On June 4, 2007, the IRS issued Notice 2007-49 which provides guidance for identifying “covered employees” for purposes of Code Section 162(m)(3). For several months, the IRS indicated it would address the uncertainty surrounding the determination of “covered employees” resulting from the Securities and Exchange Commission’s adoption of final rules relating to disclosure of executive compensation. Among other things, the SEC’s amended rules altered the composition of the group of executives covered by the compensation disclosure rules (referred to as the “named executive officers”) such that the definition of “covered employee” in Code Section 162(m) no longer mirrored the definition of “named executive officer,” as was the case prior to the SEC’s amendments. To the surprise of many, however, the IRS clarified this uncertainty by stating that a public company’s chief financial officer would generally not be a “covered employee” for purposes of Code Section 162(m), except in limited circumstances.

Code Section 162(m) and SEC Item 402 of Regulation S-K

Code Section 162(m)(1) provides that public companies may not deduct compensation paid to “covered employees” to the extent such compensation for the taxable year exceeds $1,000,000. Code Section 162(m)(3) defines a “covered employee” as (i) the company’s chief executive officer, or any individual acting in such capacity during the taxable year, and (ii) any employee whose total compensation is required to be reported pursuant to the SEC’s executive compensation disclosure rules under the Securities Exchange Act of 1934 by reason of the employee being among the four highest compensated officers for the taxable year (other than the chief executive officer). Under the SEC’s prior compensation disclosure rules, which are contained in Item 402 of Regulation S-K, “named executive officers” consisted of (i) all individuals serving as the company’s chief executive officer, or acting in a similar capacity, during the last completed fiscal year, regardless of compensation level, and (ii) the company’s four most highly compensated executive officers, other than the chief executive officer, who were serving as executive officers as of the end of the last completed fiscal year. In July 2006, however, the SEC approved an extensive overhaul of its executive and director compensation disclosure regime, including the definition of “named executive officers.” Under the SEC’s new disclosure requirements, “named executive officers” consist of (i) all individuals serving as the company’s principal executive officer (“PEO”), or acting in a similar capacity, during the last completed fiscal year, regardless of compensation level, (ii) all individuals serving as the company’s principal financial officer (“PFO”), or acting in a similar capacity, during the last completed fiscal year, regardless of compensation level, and (iii) the company’s three most highly compensated executive officers, other than its PEO and PFO, who were serving as executive officers as of the end of the last completed fiscal year.

Thus, while the SEC’s amended definition of “named executive officers” generally continues to require compensation disclosure of five executive officers, two executives are now covered by the rules based on their positions (PEO and PFO), while three are covered based on their level of compensation. In contrast, a “covered employee” under Code Section 162(m) consists of only one executive based on position, and four executives based on their level of compensation.

IRS Guidance

Applying a strict interpretation of the statutory language of Code Section 162(m)(3), Notice 2007-49 states that the IRS will interpret “covered employee” to mean (i) the company’s PEO, or an individual acting in such capacity during the taxable year, and (ii) any employee whose total compensation is required to be reported pursuant to the SEC’s executive compensation disclosure rules (as amended) by reason of the employee being among the three highest compensated officers for the taxable year (other than the PEO and PFO). Thus, because a PFO’s compensation is required to be disclosed pursuant to the SEC’s amended rules due to his or her position and not level of compensation, such person (or an individual acting in such capacity during the taxable year) will not generally be included within the definition of “covered employee.”

Analysis

As a result of the IRS guidance, most public companies will only have four “covered employees” for purposes of Code Section 162(m). A company’s PFO, or individual acting in such capacity, will not be a “covered employee” unless such person (i) is also serving as the company’s PEO as of the end of the taxable year, or (ii) also holds another executive officer position with the company that is one of the three most highly compensated executive officers of the company for the taxable year. The IRS position has created a rather large loophole for purposes of a public company’s ability to deduct executive compensation. Given Congress’ focus on executive compensation issues recently, it is possible that this loophole will soon be addressed by Congressional action.