The IRS has issued proposed regulations regarding the deductibility of employee remuneration in excess of $1 million under IRC Section 162(m).

For publicly held corporations, IRC Section 162(m) limits the employer compensation income tax deduction for certain employee remuneration in excess of $1 million. Under Section 162(m), the “covered employees” whose remuneration would not be tax deductible are currently:

• The principal executive officer or principal financial officer at any time during the tax year (or an individual without that title acting in that capacity); or
• An employee who is among the 3 highest compensated officers (other than the principal executive officer or principal financial officer) for the tax year.

These employees remain “covered employees” forever with respect to compensation paid by that publicly held corporation.

Effective for tax years beginning after Dec. 31, 2026, the American Rescue Plan Act of 2021 added an additional set of “covered employees” – namely, any employee other than those identified above who is among the 5 highest compensated employees for the tax year.

Employees who are “covered employees” under the post-2026 5 highest compensated employee rules will be determined on a year-by-year basis and will not remain as “covered employees” forever.

The proposed regulations provide guidance as to the post-2026 determination of the 5 highest compensated employees.

Proposed regulations

The primary guidance provided under the new proposed regulations is as follows:

• The term “employee” means a Common Law employee, such that both officers and non-officers may be “covered employees.”
• For “5 highest compensated employee” purposes, the term “compensation” means compensation that would be deductible by the employer for federal income tax purposes, but for the application of Section 162(m).
• The term “publicly held corporation” currently includes all corporate members of a Section 1504 affiliated group of corporations (without regard to Section 1504(b)) – clarification is provided that any employee of any corporation in the affiliated group can be one of the 5 highest compensated employees of the “publicly held corporation” even if the employee is not an employee of that corporation or does not provide any services for that corporation.
• For an affiliated group of corporations having more than one publicly held corporation, each publicly held corporation will have its own 5 highest compensated employees.
  • Consequently, an affiliated group of corporations is to be divided into smaller affiliated groups of corporations, each of which would include a publicly held corporation as well as any affiliated non-publicly held corporations.
• If an employee of a publicly held corporation is compensated by multiple affiliated group members, all such compensation would be aggregated for purposes of the “5 highest compensated” standard.
  • The determination is to be made separately for each publicly held corporation in the affiliated group of corporations, excluding any compensation to be taken into account for purposes of another publicly held corporation within the affiliated group of corporations.
• Foreign corporations are to be included in the affiliated group of corporations.
• An “employee” will include a Common Law employee of an unaffiliated organization or a Certified Professional Employer Organization if the employee functions as an employee of the publicly held corporation if the employee performs virtually all of the employee’s services for the publicly held corporation.
  • To the extent the compensation paid to such an employee is deductible for federal income tax purposes by the publicly held corporation, both amounts paid to the individual and/or paid to the unaffiliated organization or Certified Professional Employer Organization will be considered as “compensation.”

What does CohnReznick think?

Since the enactment of the American Rescue Plan Act of 2021, additional guidance has been needed as to the determination of the post-2026 “5 highest compensated employees” standard. The next step will be the receipt of public comments regarding the proposed regulations and any changes made in finalizing these additional rules.