Highly compensated finance officer was a covered employee

Plain-English summary

Chief Counsel considered the section 162(m) status of a smaller reporting company’s principal financial officer. Notice 2007-49 generally excludes an officer whose compensation is disclosed solely because the person serves as principal financial officer. Smaller reporting companies, however, do not disclose that officer based on the position alone. They disclose the two highest-paid executive officers other than the principal executive officer. Because this principal financial officer was the second-highest-paid executive other than the principal executive officer, the compensation disclosure was based on pay rank and the officer was a covered employee.

Ruling snapshot

• Question: Whether a smaller reporting company’s principal financial officer was a covered employee under section 162(m)(3)
• Outcome: Yes
• Key authorities: I.R.C. § 162(m); Treas. Reg. § 1.162-27; Notice 2007-49

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           memorandum
           Number: 201543003
           Release Date: 10/23/2015
           CC:TEGE:EB:EC
           PRESP-135590-14

 UILC:     162.36-02

  date:    August 24, 2015

     to:   Mark Hulse
           CC:TEGEDC:NELI

  from:    Thomas Scholz, Senior Counsel
           CC:TEGE:EB:EC


subject:   Principal Financial Officer of Smaller Reporting Company as Covered Employee
           under §162(m)(3)

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           ISSUE

           Whether Employee A, the principal financial officer (PFO) of a smaller reporting
           company, is a “covered employee” within the meaning of §162(m)(3) of the Internal
           Revenue Code (Code).

           CONCLUSION

           Employee A is a “covered employee” within the meaning of §162(m)(3).

           FACTUAL SCENARIO

           Corporation X is a publicly held corporation. For 2014, Corporation X is eligible to
           comply with the executive compensation disclosure requirements under the Securities
           Exchange Act of 1934 (Exchange Act) by satisfying the disclosure rules required of a
           smaller reporting company under Item 402(m) of Regulation S-K. Employee A served
           as the PFO of Corporation X at the end of 2014. Employee A is the second highest
           compensated executive officer of Corporation X for 2014 other than the principal
           executive officer (PEO).
PRESP-135590-14                              2

LAW

Section 162(a)(1) of the Code allows a deduction for all ordinary and necessary
expenses paid or incurred during the taxable year in carrying on any trade or business,
including a reasonable allowance for salaries or other compensation for personal
services actually rendered.

Section 162(m)(1) of the Code provides that for any publicly held corporation no
deduction shall be allowed for applicable employee remuneration with respect to any
covered employee to the extent that the amount of such remuneration for the taxable
year exceeds $1 million.

Section 162(m)(2) of the Code defines the term “publicly held corporation” to mean any
corporation issuing any class of common equity securities required to be registered
under section 12 of the Exchange Act.

Section 162(m)(3) of the Code defines the term “covered employee” as any employee of
the taxpayer if (A) as of the close of the taxable year, such employee is the chief
executive officer of the taxpayer or is an individual acting in such capacity, or (B) the
total compensation of such employee for the taxable year is required to be reported to
shareholders under the Exchange Act by reason of such employee being among the
four highest compensated officers for the taxable year (other than the chief executive
officer).

Section 1.162-27(c)(2) of the Income Tax Regulations provides that a covered
employee is any individual who, on the last day of the taxable year, is (A) the chief
executive officer of the corporation or is acting in such capacity; or (B) among the four
highest compensated officers (other than the chief executive officer). Whether an
individual is the chief executive officer or one of the four highest compensated officers is
determined pursuant to the executive compensation disclosure rules under the
Exchange Act (disclosure rules). See section 1.162-27(c)(2)(ii). The disclosure rules
are contained in Item 402 of Regulation S-K, 17 CFR 229.402. These rules require
disclosure of compensation awarded to, earned by, or paid to certain executive officers.

For fiscal years ending before December 15, 2006, the disclosure rules provided that
named executive officers consisted of, in relevant part, (i) all individuals serving as the
registrant's chief executive officer or acting in a similar capacity during the last
completed fiscal year, regardless of compensation level; and (ii) the registrant's four
most highly compensated executive officers other than the chief executive officer who
were serving as executive officers at the end of the last completed fiscal year. On
September 8, 2006, the Securities and Exchange Commission issued a final rule
amending the disclosure rules (71 FR 53158). Among other things, the amended
disclosure rules altered the composition of the group of executives who are covered by
the disclosure rules. Like the pre-amendment disclosure rules, the amended disclosure
PRESP-135590-14                               3

rules refer to these executives as “named executive officers.” Under the amended
disclosure rules, named executive officers consist of, in relevant part:
   i.  all individuals serving as the registrant's PEO or acting in a similar capacity
       during the last completed fiscal year, regardless of compensation level;
  ii.  all individuals serving as the registrant's PFO or acting in a similar capacity
       during the last completed fiscal year, regardless of compensation level;
 iii.  the registrant's three most highly compensated executive officers other than the
       PEO and the PFO who were serving as executive officers at the end of the last
       completed fiscal year; and
 iv.   up to two additional individuals for whom disclosure would have been provided
       but for the fact that the individual was not serving as an executive officer of the
       registrant at the end of the last completed fiscal year.

Companies were required to comply with the amended disclosure rules for fiscal years
ending on or after December 15, 2006.

In response to the amended disclosure rules, the IRS issued Notice 2007-49, 2007-1
C.B. 1429. Notice 2007-49 provides that the IRS will interpret the term "covered
employee" for purposes of section 162(m) to mean any employee of the taxpayer if, as
of the close of the taxable year, such employee is the PEO (within the meaning of the
amended disclosure rules) of the taxpayer or an individual acting in such a capacity, or
if the total compensation of such employee for that taxable year is required to be
reported to shareholders under the Exchange Act by reason of such employee being
among the three highest compensated officers for the taxable year (other than the PEO
or the PFO). The Notice also provides that the term “covered employee” for purposes
of section 162(m) does not include those individuals for whom disclosure is required
under the Exchange Act by reason of the individual being the taxpayer's PFO (within the
meaning of the amended disclosure rules) or an individual acting in such a capacity.

With respect to smaller reporting companies, Item 402(m) of Regulation S-K provides
that the named executive officers consist of, in relevant part: (i) all individuals serving as
the PEO or acting in a similar capacity during the last completed fiscal year, regardless
of compensation level; (ii) the two most highly compensated executive officers other
than the PEO who were serving as executive officers at the end of the last completed
fiscal year; and (iii) up to two additional individuals for whom disclosure would have
been provided but for the fact that the individual was not serving as an executive officer
of the smaller reporting company at the end of the last completed fiscal year.

ANALYSIS

Under §162(m)(3), an employee is a covered employee if such employee is the chief
executive officer or if the total compensation of such employee is required to be
reported to shareholders under the Exchange Act by reason of such employee being
among the four highest compensated officers for the taxable year (other than the chief
executive officer). Interpreting §162(m)(3)(B) in light of the amended disclosure rules,
PRESP-135590-14                            4

Notice 2007-49 provides that a covered employee includes the PEO and an officer
whose total compensation is required to be disclosed by reason of such employee being
among the three highest compensated officers for the taxable year (other than the PEO
and the PFO). Thus, the PEO is the only officer who is a covered employee by reason
of serving in a specific position. Under the notice, the PFO is not a covered employee
when the disclosure relating to the PFO is required by reason of the individual serving
as PFO. Notice 2007-49 does not preclude the PFO from qualifying as a covered
employee if disclosure relating to the PFO is required by reason of such officer being
among the highest compensated officers.

For smaller reporting companies, the disclosure rules require disclosure of
compensation for the PEO (based on his or her service as the PEO) and the two most
highly compensated executive officers other than the PEO who were serving as
executive officers at the end of the year. The disclosure rules for smaller reporting
companies do not require disclosure of compensation of an officer by reason of the
individual serving as PFO. Instead, the disclosure rules require disclosure of
compensation for the PFO of a smaller reporting company only if the PFO is one of the
two most highly compensated executive officers other than the PEO who were serving
as executive officers at the end of the year. In accordance with §162(m)(3)(B) and
Notice 2007-49, the PFO of a smaller reporting company is a covered employee if the
PFO is one of the two most highly compensated executive officers other than the PEO
who were serving as executive officers at the end of the year.

Employee A is a “covered employee” within the meaning of §162(m)(3) because the
compensation of Employee A is disclosed by reason of Employee A being one of the
two highest compensated executive officers (other than the PEO).

Please call Ilya Enkishev at (202) 317-5600 if you have any further questions.