More Companies Are Subject to the Compensation Deduction Limitation

Prior to the tax reform legislation of 2017, commonly referred to as the Tax Cuts and Jobs Act of (TJCA), publically held corporations were able to deduct reasonable compensation, but were generally disallowed amounts exceeding $1 million for compensation paid to covered employees under Internal Revenue Code (IRC) Section 162(m). TCJA amended IRC Section 162(m), subjecting more companies to this compensation-deduction limitation for the highest compensated officers. On August 21, 2018, the IRS issued Notice 2018-68, providing guidance on the application of IRC Section 162(m) that has significant implications for how executive compensation at publically traded corporations is taxed.


TJCA amended IRC Section 162(m) changing the definition of a covered employee, broadening the definition of a publically held corporation subject to the limitation, and repealing the performance-based compensation exception.

A covered employee is now defined as the principal executive office (PEO), principal financial officer (PFO), or any individual acting in such a capacity at any time of the year. It also includes employees whose total compensation for the tax year is required to be reported to shareholders because they’re the three highest-paid officers other than the PEO or PFO.

The new rule now applies to more publically held corporations because the definition has been expanded to include entities that are issuers required to file reports under Section 15(d) of the Securities and Exchange Act of 1934 (Exchange Act). Under prior law, employers subject to the limitation were only entities that were issuers of securities subject to the registration requirements of Section 12 of the Exchange Act.

The elimination of the performance-based compensation exception means that all compensation paid to a covered employee in excess of $1 million would be nondeductible, including severance and deferred compensation. However, the law also includes a grandfather rule that allows employment contracts, which are written binding contracts, in effect on November 2, 2017, to apply the old IRC Section 162(m) rules—provided no material modifications were made after that date.

New Guidance

IRS Notice 2018-68 provides guidance on certain provisions of the amended IRC Section 162(m) deemed integral to its application. The notice answers the following questions: 

  • Which officers are included when determining a covered employee?
  • What’s considered a binding contract?
  • How is a contract determined to have been materially modified?

Covered employees include the three officers receiving the most compensation in a taxable year. However, according to the notice, an employee doesn’t have to serve as an executive officer at the end of a taxable year to be considered a covered employee; instead, the primary requirement is simply that the employee earned compensation reported during the applicable tax year.

Contract Exception Requirements

There’s one exception to the newly modified IRC Section 162(m), which allows certain taxpayers to continue to adhere to the previous version of the law.

Contract in Effect by November 2, 2017

The first requirement for a taxpayer to qualify for an exception is to have a binding employee contract in effect on or before November 2, 2017. The contract must require the corporation, under applicable law, to pay remuneration if the employee performs certain services or satisfies vesting conditions.

If an employee continues to work with a corporation but is no longer covered by the contract because it’s since expired, the employee’s remuneration is no longer binding and becomes subject to the new IRC Section 162(m) limitations. Similarly, if a contract is renewed after November 2, 2017, the contract isn’t considered in effect on or before the applicable date and isn’t subject to the previous version of the law.

No Material Modification

To qualify for an exception to the updated law, contracts also can’t be materially modified. Material modification generally refers to an increase in compensation or acceleration or deferral of payment. If an increase is driven by a change in cost of living, the contract isn’t considered materially modified.

Stay Tuned for Further Updates

The IRS anticipates concerns that weren’t discussed in Notice 2018-68 will be addressed in future proposed regulations—which will likely also include the guidance outlined in this notice.

We’re Here to Help

For information on what the compensation deduction limitation means for you and your business, please contact your Moss Adams professional.

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