162(m) Trap for Smaller Reporting Companies

A recent IRS Chief Counsel Memorandum indicates that smaller reporting companies must treat their CFO as a covered employee under Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.

Wait a Minute! The CFO Isn't Subject to 162(m)?

Yep, that's right. For larger reporting companies, it may seem crazy, but the CFO isn't ever a covered employee under Section 162(m). This is because the definition of a named executive officer under Item 402 of Reg S-K for purposes of the executive compensation disclosures in the proxy has evolved and the definition of a covered employee under Section 162(m) hasn't kept pace.

Section 162(m) applies to the following executives:

1. The CEO
2. The top four highest paid executives other than the CEO, as determined for proxy disclosure purposes.

Back when 162(m) was adopted, this was the same group of people that were considered NEOs for purposes of the proxy disclosures.  But in 2006, the SEC changed Item 402 to carve out a separate requirement for CFOs. So now, the NEOs in the proxy are:

1. Anyone serving as CEO during the year
2. Anyone serving as CFO during the year
3. The top three highest paid executives other than the CEO and the CFO.
4. Up to two additional executives that would have been in the top three except that they terminated before the end of the year.

Unfortunately, only Congress can change the statutory language under Section 162(m), so the IRS can't modify the definition of a covered employee to match the SEC's new definition of an NEO. (When Congress drafted Section 162(m), they probably should have just said that it applies to all NEOs as determined under Item 402 of Reg S-K.)

All the IRS can do is interpret the requirement under 162(m) in light of the SEC's definition.  Their interpretation is that the SEC's change exempts CFOs from Section 162(m) (see the NASPP alert "IRS Issues Guidance on 'Covered Employees' Under Section 162(m)," June 9, 2007). (If you are wondering, former employees are also not subject to Section 162(m); this is another evolution in the SEC definition that hasn't been implemented in the tax code.)

What Gives With Smaller Reporting Companies?

Smaller reporting companies are subject to abbreviated reporting requirements, including fewer NEOs for proxy reporting purposes.  Thus, the SEC's new definition in 2006 never applied to smaller reporting companies. Instead, NEOs in smaller reporting companies are defined as:

1. The CEO
2. The top two highest paid executives other than the CEO.

Per Chief Counsel Memorandum 201543003, because the CFO isn't separately required to be included in the proxy disclosures for smaller reporting companies, he/she is still a covered employee for Section 162(m) if he/she is one of the top two highest paid executives other than the CEO.

- Barbara