IPO.

  2. 02

    Consider what constitutes compensation paid and whether it is grandfathered

    Generally, 162(m) focuses on the concept of compensation paid, including commissions, whether paid to the covered employee or a beneficiary. The grandfather rule provides that remuneration pursuant to a written binding contract that was in effect on November 2, 2017 (the “grandfather date”), and that was not modified in any material respect on or after such date, can remain deductible when paid — if it would have been deductible under pre-TCJA 162(m) rules. This treatment can apply to compensation that was considered “performance-based” or is NQDC under a written binding contract on the grandfather date.

    Counting compensation: The final regulations maintain the rule that compensation paid to a covered employee (by any member of the affiliated service group) is subject to 162(m), regardless of when paid, and companies must count compensation paid to former executives who render services as independent contractors, including those who join the board of directors. Companies also are required to count compensation paid to a covered employee if he or she returns after separation in any capacity, including as a common law employee, a director or an independent contractor.

    Newly public corporations must apply 162(m) to future compensation authorized before they became public, although the grandfather rule might still be helpful for these companies.

    Public corporations that own an interest in a partnership would need to count a portion of the compensation paid by the partnership to its covered employees when applying the section 162(m) deduction limitation. However, the final regulations add a special transition rule that only includes these amounts as compensation if paid after December 18, 2020. In addition, the final regulations continue to exclude compensation paid by the partnership after December 30, 2020, if the compensation is paid under a written binding contract that is in effect on December 20, 2019, and that is not materially modified after that date.

    Applying the grandfather rule: The final regulations maintain the rule that remuneration is payable under a written binding contract that was in effect on November 2, 2017, but only to the extent that the corporation is obligated under applicable law (for example, state contract law) to pay the remuneration under the contract if the employee performs services or satisfies the applicable vesting conditions.

    The final regulations also maintain the rule that negative discretion plans that permit the board to reduce or eliminate promised bonus compensation are not provided under a written binding contract, noting that state law may limit such an amount. Thus, in states with stronger employee wage law protections that would not honor negative discretion, it may be that a larger portion of a promised bonus can be grandfathered regardless of the existence of a negative discretion provision.

    A provision that would claw back compensation that should not have been paid, or can be clawed back by exercise of discretion, will continue not to affect the existence of a written binding contract, regardless of whether the amounts actually are clawed back.

    The final regulations continue to provide that additional benefits, contributions or earnings that accrue under a NQDC plan after November 2, 2017, are not grandfathered, with a few exceptions:

    • If a company does not have discretion to terminate or materially amend the plan, the grandfathered amount would include the benefit as of November 2, 2017, plus any additional benefits, contributions or earnings that accrue after that date.
    • If a company has discretion to terminate the plan, then the grandfathered amount includes the lump sum value of the total benefit determined as if the plan was terminated on November 2, 2017 (or, if later, the earliest possible date that termination is permitted under the terms of the plan), plus any additional benefits, contributions or earnings that the company is required to make through the earliest date that the benefit may be distributed to the employee. A similar rule applies where a company has discretion to freeze (but not terminate) a NQDC plan, although these plan provisions are rare.

    The final regulations add an alternative grandfather rule that would simply permit corporations to ignore earnings, losses and new contributions from being considered as grandfathered to help companies reduce their administrative burden of performing potentially detailed calculations.

    Because severance amounts often are tied to salary and bonus levels in place at termination, the final regulations maintain that severance is grandfathered only if the severance amount and the underlying salary and/or bonus on which it is based are under a binding written contract in effect as of November 2, 2017. In that circumstance, the grandfathered amount would be based only on the salary and bonus in place on the grandfather date; future increases would not be grandfathered unless those were guaranteed by contract. However, severance may be grandfathered if based on salary increases that are hard coded into the agreement or reasonable cost-of-living adjustments but would not be grandfathered if based on discretionary bonuses whose value is determined after the grandfather date.

    The final regulations maintain the ordering rule for NQDC that is distributed over a period of years where only a portion of the compensation is grandfathered. In that case, the grandfathered amount is allocated to the first otherwise deductible payment paid under the arrangement. If the grandfathered amount exceeds this payment, then the excess is allocated to the next otherwise deductible payment paid under the arrangement. This process is repeated until the entire grandfathered amount has been paid.

  3. 03

    Determine if there has been a material modification for grandfathered amounts

    Any action that changes the value of a grandfathered amount must be closely monitored to ensure there are no material modifications that could cause the entire amount to lose grandfather status.

    Under the final regulations, the following may be treated as a material modification:

    • A contract that is amended to increase the amount of compensation payable to the employee.
    • A supplemental contract or agreement that provides for increased or additional compensation if, under the facts and circumstances, the additional compensation is paid based on substantially the same elements or conditions as the compensation under the written binding contract. An exception is if the supplemental payment is equal to or less than a reasonable cost-of-living increase over the payment made in the preceding year under that written binding contract. As noted above, the failure, in whole or in part, to exercise negative discretion under a contract does not result in the material modification of that contract.
    • An acceleration of future payments of compensation unless the amount of compensation paid is discounted to reasonably reflect the time value of money. An exception to the restriction on accelerating payments is for compensation that was subject to a substantial risk of forfeiture as of November 2, 2017. Under this exception, a company could accelerate vesting of restricted property, a stock option or SAR, or the right to vest in cash, and it is not considered a material modification.
    • A deferral of compensation unless the amounts paid in excess of the original compensation are based on either a reasonable rate of interest or a predetermined actual investment (real or notional); however, the interest itself will not be grandfathered. The final regulations include an exception to this deferral rule for stock options or SARs whose exercise periods are extended, which sometimes happens when an employer wants a terminating employee whose options/SARs would have expired to have additional time to exercise those rights.


1 See “Key takeaways from recently proposed 162(m) regulations,” Insider, February 2020.

Title File Type File Size
Insider February 2021 PDF .3 MB

Director, Retirement and Executive Compensation

Senior Director, Executive Compensation (Arlington)

Contact Us
Related content tags, list of links Article Insider Executive Compensation Health and Benefits