The $1 million cap on compensation deductions.

• Author: Kautter, David J.

Under the Revenue Reconciliation Act of 1993, publicly held corporations cannot deduct annually more than $1 million of compensation paid or accrued to their chief executive officer (CEO) and certain other highly compensated officers for tax purposes. Although this limitation deals with corporate governance principles that have traditionally been part of the nation's securities laws, the $1 million cap is found in Sec. 162(m) of the Code.

This article will discuss the newly issued proposed regulations on the requirements of Sec. 162(m) for any payment that would be deductible in a tax year beginning after Dec. 31, 1993. It is unclear how much reliance can be placed on these proposed regulations since neither the proposed regulations nor the accompanying preamble contains any statement indicating that taxpayers who rely on the proposed regulations will be afforded any protection from a subsequent IRS challenge. Despite this silence, many taxpayers are likely to place considerable reliance on the proposed regulations since they address a large number of important issues not answered in the statute or legislative history.

General Rule

The concept set out in Sec. 162(m) is straightforward: A "publicly held corporation" cannot deduct for regular and alternative minimum tax purposes more than $1 million for compensation paid to any "covered employee" during the employer's tax year. In order to be deductible up to the $1 million cap, the compensation must still meet the reasonableness requirement of Sec. 162(a)(1).(1) It is important to realize that it does not matter when the compensation is earned; the limitation applies for the employer's tax year in which the compensation would otherwise be deductible. There are two major exceptions to the $1 million limitation: compensation paid on a commission basis and qualified performance-based compensation. Of these two exceptions, the more important is the performance-based exception. There are several transition and grandfather rules that are also important.

(1)Prop. Regs. Sec. 1.162-27(a).

* Publicly held corporations

A publicly held corporation is any corporation issuing common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Act). This determination is made solely on the basis of whether, as of the last day of its tax year, the corporation is subject to the reporting obligations of Section 12 of the Act.(2) A corporation is not considered publicly held if the registration of its equity securities is voluntary.(3) The proposed regulations provide that a publicly held corporation includes an affiliated group of corporations, as defined in Sec. 1504 (determined without regard to Sec. 1504(b)).(4) Sec. 1504(a)(2) generally requires direct or indirect ownership of 80% or more of another corporation's voting power and value. The proposed regulation seems to go beyond the literal wording of the statute, although its effect seems to comply with the intent of the legislation. This means, for example, that deductions can be limited for compensation paid to executives of wholly owned subsidiaries (domestic and foreign) whose stock is not registered under the Act, so long as the executive is a covered employee of the registered parent corporation. The proposed regulations also provide that if a covered employee is paid compensation by more than one member of an affiliated group, then the compensation paid by each member of the affiliated group is aggregated and the amount disallowed is prorated among the payor corporations in proportion to the compensation paid by each of the affiliated corporations.(5)

(2)Prop. Regs. Sec. 1.162-27(c)(1)(i).

(3)Id.

(4)Prop. Regs. Sec. 1.162-27(c)(1)(ii).

(5)Id.

* Covered employees

An individual is a covered employee if on the last day of the employer's tax year, the individual is the CEO of the corporation (or is acting as the CEO) or among the four highest compensated officers, other than the CEO.(6) The proposed regulations refer to the Act to determine whether someone is described in either of the two categories. It is important to note that the definition of covered employees for purposes of Sec. 162(m) varies from the Securities and Exchange Commission (SEC) guidelines for determining "named executive officers" whose compensation is disclosed in the company's annual proxy statement. As a result of recent amendments, it is possible for more than five individuals to be reported in a company's proxy statement. However, the Code limits the number of covered employees to five. The most significant area of difference is that, under the proposed regulations, only individuals who are employed on the last day of the tax year can be covered employees. For example, someone who retires as a CEO before the last day of the company's tax year will not be taken into account for purposes of the deduction disallowance rules, although their compensation would still have to be disclosed under the new SEC proxy guidelines. Similarly, other individuals who would have been among the four most highly compensated employees will not be taken into account if they are not employed on the last day of the tax year. This provides a significant planning opportunity for certain taxpayers. By terminating employment before the last day of the company's tax year, any compensation paid to such a terminated employee will not be subject to the new deduction disallowance rules in the termination year.

(6)Prop. Regs. Sec. 1.162-27(c)(2)(i).

Finally, any compensation paid after the year in which an individual retires will also not be subject to the deduction disallowance rules since the individual is no longer a covered employee. This will mean that many employers affected by these rules will want to consider deferral agreements, elective or mandatory, to defer the payment of compensation in excess of $1 million that is not commission or performance-based until after the executive has terminated employment.

* Compensation

For purposes of Sec. 162(m), compensation means the aggregate amount allowable as a deduction for the tax year (determined without regard to Sec. 162(m)) for remuneration for services performed by a covered employee, whether or not the services were performed during the tax year.(7) There are seven types of compensation that are not taken into account for purposes of this calculation: (1) payments made to or from a qualified trust described in Sec. 401(a); (2) payments made to or under an annuity plan described in Sec. 403(a); (3) payments made under a simplified employee pension described in Sec. 408(k)(1) (except contributions described in Sec. 408(k)(6)); (4) contributions to or under an annuity contract described in Sec. 403(b) unless the payment for the purchase of the contract is made by reason of a salary reduction agreement;(8) (5) remuneration consisting of any benefit provided to or on behalf of an employee if, at the time the benefit is provided, it is reasonable to believe that the employee will be able to exclude it from gross income; (6) salary reduction contributions to a Sec. 401(k) plan; and (7) amounts treated as employer contributions to governmental plans under Sec. 414(h)(2).(9)

(7)Sec. 162(m)(4)(A); Prop. Regs. Sec. 1.162-27(c)(3).

(8)Prop. Regs. Sec. 1.162-27(c)(3)(ii)(A).

(9)Prop. Regs. Sec. 1.162-27(c)(3)(ii)(B).

Exception for Compensation Paid on a Commission Basis

Any compensation paid on a commission basis is not subject to the deduction disallowance rules of Sec. 162(m). Compensation is considered paid on a commission basis if the facts and circumstances show that it is paid solely on account of income generated directly by the individual performance of the person to whom the compensation is paid. If the compensation is paid on account of broader performance standards, such as income produced by a business unit, the compensation will not qualify for this exception.(10) This exception appears to have limited applicability and, while helpful in certain circumstances, will not be used by many taxpayers.

(10)Prop. Regs. Sec. 1.162-27(d).

Exception for Qualified Performance-Based Compensation

The major exception to the $1 million limitation is "performance-based compensation." This exception will be the centerpiece of discussion in most affected corporations in the short and long term as they attempt to avoid the loss of a corporate deduction for compensation paid to a covered employee.

In general, compensation...