IRS provides guidance on meaning of covered employee

Taxpayers can rely on new guidance related to the limitation on the deduction for employee compensation in excess of $1 million. Specifically, the guidance addresses:

  • the definition of a covered employee for purposes of Code Sec. 162(m)(3).
  • what constitutes a binding contract under the grandfather rule in Code Sec. 162(m)(4); and
  • what constitutes a material modification of a binding contract so that the grandfather rule no longer applies.

Limitation on excessive employee compensation

Effective for tax years beginning after December 31, 2017, the Tax Cuts and Jobs Act (P.L. 115-97) modified the definitions of “covered employee,” “compensation,” and “publicly held corporation” for purposes of the limitation on the deduction for excessive employee compensation paid by publicly held corporations.

Covered employee. A covered employee is any employee of the corporation who:

  • is the principal executive officer (PEO ) (or an individual acting in such capacity) at any time during the tax year;
  • is the principal financial officer (PFO) (or an individual acting in such capacity) at any time during the tax year;
  • is among the three highest compensated officers for the tax year (other than the PEO or the PFO); or
  • was a covered employee of the corporation (or any predecessor) for any prior tax year beginning on or after January 1, 2017.

Applicable employee compensation (remuneration). For tax years beginning after 2017, compensation includes any cash and noncash benefits paid for services, including commissions and performance-based compensation. Compensation does not include:

  • income from specified employee trusts, annuity plans, pensions, or any benefit that is reasonably anticipated to be tax free;
  • income payable under a written binding contract which was in effect on February 17, 1993; and
  • compensation paid before a corporation became publicly held.

Grandfather rule. A transition rule applies to compensation provided pursuant to a written binding contract which was in effect on November 2, 2017, and that is not modified in any material respect on or after such date.

Amended definition of covered employee

As stated above, under the amended law, a covered employee is the PEO, the PFO, or one of the three other highest compensated executives. The IRS clarifies that there is no requirement that an employee must be an executive officer at the end of the tax year to be a covered employee. The definition applies regardless of whether the executive officer is serving at the end of the publicly held corporation’s tax year. Furthermore, the definition applies regardless of whether the executive officer’s compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules.

The Treasury Department and IRS are requesting comments on the application of the SEC executive compensation disclosure rules for instances where a publicly held corporation’s tax year and last completed fiscal year do not end on the same date. Until additional guidance is issued, taxpayers in that specific circumstance should use a good faith interpretation of the statute and this notice to determine the three most highly compensated employees.

The notice provides thorough examples that address both of these issues.

Binding contract

The amendments made by P.L. 115-97 to Code Sec. 162(m) do not apply to any compensation paid under a written binding contract that is effect on November 2, 2017 and is not materially modified after that date. In order for the IRS to consider a contract binding the publicly held company must be obligated to pay the compensation if the employee performs services or satisfies requirements in the contract. Thus, the amendments to Code Sec. 162(m) apply to any amount of compensation that exceeds the amount required to be paid to an executive under a binding contract.

Amendments to Code Sec. 162(m) also apply to a written binding contract that is renewed after November 2, 2017. If the terms of the contract allow for termination or cancellation of the contract without the employee’s consent after November 2, 2017, the contract is treated as renewed as of the date that the termination, if made, would be effective. However, if the company will remain legally obligated by the terms of a contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as renewed if the employee exercises the discretion to keep the company bound to the contract. In addition, a contract is not treated as terminable or cancelable if it can be canceled only by terminating the employment relationship. Furthermore, a contract is not treated as renewed if upon termination of the contract the employment relationship continues but would no longer be covered by the contract. Note that if the employment continues after such termination, they are not grandfathered and are subject to the amended Code Sec. 162(m).

If a compensation plan or arrangement is binding, the amount that is required to be paid as of November 2, 2017, to an employee will not be subject to the amended Code Sec. 162(m) even if the employee was not eligible to participate in the plan or arrangement as of November 2, 2017. However, the new rules will apply to any compensation plan unless the employee was already employed on November 2, 2017, by the company or the employee had the right to participate in the plan or under a written binding contract as of that date.

Material modification

Material modifications include an increase the amount of compensation payable to the employee. If a contract is modified to accelerate the payment of compensation, it is a material modification unless the amount of compensation paid is discounted to reasonably reflect the time value of money. Material modifications may also include modifications that defer compensation under certain circumstances. In addition, supplemental contracts or agreements may materially modify the exiting contract. The IRS provides several examples to illustrate when such contracts are modified.


The guidance provided by the IRS is expected to be incorporated into the proposed regulations when they are released. The IRS notes that any future guidance that addresses the definition of covered employees, binding contracts, or material modification of such contracts would apply prospectively only. (Notice 2018-68, I.R.B. 2018-36, September 4, 2018.)

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