On Jan. 16, 2025, the Internal Revenue Service (“IRS”) issued proposed regulations under Section 162(m) of the Internal Revenue Code (the “Code”), which limits the deductibility of certain employee remuneration in excess of $1 million. 

Existing Rules

Code Section 162(m) disallows a corporate income tax deduction by any publicly held corporation for remuneration paid to certain “covered employees” to the extent that such remuneration for the taxable year exceeds $1 million. Prior to passage of the America Rescue Plan Act of 2021 (“ARPA”), Code Section 162(m)(3) defined a “covered employee” as any employee of a publicly held corporation who:

(A) Was the principal executive officer (PEO) or principal financial officer (PFO) of the corporation at any time during the taxable year, or was an individual acting in such capacity; or

(B) Was one of the three highest compensated officers for the taxable year (excluding any individual described in (A)).

Beginning with tax years commencing on or after Jan. 1, 2017, any individual who, for any prior tax year, qualifies as a covered employee described in (A) or (B) (we collectively refer to these two categories in this Alert as the “Top 5”) is treated as a covered employee for all later tax years.

ARPA Amendment for Taxable Years Beginning After Dec. 31, 2026

In 2021, the ARPA amended Code Section 162(m) to expand the definition of covered employee for taxable years beginning after Dec. 31, 2026 to also include any employee who is among the five highest compensated employees for the taxable year, excluding any individual already in the Top 5 (we refer to this new group in this Alert as the “Next 5”). 

Unlike the Top 5, the status of each of the Next 5 as a covered employee pursuant to this new ARPA-added category applies only to the taxable year in which the individual is among the Next 5 (it does not carry forward to future taxable years).

Proposed Regulations

The proposed regulations clarify a number of key terms associated with the new Next 5 group:

• Determination of Next 5. The proposed regulations confirm that an individual treated as a covered employee for the current taxable year solely because he or she was in the Top 5 in a previous taxable year may also be counted among the current taxable year’s Next 5.
• Definition of Employee - The proposed regulations provide that, for purposes of determining whether an employee is one of the Next 5, the term “employee” means both common law employees and officers of the corporation who are employed on any day of the tax year. 
• Definition of Compensation - The proposed regulations, for purposes of determine the Next 5, define “compensation” as tax-deductible compensation (i.e., compensation that would (but for Code Section 162(m)) be allowable as a deduction by the corporation). Compensation from all members of the affiliated group is aggregated. It should be noted that the proposed regulations do not address how to treat compensation that is not deductible (e.g., incentive stock options) or compensation that is deferred (and deductible in a future year). This definition of compensation is different from the definition to be used for the Top 5 determination (which applies the definition of compensation used for purposes of Regulation S-K Item 402 of the SEC’s proxy disclosure rules). This will require a careful review of the compensation being counted for each of the Top 5 and the Next 5.
• Affiliated Groups - The proposed regulations provide that any employee of any corporation in a publicly held corporation’s affiliated group (including foreign corporations) may be in the Next 5 group regardless of whether the employee is an employee of or performs services directly for the publicly held corporation.  In addition, an employee who is (i) employed by a separate employer that is related but is an unaffiliated company or (ii) employed by a certified professional employer organization (PEO), but who functions as an employee of the publicly held corporation or an affiliated group company may be in the Next 5.

Effective Date

As drafted, the proposed regulations apply to compensation that is otherwise deductible for taxable years beginning after the later of Dec. 31, 2026 or the date that final regulations are effective. Comments on the proposed regulations are due by Mar. 17, 2025. 

President Trump’s Executive Order to withdraw rules that have not been published in the Federal Register as of Jan. 20, 2025 is not expected to apply to these proposed regulations, since they were published Jan. 16, 2025.

Action Steps

In consideration of these new proposed regulations, publicly held corporations (and non-publicly held corporations within the same affiliated group as a publicly held corporation) should:

1. review the compensation paid to highly paid employees, including executives and officers, to identify which employees are expected to be part of the Next 5 group; and
2. consider whether current practices as to the exercise or settlement of equity awards or the future payout of deferred compensation or large severance, change in control or bonus payments could unexpectedly trigger covered employee status in a given year, and modify such practices as desired to limit such risks. 

The Nelson Mullins Employee Benefits Group is ready to assist with questions or compliance steps. Please contact one of our Employee Benefits attorneys or the Nelson Mullins attorney with whom you work.