United States: CFO Compensation No Longer Subject To $1 Million Deduction Limit: But For How Long?

On June 4, 2007, the IRS issued Notice 2007-49, which changes the group of executive officers who are considered covered employees for purposes of Section 162(m) of the Internal Revenue Code. The Notice specifically excludes the chief financial officer (CFO) from coverage under Section 162(m) and provides that the only individuals who will be considered covered employees are the chief executive officer (CEO) and the three highest compensated officers (other than the CEO or CFO). Previously, the CEO and the four other highest compensated officers were subject to Section 162(m), and the CFO was not automatically excluded.

Under Section 162(m), a publicly-held corporation may not deduct more than $1 million of compensation for each covered employee per year, unless the compensation qualifies under an exemption, such as for performance-based. The term "covered employee" is defined in Section 162(m) as the CEO and any other officer whose compensation is required to be reported to shareholders under the SEC disclosure rules because the officer is among the corporation’s four highest compensated officers (other than the CEO). Previously, the group of executives who were considered covered employees under Section 162(m) all were included in the group of executives who were subject to the SEC disclosure rules. However, in 2006, the SEC disclosure rules were amended to require reporting for the CEO and CFO, regardless of their compensation level, and the three highest compensated officers (other than the CEO and CFO). Therefore, the CFO is subject to the new SEC disclosure rules based solely on position, rather than because of compensation level. However, the only executive who is covered under Section 162(m) based solely on position is the CEO. In order to address this regulatory discrepancy, the IRS issued the recent Notice, clarifying that because the CFO is subject to the new SEC disclosure rules based solely on position, the CFO cannot be a covered employee under Section 162(m) even if the CFO is among the most highly paid officers of the corporation. Accordingly, corporations will now have only four executives subject to the $1 million deduction limitation under Section 162(m), and this group of executives will no longer match the group of five named executive officers subject to the SEC disclosure rules.

Some have suggested that the CFO may be a covered employee under Section 162(m) if the CFO is also acting as the CEO or holds another officer position at the corporation that is among the three highest compensated. However, the IRS has informally indicated that the dual CEO/CFO case appears to be the only exception to the rule that Section 162(m) does not apply to CFOs. Accordingly, in the case of a CFO holding another position that is required to be reported under the SEC disclosure rules based on compensation level, because the CFO’s compensation still would be reported to shareholders due to his position as the CFO (rather than his compensation from the other officer position), it appears that the CFO would not be a covered employee under Section 162(m).

The IRS has informally confirmed that the effective date of the Notice will conform to the effective date of the new SEC disclosure rules, which became effective for fiscal years ending on or after December 15, 2006. Therefore, for calendar year corporations, the Notice will apply to compensation paid to covered employees beginning in 2006. However, Congress has recently considered a number of legislative proposals regarding Section 162(m), and it may well decide to amend Section 162(m) in the future to again subject CFOs to the $1 million compensation deduction limit. Accordingly, public companies likely will not (and should not) use what may amount to a temporary absence of regulation as an opportunity to compensate CFOs without reference to the Section 162(m) limit or without compliance with normal performance-based compensation procedures.

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