Deduction limitations of Sec. 162(m) to compensation paid by partnerships in Up-C and UPREIT structures

By Robert W. Delgado, J.D., LL.M.; Gary Q. Cvach, J.D., LL.M.; Erinn Madden, J.D., LL.M.; and Carly M. Rhodes, J.D., LL.M., Washington, D.C.

Editor: Mary Van Leuven, J.D., LL.M.

Partnerships and corporations in an umbrella partnership-C corporation (Up-C) structure or umbrella partnership real estate investment trust (UPREIT) structure are facing a potential reversal in the tides for the deductibility of compensation paid by the partnerships. Sec. 162(m) limits the compensation deduction a public corporation may take to $1 million per tax year for compensation paid to each of certain executive officers. The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, significantly expanded the scope and application of the limitation.

This expansion brings a wider cross-section of entities within the definition of publicly held corporations, drastically broadens the population of covered employees, and sweeps in compensation that was previously excluded. The new rules include a grandfathering provision, allowing compensation paid pursuant to a written binding contract in effect on Nov. 2, 2017, and not materially modified on or after that date to continue to follow the pre-TCJA rules. With respect to compensation paid by a lower-tier partnership, additional transition relief is offered in proposed regulations effectively extending the cutoff date for grandfathering to Dec. 20, 2019 (discussed below).

As taxpayers grappled with the implications of these changes, Treasury and the IRS released additional guidance on how they intend to interpret the new rules. Notice 2018-68 was released in late summer 2018, followed in December 2019 by proposed regulations (REG-122180-18) generally adopting the positions outlined in the notice and arguably expanding the scope of the changes made by the TCJA. Notably, the proposed regulations change the paradigm for the tax treatment of compensation paid by a partnership situated below a publicly held corporation in an Up-C or UPREIT structure.

Compensation subject to limitation

The Sec. 162(m) deduction disallowance analysis generally requires consideration of all compensation for services of a covered employee that would otherwise be deductible for the tax year, regardless of whether the services were performed during that year. There are a few long-standing exceptions from compensation subject to the limitation, such as qualified retirement plan payments, certain health and welfare benefits, and other benefits that are expected to be excludable from the employee's income.

Prior to amendment by the TCJA, Sec. 162(m) also allowed a fairly expansive and frequently used exception for qualified performance-based compensation. The performance-based compensation exception was eliminated by the TCJA (although this elimination may not affect compensation paid through a written binding contract that was in effect as of Nov. 2, 2017, and not materially modified on or after that date). (The statute defines the limitation with respect to "applicable employee remuneration," and the proposed regulations refer to a deduction limitation for "compensation"; for ease of reading and consistency, this item uses the term "compensation" throughout.)

Typical Up-C or UPREIT structureGenerally, Up-C and UPREIT structures involve an upper-tier publicly held corporation with an interest in a lower-tier partnership. Often, the lower-tier partnership is a limited liability company that holds most of the business operating assets. Most employees, including executives, of the publicly held corporation perform services for the lower-tier partnership.

Historical treatment of compensation paid in Up-C and UPREIT structures: The IRS addressed compensation payments in Up-C and UPREIT structures in four letter rulings issued between 2006 and 2008. In each of these rulings, the corporation had covered employees for purposes of Sec. 162(m); the covered employees were also employees and executives of the partnership. These employees received salaries and participated in bonus and executive compensation plans based on their status as employees of both entities. Only a small portion of services were performed for the corporation. In each ruling, the IRS determined that the pre-TCJA Sec. 162(m) deduction limitation did not apply to the partnership for compensation the partnership paid for services performed by the covered employees to the partnership. Further, the IRS determined that the Sec. 162(m) deduction limitation did not apply to the corporation for its distributive share of income or loss from the partnership that includes the compensation expense of the covered employees for services performed for the partnership.

In 2010, however, the IRS announced in Rev. Proc. 2010-3 a no-rule position in this area while the issue was "under study." Despite this announcement, the IRS never formally revoked the letter rulings, and many taxpayers continued to view these IRS rulings as support for the position that Sec. 162(m) did not limit the otherwise deductible compensation expense of the publicly held corporation for compensation the partnership paid to a covered employee of the corporation. (Note that letter rulings represent the IRS's analysis of the law as applied to a taxpayer's specific facts and are not intended to be relied on by third parties and may not be cited as precedent (Sec. 6110(k)(3)). They do, however, indicate the IRS's position on the issues addressed.)

Compensation subject to the Sec. 162(m) limitation has always included certain amounts paid to covered employees by other members of the publicly held corporation's affiliated group. An affiliated group for this purpose was — and continues to be — defined by reference to Sec. 1504, which describes corporations connected by at least 80% ownership. In other words, the affiliated-group rules do not include noncorporate entities and do not include subsidiaries connected with less than 80% ownership — that is, affiliated groups do not include lower-tier partnerships. The letter rulings appear to rely on a plain reading of this definition in concluding that Sec. 162(m) does not limit a deduction for compensation paid by a partnership for services to the partnership.

Proposed Sec. 162(m) regulations' application to compensation paid in Up-C and UPREIT structures: The proposed regulations include a definition of compensation that critically changes the landscape for certain partnerships and related entities in an Up-C or UPREIT structure. As proposed, the new rule would require that a corporate partner take into account its distributive share of the partnership's deduction for compensation expense paid by the partnership in calculating any deduction disallowance with respect to its covered employee. The corporation's distributive share is essentially treated for purposes of the Sec. 162(m) deduction limitation as an amount paid to that employee by the corporation even though paid by the partnership. The preamble to the proposed regulations explains the basis for this position is that the statutory language limits the deduction for compensation "with respect to any covered employee," regardless of who makes the payment (preamble, REG-122180-18, Section IV.B.).

The proposed regulations include an example to illustrate the application of this new rule (Prop. Regs. Sec. 1.162-33(c)(3)(iv)(D), Example (3)).

Example: Corporation T is a publicly held corporation for the 2021 tax year, and Corporation S is a privately held corporation for that same year. The two corporations form a general partnership, and each has a 50% distributive share of the income, loss, and deductions of the partnership. Employee D, a covered employee of Corporation T, performs services for the partnership and is paid $800,000. Pursuant to the partnership agreement, $400,000 of the $800,000 deduction is allocated to Corporation T. As a result, $400,000 is treated as compensation when determining the potential Sec. 162(m) deduction disallowance and must be aggregated with other compensation paid to Employee D by Corporation T for that tax year.

Transition relief: In the preamble to the proposed regulations, Treasury and the IRS acknowledge that taxpayers may have taken contrary positions to the above-described proposed rule and that the issue was not addressed in generally applicable guidance (i.e., other than the nonprecedential letter rulings). As a result, the new rule would not apply to compensation paid pursuant to a written binding contract in place when the proposed regulations were published in the Federal Register (Dec. 20, 2019) and not materially modified after that date. Some public comments on the proposed regulations suggest this is an insufficient transition period.

Note that this discussion does not address the initial allocation of employee compensation. Regardless of the position taken for compensation expense allocated to the partnership, entities should give consideration to reasonably allocating compensation to each entity based on the services provided.

Covered employees

Although the compensation paid by a lower-tier partnership must be considered in calculating any lost deduction under the proposed regulations, the limitation applies only to individuals who are covered employees of the publicly held corporation. Thus, once a corporation determines that it is within the purview of Sec. 162(m), a fundamental next step is identifying its pool of covered employees for the tax year.

As amended by the TCJA, covered employees include (1) the principal executive officer and principal financial officer (typically, the CEO and CFO) and anyone acting in that capacity (such as an interim CEO or CFO) at any time during the year; and (2) the top three highest-compensated officers for the tax year, regardless of employment status on the last day of the year or whether included in any SEC filings for the year. In addition, the covered employee population for each tax year includes all individuals who were considered a covered employee of the corporation or any predecessor for any tax year beginning after Dec. 31, 2016. In other words, once an officer becomes a covered employee, that person remains a covered employee of the corporation for all future years. The proposed regulations explicitly state that the limitation continues to apply with respect to compensation paid in any capacity following termination as an officer and even to payments made to the beneficiaries of a deceased former employee.

The preamble to the proposed regulations indicates that the covered employee definition is limited to "executive officers" determined in line with SEC compensation disclosure requirements. Under these SEC rules, an executive officer includes a person who performs a policymaking function for the publicly held corporation. As defined, this explicitly includes executive officers of a lower-tier disregarded entity who perform a policymaking function for the upper-tier public corporation. In an Up-C or UPREIT structure, an executive officer of the partnership may be considered a covered employee of a publicly held corporation if the officer performs a policymaking function at the corporate level and is among the three highest-compensated for the year. This is true even if the individual is not otherwise an executive officer of the public corporation. It is important that affected entities work with their SEC counsel to identify covered employees on an annual basis.

Other considerations

The amendments made by the TCJA are generally effective for tax years beginning after Dec. 31, 2017. The proposed regulations and its rules and interpretations would generally become effective if and when finalized and generally would apply to tax years beginning on or after that date. However, a number of special applicability dates are included in the proposed regulation — some tied to the issuance of Notice 2018-68 and some to the publication of the proposed regulations.

As discussed above, the definition of compensation as including a corporate partner's distributive share of a partnership's compensation expense deduction is proposed to apply for tax years ending on or after Dec. 20, 2019. All entities with an SEC registration and/or filing obligation should consider whether they are subject to the Sec. 162(m) deduction limitation. As amended by the TCJA, the definition of "publicly held corporation" includes entities that may not traditionally consider themselves to be "public" corporations. Groups that include a publicly held corporation for this purpose, including Up-C and UPREIT structures, generally need to coordinate to identify and aggregate compensation paid or payable with respect to each covered employee, as well as to calculate and allocate any disallowed deductions. Further, entities may need to take additional precautions and consider the potential tax, financial statement, and other reporting consequences of the new proposed Sec. 162(m) rules.

EditorNotes

Mary Van Leuven, J.D., LL.M., is a director, Washington National Tax, at KPMG LLP in Washington, D.C.

For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

These articles represent the views of the author(s) only, and do not necessarily represent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.

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