One Big Beautiful Bill Act, Part 3: Executive Pay IRC 162 changes, Alternative Minimum Tax considerations, and the New Section 4960 Landscape

Stephanie Vasconcellos

Welcome to our Employment and Benefits Unpacked series, where we dive into the many employment, benefits, and mobility issues facing employers around the world. Each episode is hosted by a different Mayer Brown lawyer from our Global Employment and Benefits group, and we hope to offer fresh perspectives and insights for employers, HR professionals, and in-house counsel. I'm Stephanie Vasconcellos, a partner in our Chicago office, and I'm delighted to be joined today by Ryan Liebl, another partner in our Chicago office. Ryan, thank you for joining me.

Ryan Liebl

Thanks, Stephanie. And as Stephanie noted, I'll be covering the Exec Comp topics today. As you listen to this, you'll note that I want to thank my co-panelists, Stephanie and Hilary for parts one and two, because I think they definitely had the harder parts. But for the One Big Beautiful Bill, what is impacted by Exec Comp is important. And I think you'll see as I talk through these that the general theme for Exec Comp is revenue raising. So if you think of the overall impact of the One Big Beautiful Bill Act, to be tax reduction for some individuals, this would be seen, I think, as the side of efforts to raise revenue in the bill. So we'll start with 162(M), and I think it's helpful to start from the beginning. There's been a lot of changes over the last 10 years to 162(M). So originally, 162(M) generally applies to public companies and limits the deduction for reasonable compensation paid to $1 million for individuals who are covered employees.

Prior to 2017, there was two big ways to exclude income from this deduction. One was if it was structured as performance-based comp. So in the old days, many of us took a lot of time to help public company clients structure almost all comp as performance-based comp so that it was not subject to the deduction limitation. The only real exception was base salary. So in the good old days, a lot of public company executives had a base salary of $1 million or less so that that was fully deductible.

And then we tried to get everything else to be structured as performance-based comp. The other part that was key in the old days is that a covered employee was analyzed on a year-by-year basis and it depended on their role during that year. Generally CEO, CFO and the top three other officers. And if people, there were some situations where you may have one or two more individuals who would make the list for that year. But then the next year was a whole new list and the deduction limitation applied to comp that was paid that year to them.

And then the next year you'd have a new list. So starting in 2017 with the Tax Cuts and Jobs Act, and again with that act back in Trump's first term, also generally overall net less taxable income for the treasury. This was still a revenue raiser back then. It did a couple of significant things. One, it removed the performance-based compensation exception. So that whole structuring effort has just gone and has been now for several years where that doesn't help with the deduction. It's still now the $1 million limit. If performance-based comp is paid, if it's over the limit, it's not deductible. It also changed the definition of publicly held corporation. It generally aggregated under 1504, which in the tax world, that's generally the aggregated filing for a group of corporations. So it's generally the corporations within a group that was aggregated for tax purposes in the US.

And then it expanded the definition of covered employee. Still again, generally there was some between CEO, CFO, top three, and then possibly one or two others depending. But the key that I want to note here is that it became permanent. So once someone in any given year for a public company or group of companies was a covered employee, they were covered employee forever. That effectively removed one other way to maximize the deduction under 162(M) that employers used to use, which is to defer cop. Because if somebody would wait to get paid amounts until they cease to be a covered employee, it would be deductible then. But now that effective exception is gone as well, because it doesn't matter. They've ever been an employee, anything you pay them in any given year above a million dollars is not deductible.

Stephanie Vasconcellos

Were these changes unexpected at the time? I know that people think that the Trump administration is fairly favorable to businesses and taxpayers generally, but this seems like a pretty significant change.

Ryan Liebl

Yeah, it's a good question. And I've always been a little bit surprised too, that a Republican administration would use this as a revenue raiser, because generally I think the one thing I would note on 162M that's interesting is it's an effective raising of the corporate tax rate. Because it's not a tax on the individual, it effectively in the original act in 2017 lowered corporate taxes. And this was a little bit of a client or sort of raising it back up to an effective tax rate. And I think executives are generally viewed as unsympathetic. So it's easier to sell to the public generally that, you know, we don't feel sorry, but it is interesting to me because it's not a tax on the executive. So even though in some ways they may be an unsympathetic group for raising taxes, it's still effectively a corporate tax. The other part that's always seemed interesting to me too, in the rise of private companies and a lot of us that work in exec comp know there are—

Stephanie Vasconcellos

Right, the corporate tax.

Ryan Liebl

Really large private companies, there's lots of private equity, privately owned companies that pay a lot of executive comp, but this does always just limit itself to publicly traded companies. And we'll get to some more changes that have been further expanded. But I think, you know, one thing public company clients would have a legitimate complaint about too is, why just us Why not anyone paying exec comp over a million dollars? Don't they lose the deduction?

And I think it's just because historically when this was originally enacted years ago, public companies were the main ones paying higher exact comp, but I don't think that's true anymore. So, but I agree. It was unexpected for me, too. In the original bill in 17, it was there sort of from the beginning. So we adapted to that thinking, but there was nothing that led me to believe those changes would be coming when they first started to talk about the bill. Then in 2021, the American Rescue Plan Act made additional changes.

So again, we're still on the One Big Beautiful Bill Act. But interestingly, the changes in 2021 that were made are not effective until after 2026. So it's an act from four years ago, but will actually take effect after the changes I'll describe in a minute for the One Big Beautiful Bill Act. The key here is it further expanded covered employees to include the five most highly compensated employees without regard to them being officers.

So every year you could have additional. So again, the covered employee list traditionally is now always growing. And then every year you add five more based on the comp. But this list is not permanent. So it's just a year-to-year, whoever received a ton of comp this year. This had been talked about for years. And for those of you on the security side know that the 162(M) concept correlates with the NEO concept in the SEC world. And there was a lot of talk for years about expanding that list too based on comp.

It's often referred to as the Katie Couric rule, but from back in the days when she was the highest-paid employee, I think of CBS at the time, but was not reported and not subject to the deduction limitation. Now this change will capture it. But I do want to note again, this change in theory is not effective until after 2026, so beginning in 2027. Now we get to the One Big Beautiful Bill.

The additional changes this year are to further expand companies subject to 162(M). So now it includes companies aggregated under 414(B), (C), or (O). And for those of us in the benefits world, we're used to working with these sections, we're not used to working with them in this context. B and C are generally mathematical analyses. They're fairly similar to the 1502 rules, did I get that right? Let me fit 1504 rules.

Stephanie Vasconcellos

Thanks.

Ryan Liebl

But still broader because they can include companies that are not corporations. They can include other businesses or pass through. Those of us in the benefits world find these to be very unclear in the best way to say it. They're very unclear and hard to apply. But the one thing I would note for employers is—

Stephanie Vasconcellos

I'm to say M&O is a totally different ballgame.

Ryan Liebl

Because these concepts are used for your benefit plans, most employers will have had to take a position already on which entities are included or not included for purposes of 414(B), (C), (M), (O). So now 162(M) will require a consistent analysis with respect to these provisions too. The other part I want to note is because it's no longer the consolidated tax return, there's a chance the deduction limitation applies to multiple tax returns.

So the statute has rules about apportioning the limit of the deduction to the different entities within the related companies because they may no longer be a consolidated tax return. They also create a new concept called specified covered employee, which is generally a combination of the updated definition of covered employee for 2017 and 2021, but then a broader group of employees. So it's again, sort of catching up these changes.

And these changes do generally, in theory, take effect this next year, beginning after 2025. I think a lot of people have questions about how does this relate to the changes from 2021? How do we read all of this together? I do expect the IRS to put out more guidance. They had put out proposed regulations on the 2021 changes earlier this year, but I think most practitioners expect those to be updated and then further address these more recent changes and provide guidance. Then, yeah.

Stephanie Vasconcellos

And if you think about that timing, they put out proposed regulations on the 2021 law in 2025. So it may be some time before we get guidance on this, right? Yeah.

Ryan Liebl

Yes. Yes. Yeah, but it's a little bit scary in the sense that the new rules do apply next year. So hopefully, but I agree with you. Comments are made in part two with guidance. There's been the shutdown. You know, I would think there's a backup on a lot of different things we're hoping to get from the government right now on these different topics. And the one thing I'll note for 162 before we leave this topic is most of the ways attorneys used to help companies plan around the deduction limitation are now gone.

It's more now than just a compliance exercise. There's still key questions that we are happy to help weigh in on and help you analyze how it would apply to different comp. There is sometimes still grandfathering questions from the original changes in 2016 and 17 that may still apply. Happy to weigh in on all of those things. But essentially, there's not a lot of planning. And I will say that the...the analysis of the aggregated companies, there's a million factors that go into that. I don't think any clients will try to structure around this because structures are complicated and there's a lot of other tax issues at play. So it's more, think, just an analysis of how it applies. The one thing I will note that could still apply is a helpful planning mechanism is for deferred comp that is paid out after termination of employment. If it's paid in installments, that could maximize the deductibility. Again, someone will be a covered employee for the duration even after they're terminated. But if the installments are a million dollars or less, they'd be fully deductible. Whereas if they're above that, the extent they're above that after they terminate would not be deductible. That's the one thing I think clients could look at here. The next topic is 4960, which is an excise tax that was added to the code also in 2017. So you see parallels between the original Trump Act and the one that was recently, they sort of went back to the similar concepts for revenue raising. This is a tax on tax exempt organizations where they're required to pay a 20 % excise tax on comp paid to certain covered employees that exceeds $1 million during your taxable year or that's an excess parachute payment. And both of these conceptually are similar concepts to what we see in other code provisions. The excess parachute payment is similar to the 280(G) concept. But essentially, the one point I want to make here, or two points, I guess, if you're a not-for-profit employer, the reasons there's some differences. One is they couldn't do this one as a deduction limitation because, of course, not-for-profits don't care about a deduction. They're not paying taxes. So the excise tax is to sort of extract some consequence on a tax basis. It has to be an additional tax because there's no consequence for loss of deduction. So hence it's an excise tax. Again though, similar to 162(M), it's on the organization and not the employee. So it effectively raises, and also again, it's an excise tax. So they're normally tax exempt on income, but this is an additional tax paid, not withstanding income for the organization. The other thing I want to note is not-for-profits generally cannot allow employees to defer taxation. There are limited exceptions to that. But generally, the code does not want employees of not-for-profits to delay deferring. The reason for that is for profit companies, the delay or the deferral of income delays the deduction. And so the IRS views that as neutral. But for not-for-profits, there's no deferral of a deduction. And so any deferral of compensation is just a loss to the Treasury.

To line this concept up, it's important for tax exempt organizations to note that the comp is considered paid when it becomes vested, not when it's received. So the excise tax could be due in a year when the employee is not actually paid $1 million. But if they become vested in an amount in $1 million or more, the excise tax may be due in that year. So the two may not line up and that's important to note. The changes this year were to expand the covered employee to add the—

So a similar change that was made to 162(M). So now if you're a covered employee for a not-for-profit employer, that employee will always be. So again, there's no benefit to deferring until after they terminate. That won't work here. So that's one key. Well, actually, that's the key change for this one. It's that it's permanent. So that's the one recent change of note. So.

The last topic I wanted to mention today is not really an employer topic, but it does impact some employees. And so we want to note that there were changes made to the alternative minimum tax. And to back up and explain for those of you who are not familiar with it, this was a shadow, I sort of call it a shadow or a second tax system passed on the federal level in the 90s that was intended to capture taxes for employees that were viewed or other service providers as successfully avoiding paying federal taxes by the use of deductions or other methods to effectively reduce their income to the extent they didn't pay many taxes. The tax rates of the AMT are lower, but there are fewer exclusions from the income for AMT. So for many of you, you may be familiar with this. If you use online tax preparers, they'll prepare your taxes based on all the information you get from your employer. And then at the end, it'll rerun the numbers for the AMT. Some of you have had the unfortunate experience to watch your refund or the taxes you owe change dramatically on the AMT. And so we wanna note that there were changes this year that will further change that. It's a little bit of a mixed bag of good news, bad news. There's lowering of the maximum federal bracket where there's a phase out, but the tax base is larger. It's again, because there's fewer deductions. The other key part, I wanna line this up with employers where this may matter the most.

Employers who grant ISOs or incentive stock options, which we see the most with startup companies or newer companies, but sometimes larger public companies grant ISOs too. ISOs under federal taxes generally can be a very good result for employees because no tax on grant, no tax on vesting, no tax on exercise. And then if they hold the shares for a holding period, they only pay capital gain or loss at the end of the holding period. So it can effectively avoid a lot of ordinary income tax. The problem has always been ISOs are not excluded from the AMT on exercise. So when an employee exercises an ISO, if they're not aware of this and employers have no withholding obligations for the AMT, so it will go unnoticed to the employee. There would be an exercise.

They receive shares, they pay no tax, they think this is the best deal in the world, I'm not gonna pay tax on this. And then they file their online tax return and they get a bad result because it is included there. And I just always wanna note that I think a lot of employers are not aware of that, a lot of employees are not aware of that, but that inclusion in AMT can actually trigger the AMT and trigger a very large tax due actually on the filing of the AMT. Unfortunately, it depends on how successful the options are. If they're those sort of great stories where they're worth a ton of money when they're exercised, it will impact the AMT.

Stephanie Vasconcellos

And that didn't change under the One Big Beautiful Bill Act, right?

Ryan Liebl

Very good point. That did not change. I'm just sort of highlighting with the changes to AMT, that's where we see it at least impacting employers and employees the most. So yes, good point. But that part did not change. With that, I think I'll wrap up with the exact comp side unless Stephanie, is there anything else you want to note or jump in on? I think that covers it.

Stephanie Vasconcellos

Yeah, great. Yeah. No, I think that's covered the benefits provisions under the One Big Beautiful Bill Act. So we hope you listen to our first and second podcasts. If not, please go back and listen. And Ryan, thanks for joining me today to talk about the executive compensation provisions under the One Big Beautiful Bill Act. For our viewers and listeners, there are more episodes to come. They will not all be about the One Big Beautiful Bill Act.

So please check out our Employment and Benefits Unpacked page on the Mayer Brown website or on your preferred streaming platform. If you'd like to discuss any of the issues that we've covered today, please get in touch. And until next time, thank you for joining us.