ARPA Expands Deduction Limits on Executive Pay Over $1 Million

A provision in the American Rescue Plan Act (ARPA), signed into law March 11, will increase the number of employees subject to the limit on a corporation's ability to deduct executive compensation.

Internal Revenue Code Section 162(m) generally prohibits tax deductions by publicly traded companies on the portion of pay for "covered employees" that exceeds $1 million per year. Currently, covered employees are the chief executive officer, chief financial officer and the three next-highest-compensated individuals.

For tax years beginning in 2027, however, the ARPA requires corporations to treat the five next-highest-compensated individuals as covered employees, doubling the number of covered employees to at least 10.

Two Distinct Groups

"Once an individual is subject to Section 162(m) under pre-ARPA law, the individual continues to be covered by Section 162(m) even if he or she is no longer among the five highest-compensated employees," keeping their pay in excess of $1 million nondeductible by their employer, wrote Jeffrey H. Paravano, an attorney with BakerHostetler.

Steve Seelig, executive compensation counsel at consultancy Willis Towers Watson, noted that "even payments made by a company post-termination and post-death [for these employees] must be viewed under the $1 million deduction limit," under current law.

However, with respect to the ARPA's inclusion of the five next-highest-compensated individuals, the ARPA does not provide for continuing coverage under Section 162(m) if they later fall outside the ARPA-expanded group. That means, for example, that if they no longer were among the top 10 earners at their company, their annual pay in excess of $1 million could then be deducted as a business expense by the corporation.

Tracking Two Groups of 'Covered Employees'

Because of the different tax treatment for the "original" and "expanded" groups of Section 162(m) covered employees, attorneys at Foley and Lardner advised that "public companies will have to keep track of two lists of covered employees: (1) their 'permanent list,' which covers the CEO, CFO and next three highest-paid officers each year and who, once on the list of covered employees, will always remain on the list [the once/always rule], and (2) a 'current year list,' which will include those officers who are the next five top-paid officers for the year in question, and which may change from year to year."

Deferred-Pay Tax Strategies

Because the ARPA does not apply the "once/always" rule under current Section 162(m) to the expanded top-five group of employees, Seelig noted, and because they will not automatically be treated as covered employees in a future year, "this also means that, as companies often did under prior law, corporations can sidestep the $1 million pay deduction limit by deferring compensation payments to a later year after the recipient is no longer in the top five, often until after separation from service."

Planning Ahead

The ARPA's executive compensation provisions "will involve administrative, compliance and communications challenges for employers and executives, but not until 2027," said Brian Pinheiro, practice leader of law firm Ballard Spahr's employee benefits and executive compensation group.

Given the delayed effective date, attorneys at Shearman and Sterling wrote that "it remains to be seen whether Treasury regulations will provide for the grandfathering of any deferred compensation or other compensatory arrangements currently in place."

They added, "Notwithstanding the future effective date, publicly held corporations may consider it prudent to audit their compensation arrangements (including employment agreements with severance obligations) to determine the potential impact of the statutory change."

Noted Seelig, "the potential good news is that a lot can change in Congress" between enactment of the ARPA and the effective date of the Section 162(m) provisions. "The bad news is that Congress may very well need more revenue offsets as additional infrastructure and other spending bills are considered later this session."

Related SHRM Articles:

IRS Clarifies Tax on Executive Pay at Nonprofit Organizations, SHRM Online, February 2021

Responding to the Tax Act's Executive Compensation Changes, SHRM Online, January 2018

Tax Act Alters Executive Pay, Affects Bonus Deductions and Withholding, SHRM Online, December 2017