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On January 16 the IRS issued proposed regulations implementing the impending expansion of the $1 million deduction limit to the five most highly paid employees other than the executive officers currently covered by this limit.  While most of the proposed regulations appear uncontroversial, one portion has aroused widespread surprise—the IRS’s proposal to cover certain individuals who are not employees of the publicly held corporation but who perform substantial services for the publicly held corporation.

Background

Back when it loomed large, publicly held corporations (PHCs) paid great attention to Code section 162(m), the provision that generally limited compensation deductions to $1 million for “covered employees.” “Covered employees” were generally defined as the five highest paid executive officers listed in the proxy statement.¹  In particular, due to an exception in the rule for “performance-based” compensation, much attention was spent designing executive pay in a manner that qualified for the exception.

The attention to 162(m) greatly diminished with the enactment in 2017 of the Tax Cuts and Jobs Act, which removed the exemption for performance-based compensation and provided that, once someone was a covered employee, the taint lasted forever.  The latter change eliminated one gambit for avoiding the 162(m) deduction limitation — delaying payments to a covered employee until a year in which the individual is no longer an executive officer.

Section 162(m) resurfaced in 2021 with the enactment of the American Rescue Plan Act of 2021 (ARP Act).  The ARP Act expanded the definition of covered employee to include “any employee who is among the five highest compensated employees, regardless of whether they are executive officers, for the taxable year.  This new group is in addition to the five individuals already picked up by 162(m).  We will call the two groups of covered employees the “Old Covered Employees” and the “New Covered Employees.” The new rule is effective for taxable years beginning January 1, 2027, and thereafter.

The IRS proposed regulations on January 16 to implement this new provision.  They are generally unsurprising, except for one showstopper.

The Unsurprising

Unlike the rule for Old Covered Employees, which ranked employees based on compensation as reported in the Summary Compensation Table, the new rule measures compensation by looking at the amount of income that would be deductible for tax purposes (generally W-2 compensation).  This seems reasonable since the New Covered Employees will generally not be included in the Summary Compensation Table.

Also, the proposed regulations do not apply the perpetual taint rule to the New Covered Employees.  An individual can go in and out of covered employee status on a year-to-year basis.  While the IRS might have liked extending the perpetual taint rule to New Covered Employees, the statutory language is written in a way that makes that result impossible. 

The Showstopper — A Covered Employee Does Not Need to Be an Employee of the PHC

The showstopper is the IRS’s assertion that New Covered Employees can include individuals who have never been employed by the PHC or any affiliated corporation.  We see nothing in the statutory language that would authorize such a result.

The preamble suggests what possibly motivated the IRS was a concern about someone who would typically be an employee of the PHC avoiding 162(m) by structuring his or her employment through a loan out corporation.  The preamble refers to an “‘employee’ of a person other than the publicly held corporation (such as a related but unaffiliated organization or certified professional employer organization) ...”  Unfortunately, the proposed regulations appear to cover all organizations:

“[A] employee of a publicly held corporation includes an individual who . . . is an employee of a person other than the publicly held corporation but performs substantially all the individual’s services during the relevant taxable year for the publicly held corporation.  Consequently, for purposes of [162(m)], compensation includes the aggregate amount allowed as a deduction to the publicly held corporation . . .  for the taxable year . . .  to obtain the services performed by such individual, whether or not the particular services that give rise to the deduction were performed during the relevant taxable year.” 

While many PHCs may be little affected by this rule, there are some for whom this rule could be a major pain, administratively, legally and financially.  This will arise in situations where, for one reason or another, the employee of another organization spends substantially all his or her time working for the PHC in a particular year.  For example:

The big lawsuit.  Suppose the PHC is involved in a massive lawsuit spanning several years.  A senior lawyer works at the PHC’s outside law firm full time on the case for many years.  Given the magnitude of lawyer billing rates and the amount of hours that can be spent on a giant lawsuit, it is easy to imagine situations where the billings for the individual’s individual services could exceed $3 million for the year.  That could put the individual into the top 10 territory at many PHCs.  Does that mean that the PHC must include the individual as a New Covered Employee and thus limit the otherwise deductible legal fees attributable to that individual to $1 million for the year?²

But the situation is much more complicated.  The law firm, of course, provides one overall bill.  In some cases, in fact the bill is not the sum of hourly billings, but some kind of flat fee arrangement.  In this case, how would you decide what part of the bill relates to the senior lawyer?

In fact, note how the amount you are trying to compute is the “aggregate amount allowed as a deduction . . . to obtain the services performed by such individual.”  Does this mean the entire bill is subject to 162(m) if the lawyer in question is the partner in charge of the litigation and the law firm was specifically retained because this individual would be the lead partner?

Alternatively, in large service organizations like big law firms, the compensation of a senior partner can often be more than the amount of the individual’s hourly rate times hours billed.  The compensation, in effect, may take into account the amount billed by other attorneys to the same client, for example.  The compensation structure at the law firm is, of course, unavailable to the PHC and yet the proposed regulation could be interpreted to require the PHC to obtain that information in order to determine how much of its payment to the law firm is deductible.

In the case of most law firms, there may be an escape hatch.  Note that the proposed regulation requires that the individual be an employee of the other corporation.  If the law firm is organized as a partnership and the attorney is a partner, this may mean there’s no problem.  But the result would be different if the law firm was organized as a professional services corporation.

The big consulting project/construction project.  Many of the large consulting/construction firms are organized as corporations, so the not-an-employee loophole would not apply.  Depending on how the work is billed to the PHC, there could be daunting issues in determining how much was paid to obtain the services of a particular individual. For example, suppose the outside firm is a construction firm engaged in a multi-year project for the PHC.  Many people will be working substantially full time for the PHC.   Depending on the billing arrangement, it could be almost impossible to determine how much is attributable to a single individual. 

Also, how does 162(m) work if part of the bill is properly classified as a capital expenditure rather than a currently deductible expense,³ as will be the case in a construction project?  Does it matter if the deduction would occur in a future year as the property in question is depreciated?  We have not researched this issue in any detail, but as noted above, 162(m) purports to not just disallow deductions under section 162(m), but deductions under any of the income tax provisions of the Internal Revenue Code.

Special problems in the entertainment industry.  The proposed regulation may be a particular problem for entertainment or gaming industry PHCs where performers can command enormous fees for their services.  In the movie industry, the problem could arise with an actress that performs all her services for the PHC pursuant to a contract with her corporation, which employs the actress and many others.  The same problem could arise with high paid talent in the television industry.  The problem could also arise with a gaming industry PHC to the extent an entertainer is employed on a year-round basis through a contract with the individual’s corporation.  Once again, one worries that the entire amount of the contractual payment might be counted for purposes of the 162(m) limits.

Situations involving entertainers may offer a work around insofar as the proposed rule does not affect individuals who provide service as independent contractors.  So, if the rule is finalized as written, it is possible that a PHC will attempt to restructure arrangements with entertainers to have them contract directly with the PHC as an independent contractor. 

The Comment Period Is Open

We believe an IRS rule potentially capturing these outside employees is not justified by the statutory language and, if enough public comment occurs, may be subject to change.  Companies that might be caught by the proposed rule are urged to consider commenting on the proposed rule by the March 17th deadline.  If the comment does not urge abolition of the coverage of nonemployees, it should at least seek clarification as to how the rule would operate under some of the troubling scenarios sketched out above.

¹ There were a number of nuances involved in determining the top five, none of which we will cover here.
² Section 162(m) purports to not just disallow deductions under section 162(m), but deductions under any of the income tax provisions of the Internal Revenue Code. Specifically, 162(m)(1) says “no deduction shall be allowed under this chapter” for compensation subject to the 162(m) limit.
³ Subject to various exceptions, expenditures to acquire or improve a business asset that will last longer than a year are not deductible as business expenses.

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