Annual Effective Tax Rate Considerations of Section 162(m)
Recent amendments to the provisions on business deductions for highly compensated executives may result in changes to a public company’s calculation of its deferred tax assets that would negatively impact the company’s annual effective tax rate.
Internal Revenue Code Section 162(m) prohibits tax deductions by publicly traded corporations on the portion of pay for covered employees — CEO, CFO and the three next-highest-compensated officers — that exceeds $1 million per year. A provision in the American Rescue Plan Act of 2021 (ARPA), signed into law on March 11, increases the number of covered employees to 10 for tax years beginning in 2027. However, proposed legislation would accelerate the effective date of the increase in the number of covered employees to tax years beginning after December 31, 2021. This article summarizes the provisions of Section 162(m) and analyzes how this change may create a surprise in a company’s annual effective tax rate.
Background
Section 162(m) limits the deductibility of compensation paid to certain covered employees of a publicly held corporation to $1 million per year. For tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act removed the performance-based exception for non-grandfathered plans, expanded the definition of covered employees, made covered employee status applicable to all future payments to that individual and removed the beneficial transition relief to companies that went public via an IPO after December 21, 2019.
The ARPA also included changes to IRC Section 162(m) that will expand the definition of covered employees for tax years beginning after December 31, 2026. However, H.R. 5376, also known as the Build Back Better Act, or the reconciliation bill, includes a proposal to accelerate the effective date of the amendment to tax years following December 31, 2021. The proposed legislation would also include more payments when determining to what extent a covered employee exceeds the limit on deductible compensation by applying the Section 414 aggregation rules to all entities subject to Section 162(m), not only to “covered health insurance providers” as currently provided. Also, the proposal clarifies that compensation paid by different members of a controlled group would be aggregated for these purposes.
Covered Employees
The definition of covered employee has been modified throughout the years, but currently includes individuals who serve as principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year and the three most highly compensated executive officers other than the PEO or PFO. Additionally, any covered employee for a tax year beginning after December 31, 2016 remains a covered employee for all future taxable years.
The ARPA expands this definition to add the five most highly compensated employees, not only officers, other than those already treated as covered employees. However, this is an annual addition, and anyone included solely as a top-five most highly compensated employee will not be a covered employee permanently.
Important Accounting for Income Tax Considerations related to Section 162(m)
The deduction limit under Section 162(m) is applicable to compensation payments such as salary, bonus, equity-based compensation and/or deferred compensation agreements and therefore may complicate a public company’s calculation of its deferred tax assets (DTAs). An ongoing assessment of compensation expense for payments that will be made to a covered employee in the future must be maintained to determine the likelihood that the tax benefit will be realized when the payment occurs. To the extent this assessment shows that future payments to covered employees are not expected to be deductible, it may result in a reduction to the DTAs that negatively impacts the company’s annual effective tax rate.
For companies that have been public for some time, it’s likely that the only change to their ongoing assessment will be the need to identify the individuals who fit the new covered employee definition and to prepare to adjust the DTAs, if needed, for compensation that is expected to be paid to them in future years. Given the proposal to accelerate the timing of the ARPA expansion of covered employees, it would be prudent to act now to identify the next five top-paid employees so a company’s DTAs can be quickly remeasured if the effective date is accelerated.
Companies going public through an IPO typically have sufficient lead time to prepare for the application of IRC Section 162(m), but companies that become public through acquisition, including through special purpose acquisition companies (SPACs), will have a much shorter time frame to make the book adjustments. For newly public companies, the evaluation is more extensive because they will be selecting an accounting policy for the ordering of total future compensation paid from three generally acceptable approaches: cash compensation first, equity compensation first or pro-rata between cash and equity. They will need to review their DTAs for all compensation plans for all covered employees.
Any adjustments to DTAs will have to be recognized in the accounting period in which the company becomes public, or in which the changes become effective. Early focus on the identification of additional covered employees, as well as an assessment of a company’s overall compensation and DTAs is imperative to ensure companies are prepared and to avoid a surprise in a company’s annual effective tax rate.
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