Part IV — Internal Revenue Bulletin 2020-3

Notice of Proposed Rulemaking and Notification of Public Hearing

Treatment of Payments to Charitable Entities in Return for Consideration

REG-107431-19

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notification of public hearing.

SUMMARY: This document provides proposed amendments to the regulations under sections 162, 164, and 170 of the Internal Revenue Code (Code). First, the proposed amendments update the regulations under section 162 to reflect current law regarding the application of section 162 to a taxpayer that makes a payment or transfer to an entity described in section 170(c) for a business purpose. Second, the proposed amendments provide safe harbors under section 162 to provide certainty with respect to the treatment of payments made by business entities to an entity described in section 170(c). Third, the proposed amendments provide a safe harbor under section 164 for payments made to an entity described in section 170(c) by individuals who itemize deductions and receive or expect to receive a state or local tax credit in return. Fourth, the proposed amendments update the regulations under section 170 to reflect past guidance and case law regarding the application of the quid pro quo principle under section 170 to benefits received or expected to be received by a donor from a third party.

DATES: Written or electronic comments must be received by January 31, 2020. Requests to speak and outlines of topics to be discussed at the public hearing scheduled for February 20 , 2020, must be received by January 31, 2020.

ADDRESSES: Submit electronic submissions via the Federal eRulemaking Portal at http:// www.regulations.gov (indicate IRS and REG–107431–19) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG–107431–19), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–107431–19), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Mon L. Lam and Merrill D. Feldstein at (202) 317-4059; concerning submission of comments and requests to speak at the public hearing, Regina Johnson at (202) 317-6901 (not toll-free numbers) or fdms. database@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

I. Contributions in Exchange for State and Local Tax Credits

Section 170(a)(1) generally allows an itemized deduction for any “charitable contribution” paid within the taxable year. Section 170(c) defines “charitable contribution” as a “contribution or gift to or for the use of” an entity described in that section. Under section 170(c)(1), such entities include a State, a possession of the United States, or any political subdivision of the foregoing, or the District of Columbia. Section 170(c)(2) includes certain corporations, trusts, or community chests, funds, or foundations, organized

and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster national or international amateur sports competition, or for the prevention of cruelty to children or animals. Section 1.170A-1(c)(5) of the Income Tax Regulations provides that transfers of property to an organization described in section 170(c) that bear a direct relationship to the taxpayer’s trade or business and that are made with a reasonable expectation of financial return commensurate with the amount of the transfer may constitute allowable deductions as trade or business expenses rather than as charitable contributions. Section 162(a) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. Section 162(b) provides that no deduction shall be allowed under subsection (a) for any contribution or gift that would be allowable as a deduction under section 170 were it not for the percentage limitations, the dollar limitations, or the requirements as to the time of payment set forth in that section.

Section 1.162-15(a) applies to contributions to entities described in section 170(c). Section 1.162-15(a)(1) currently provides that no deduction is allowable under section 162(a) for a contribution or gift by an individual or a corporation if any part thereof is deductible under section 170. For example, if a taxpayer makes a contribution of $5,000 and only $4,000 of this amount is deductible under section 170(a) (whether because of the percentage limitation under either section 170(b)(1) or (2), the requirement as to time of payment, or both), no deduction is allowable under section 162(a) for the remaining $1,000. However, §1.162-15(a)(2) clarifies that the limitations provided in section 162(b) and §1.162-15(a)(1) apply only to payments that are in fact contributions or gifts to organizations described in section 170. For example, payments by a transit company to a local hospital (which is a charitable organization within the meaning of section 170) in consideration of a binding obligation on the part of the hospital to provide hospital services and facilities for the company’s employees are not

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contributions or gifts within the meaning of section 170 and may be deductible under section 162(a) if the requirements of section 162(a) are otherwise satisfied.

Section 164(a) allows a deduction for the payment of certain taxes, including: (1) state and local, and foreign, real property taxes; (2) state and local personal property taxes; and (3) state and local, and foreign, income, war profits, and excess profits taxes. In addition, section 164 allows a deduction for taxes not described in the preceding sentence that are paid or accrued within the taxable year in carrying on a trade or business or an activity described in section 212. Moreover, under section 164(b)(5), taxpayers may elect to deduct state and local general sales taxes in lieu of state and local income taxes.

Section 164(b)(6), as added by section 11042(a) of the Tax Cuts and Jobs Act Pub. L. 115-97, (the “TCJA”) provides that in the case of an individual, deductions for foreign real property taxes are not allowable under section 164(a)(1), and the deduction for the aggregate amount of the following state and local taxes paid during the calendar year is limited to $10,000 ($5,000 in the case of a married individual filing a separate return): (1) real property taxes; (2) personal property taxes; (3) income, war profits, and excess profits taxes; and (4) general sales taxes. This limitation applies to taxable years beginning after December 31, 2017, and before January 1, 2026, and does not apply to foreign taxes described in section 164(a)(3) or to any taxes described in section 164(a)(1) and (2) that are paid or accrued in carrying on a trade or business or an activity described in section 212.

In response to the limitation in section 164(b)(6), some taxpayers have considered tax planning strategies to avoid or mitigate its effects. Some of these strategies rely on state and local tax credit programs under which states provide tax credits in return for contributions by taxpayers to entities described in section 170(c), and some state and local governments have created new programs intended to facilitate use of these strategies.

On June 11, 2018, the Treasury Department and the IRS announced their intention to propose regulations addressing the proper application of sections 164 and 170 to taxpayers who make contributions

under state and local tax credit programs to entities described in section 170(c). See Notice 2018-54, 2018-24 I.R.B. 750. On August 27, 2018, proposed regulations (REG-112176-18) under sections 170 and 642(c) were published in the Federal Register (83 FR 43563) (“2018 proposed regulations”). The 2018 proposed regulations proposed amending §1.170A-1(h)(3) to provide, in general, that if a taxpayer makes a payment or transfers property to or for the use of an entity described in section 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such payment or transfer, the tax credit constitutes a return benefit to the taxpayer and reduces the taxpayer’s charitable contribution deduction. The 2018 proposed regulations were premised, in part, on the quid pro quo principle articulated by the Supreme Court in United States v. American Bar Endowment, 477 U.S. 105, 116 (1986), and its progeny that “a payment of money generally cannot constitute a charitable deduction if the contributor expects a substantial benefit in return.” The 2018 proposed regulations also proposed amending regulations under section 642(c), to provide a similar rule for payments made by a trust or decedent’s estate.

The Treasury Department and the IRS received over 7,700 comments responding to the 2018 proposed regulations and 25 requests to speak at the public hearing, which was held on November 5, 2018. After taking into account the comments received and the concerns expressed at the public hearing, the Treasury Department and the IRS published final regulations in the Federal Register on June 13, 2019 (T.D. 9864, 84 FR 27513) (“the final regulations”). The final regulations retained the rules set out in the 2018 proposed regulations, with certain clarifying and technical changes. Most significantly, the final regulations retained the general rule that, if a taxpayer makes a payment or transfers property to or for the use of an entity described in section 170(c), and the taxpayer receives or expects to receive a state or local tax credit in return for such transfer, the tax credit constitutes a return benefit to the taxpayer, or quid pro quo, reducing the taxpayer’s charitable contribution deduction. See §1.170A-1(h)(3) of the final regulations.

In response to Notice 2018-54 and the 2018 proposed regulations, commenters raised several ancillary issues. These issues involved: (1) treatment of business entity payments to entities described in section 170(c); (2) treatment of payments by individuals with total state and local tax liabilities that were less than or equal to the section 164(b)(6) limitations; and (3) application of the quid pro quo principle under section 170 to benefits received or expected to be received by the donor from a party other than the donee.

Although the Treasury Department and the IRS have provided sub-regulatory safe harbors related to the first two issues (in Rev. Proc. 2019-12, 2019-04 I.R.B. 401, and Notice 2019-12, 2019-27 I.R.B. 57), the Treasury Department and the IRS believe that it is appropriate to include these safe harbors in proposed regulations and to request comments. Further, in the preamble to the final regulations, the Treasury Department and the IRS extensively addressed the third issue — whether a benefit received or expected to be received from a party other than the donee may constitute a quid pro quo that reduces the taxpayer’s charitable contribution deduction under section 170. The preamble to the final regulations stated that the Treasury Department and the IRS would propose additional regulations setting forth a general rule for benefits received or expected to be received from third parties. Accordingly, the proposed regulations, provided herein, would amend the regulations under sections 162, 164, and 170 to provide guidance on these three issues.

II. Payments by Business Entities in Exchange for State or Local Tax Credits

After the issuance of Notice 2018-54, and continuing after the publication of the 2018 proposed regulations, the Treasury Department and the IRS received inquiries from taxpayers regarding the application of the proposed regulations to businesses that make payments to entities described in section 170(c) pursuant to state and local tax credit programs. The taxpayers sought guidance as to whether a business entity may deduct these payments under section 162 as ordinary and necessary business expenses incurred in carrying on a trade

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or business. In response, on September 5, 2018, the IRS released a frequently asked question (“FAQ”) stating that a business taxpayer making a payment to an entity described in section 170(c) is generally permitted to deduct such payment as an ordinary and necessary business expense under section 162 if the payment is made with a business purpose. However, after the release of the FAQ, taxpayers continued to express concern about whether the business purpose requirement is met for contributions that result in a tax credit. Specifically, taxpayers asked whether payments by business entities in exchange for state and local tax credits would bear a direct relationship to the taxpayer’s trade or business such that these payments would qualify as ordinary and necessary business expenses of carrying on a trade or business under section 162(a).

On December 28, 2018, the IRS issued Rev. Proc. 2019-12, providing a safe harbor under section 162 for payments made by a business entity that is a C corporation or specified passthrough entity to or for the use of an organization described in section 170(c) if the C corporation or specified passthrough entity receives or expects to receive state or local tax credits in return. The revenue procedure states that, to the extent that a C corporation receives or expects to receive a state or local tax credit in return for a payment to an organization described in section 170(c), it is reasonable to conclude that there is a direct benefit and a reasonable expectation of commensurate financial return to the C corporation’s business in the form of a reduction in the state or local taxes the C corporation would otherwise be required to pay. Thus, the revenue procedure provides a safe harbor that allows a C corporation engaged in a trade or business to treat the portion of the payment that is equal to the amount of the credit received or expected to be received as meeting the requirements of an ordinary and necessary business expense under section 162.

The IRS determined that a similar analysis is appropriate in the case of a business entity other than a C corporation if (1) the business entity is regarded as separate from its owner for all Federal tax purposes under §301.7701-3 of the Procedure and Administration Regulations (“passthrough entity”); (2) the passthrough entity oper

ates a trade or business within the meaning of section 162; (3) the passthrough entity is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and (4) in return for a payment to an entity described in section 170(c), the passthrough entity receives or expects to receive a state or local tax credit that the entity applies or expects to apply to offset a state or local tax other than a state or local income tax. Thus, to the extent that a specified passthrough entity makes a payment to an entity described in section 170(c) and receives or expects to receive a state or local tax credit, Rev. Proc. 2019-12 permits the passthrough entity to treat the payment as meeting the requirements of an ordinary and necessary business expense under section 162. The safe harbors for C corporations and specified passthrough entities apply only to payments of cash and cash equivalents.

In the interest of providing certainty for taxpayers, the Treasury Department and the IRS believe that it is appropriate to propose regulations to incorporate the safe harbors set out in Rev. Proc. 201912 and to request comments on these safe harbors. Thus, these proposed regulations propose amending §1.162-15(a) to incorporate the Rev. Proc. 2019-12 safe harbors. These proposed regulations also propose amending §1.170A-1(c)(5) and (h)(3)(viii) to provide cross references to §1.162-15(a). The Treasury Department and the IRS specifically request comments on whether the safe harbors should be expanded to apply to an individual who is carrying on a trade or business or an activity described in section 212.

The proposed regulations propose additional revisions to §1.162-15(a) to more clearly reflect the current state of the law regarding a taxpayer’s payment or transfer to an entity described in section 170(c). If the taxpayer’s payment or transfer bears a direct relationship to its trade or business, and the payment is made with a reasonable expectation of commensurate financial return, the payment or transfer to the section 170(c) entity may constitute an allowable deduction as a trade or business expense under section 162, rather than a charitable contribution under section 170. See §1.170A-1(c)(5); Marquis v. Commis- sioner, 49 T.C. 695 (1968). A proposed

example illustrates that this rule applies regardless of whether the taxpayer expects to receive a state or local tax credit in return.

The proposed revisions are also consistent with the decision in American Bar Endowment, which states that a payment to an entity described in section 170(c) may have a dual character—part charitable contribution and part business expense. 477 U.S. at 117. Under American Bar Endowment and §1.170A-1(h), if a taxpayer makes a payment to an entity described under section 170(c) in an amount that exceeds the fair market value of the benefit that the taxpayer receives or expects to receive in return, and this excess amount is paid with charitable intent, the taxpayer is allowed a charitable contribution deduction under section 170 for this excess amount.

In addition, the proposed regulations propose to add a cross-reference to §1.170A-1(h) (payments to section 170(c) entities in exchange for consideration), which provides more detailed rules for determining whether a payment, or a portion of a payment, to an entity described in section 170(c) may be deducted under section 162(a) or section 170.

III. Payments by Individuals in Exchange for State and Local Tax Credits

After publication of the 2018 proposed regulations, commenters expressed concerns that the proposed regulations would create unfair consequences for certain individuals who receive state or local tax credits in return for their payments. Specifically, commenters noted that individuals who itemize deductions for Federal income tax purposes and have total state and local tax liabilities for the taxable year of $10,000 or less ($5,000 or less in the case of a married individual filing a separate return) would be precluded from taking charitable contribution deductions to the extent that they receive state or local tax credits even though the individuals would have been able to deduct equivalent payments of state and local taxes. Thus, if these individuals chose to make a payment to a section 170(c) entity through a state or local tax credit program instead of paying tax to the state or local government, they

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would lose the deduction to which they would otherwise have been entitled under section 164 even after the application of the section 164(b)(6) limitation.

These state and local tax credit programs effectively offer taxpayers a choice of paying taxes to the state or local government or making a payment to a section 170(c) entity and receiving a tax credit that offsets a tax liability the taxpayer would otherwise owe to the state or local government. This situation can be analogized to situations in which an individual entitled to receive a payment from a second party directs or permits the second party to satisfy its payment obligation by making a payment to a third party. In such situations, the payment may be treated, for Federal income tax purposes, as a payment by the payor to the individual entitled to receive payment. Cf. Rev. Rul. 8614, 1986-1 C.B. 304, modifying Rev. Rul. 74-75, 1974-1 C.B. 19 (payment made by an employer to a third party to discharge an obligation of an employee treated for Federal income tax purposes as made by the employer to the employee).

For these reasons, on June 11, 2019, the IRS released Notice 2019-12, announcing that the Treasury Department and the IRS intend to publish proposed regulations with a safe harbor under section 164 for individuals who make payments to section 170(c) entities in return for state or local tax credits. Under this safe harbor, an individual who itemizes deductions and who makes a payment to an entity described in section 170(c) in exchange for a state or local tax credit may treat as a payment of state or local tax for purposes of section 164 the portion of such payment for which a charitable contribution deduction is or will be disallowed under §1.170A-1(h) (3). This treatment is allowed in the taxable year in which the payment is made, but only to the extent that the individual applies the resulting credit pursuant to applicable state or local law to offset the individual’s state or local tax liability for such taxable year or the preceding taxable year. Notice 2019-12 requested comments for purposes of incorporating the safe harbor in proposed regulations.

The Treasury Department and the IRS received several comments in response to Notice 2019-12. Generally, commenters responded favorably to the safe harbor in

the notice, finding that its rationale was sound and that the rule would effectively eliminate concerns that the final regulations under §1.170A-1(h)(3) unfairly burden individuals who itemize deductions and have state and local tax liabilities that are less than the section 164(b) (6) limitation. One commenter noted that Executive Order 12866, which directs the agency issuing a regulation to identify the problem it intends to address and design the regulation in the most cost-effective manner to achieve that objective with the least amount of burden on society, further supports the safe harbor. See Executive Order 12866, section 1(b). This commenter also suggested that the IRS should track the effects of the safe harbor by requiring taxpayers to disclose state tax and local tax credits on their Form 1040, Schedule A. Alternatively, the commenter suggested that the IRS obtain this information directly from the states. Another commenter generally supported the safe harbor, but suggested that the Treasury Department and the IRS should avoid creating more safe harbor exceptions to §1.170A-1(h)(3) of the final regulations. This commenter also expressed concerns about the application of the safe harbor when the state and local tax limitation under section 164(b) (6) expires or is modified.

Other commenters were concerned that Notice 2019-12 did not fully address the tax consequences to taxpayers who received or expected to receive state or local tax credits. Specifically, these commenters asked that the Treasury Department and the IRS provide guidance to address the treatment of state or local tax credits for Federal income tax purposes upon their sale or expiration. As noted in the preamble to the final regulations, the Treasury Department and the IRS recognize the significance and complexity of these questions. The Treasury Department and the IRS continue to study these issues and invite additional comment to inform potential future guidance on these issues.

The Treasury Department and the IRS continue to believe that the notice provides a fair, reasonable, and legally sound basis for the safe harbor for individual taxpayers, and that the safe harbor should be added to the regulations under section 164. Accordingly, these proposed regulations propose adding §1.164-3(j)

to provide a safe harbor for individuals who make a payment to or for the use of an entity described in section 170(c) in return for a state or local tax credit. These proposed regulations also propose adding §1.170A-1(h)(3)(ix) to provide a cross reference to the safe harbor proposed under §1.164-3(j) and to request comments.

Under these proposed regulations, an individual who itemizes deductions and who makes a payment to a section 170(c) entity in exchange for a state or local tax credit may treat as a payment of state or local tax for purposes of section 164 the portion of such payment for which a charitable contribution deduction under section 170 is or will be disallowed under §1.170A-1(h)(3). This treatment is allowed in the taxable year in which the payment is made, but only to the extent that the resulting credit is applied pursuant to applicable state or local law to offset the individual’s state or local tax liability for such taxable year or the preceding taxable year. Any unused credit permitted to be carried forward may be treated as a payment of state or local tax under section 164 in the taxable year or years for which the carryover credit is applied in accordance with state or local law. The safe harbor for individuals applies only to payments of cash and cash equivalents.

The proposed regulations are not intended to permit a taxpayer to avoid the limitations of section 164(b)(6). Therefore, the proposed regulations provide that any payment treated as a state or local tax under section 164, pursuant to the safe harbor provided in §1.164-3(j) of the proposed regulations, is subject to the limitations on deductions in section 164(b)(6). Furthermore, the proposed regulations are not intended to permit deductions of the same payments under more than one provision. Thus, the proposed regulations provide that an individual who relies on the safe harbor in §1.164-3(j) to deduct qualifying payments under section 164 may not also deduct the same payments under any other section of the Code.

IV. Consideration Provided by Party Other Than the Donee

Section 1.170A-1(h)(1) provides that no part of a payment that a taxpayer makes to or for the use of an organi

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zation described in section 170(c) that is in consideration for (as defined in §1.170A-13(f)(6)) goods or services (as defined in §1.170A-13(f)(5)) is a contribution or gift within the meaning of section 170(c) unless the taxpayer (i) intends to make a payment in an amount that exceeds the fair market value of the goods or services; and (ii) makes a payment in an amount that exceeds the fair market value of the goods or services.

Section 1.170A-1(h)(2) states that the charitable contribution deduction under section 170(a) may not exceed the amount of cash paid and the fair market value of property transferred to an organization described in section 170(c) over the fair market value of goods or services the organization provides in return. Section 1.170A-13(f)(5) defines goods or services as cash, property, services, benefits, and privileges. Section 1.170A-13(f)(6) provides that a donee provides goods or services in consideration for a taxpayer’s payment if, at the time the taxpayer makes a payment to the donee, the taxpayer receives or expects to receive goods or services in exchange for that payment.

Section 1.170A-1(h)(3)(iii) defines “in consideration for” for purposes of determining whether a state or local tax credit should reduce a charitable contribution under section 170. This section provides that the term “in consideration for” shall have the meaning set forth in §1.170A-13(f)(6), except that the state or local tax credit need not be provided by the donee organization.

Some commenters on the 2018 proposed regulations interpreted the definition of “in consideration for” under §1.170A-13(f)(6) to suggest that consideration provided by a third party is disregarded in calculating the charitable contribution deduction, and that §1.170A-1(h) (3)(iii) of the proposed regulations provided an exception from this rule solely for state or local tax credits provided by third parties. Other commenters disagreed with this interpretation and suggested that the final regulations should set forth a general rule clarifying that consideration includes all benefits that a taxpayer receives or expects to receive, regardless of whether they are provided by the donee.

In the preamble to the final regulations, the Treasury Department and the IRS

acknowledged that the final regulations did not address all situations in which a taxpayer makes a payment or transfers property and receives or expect to receive benefits from a party that is not the donee. Accordingly, the preamble to the final regulations indicated that the Treasury Department and the IRS intended to propose amendments to the regulations under section 170 to make clear that the quid pro quo principle applies regardless of whether the party providing the quid pro quo is the donee.

As noted in the preamble to the final regulations, in American Bar Endow- ment, 477 U.S. at 116-17, and Hernandez v. Commissioner, 490 U.S. 680, 691-92 (1989), the Supreme Court made clear that a payment is not a charitable contribution if the donor expects to receive a substantial benefit in return. American Bar Endowment and Hernandez did not directly address the question of benefits provided by third parties; the return benefits at issue in those cases were provided by the donees. However, the Court derived the quid pro quo principle in those cases from a lower court decision and a revenue ruling that directly addressed the question. See American Bar Endowment, 477 U.S. at 117 (citing Singer v. United States, 449 F.2d 413 (Ct. Cl. 1971), and Rev. Rul. 67-246, 1967-2 C.B. 104); Her- nandez, 490 U.S. at 691 (citing Singer ). In Singer, the appellate division of the Court of Claims (the predecessor to the Court of Appeals for the Federal Circuit) held that a sewing machine company was not eligible for a charitable contribution deduction for selling sewing machines to schools at a discount because the company “expected a return in the nature of future increased sales” to students. Singer, 449 F.2d at 423–24. In so holding, the court expressly rejected the company’s argument that this expected benefit should be ignored because it would come from the students rather than from the schools. Id . at 422-23. The court stated, “Obviously, we cannot agree with plaintiff’s distinction.” Id .

In Rev. Rul. 67-246, Example 11, a local store agreed to award a transistor radio, worth $15, to each person who contributed $50 or more to a specific charity. The ruling concluded that if a taxpayer received a $15 radio as a result of a $100 payment to the charity, only $85 qualified

as a charitable contribution deduction. It did not matter that the donor received the $15 radio from the store, a third party, rather than from the charity. This conclusion is reflected in the IRS’s audit practices. See IRS Conservation Easement Audit Techniques Guide (Rev. Jan. 24, 2018, p. 16) (stating that a “quid pro quo contribution is a transfer of money or property . . . partly in exchange for goods or services in return from the charity or a third party,” and “a quid pro quo may also be in the form of an indirect benefit from a third party”).

Moreover, courts have ruled that a taxpayer’s expectation of significant financial returns demonstrates a lack of charitable intent. For example, in Ottawa Silica Co. v. United States, 699 F.2d 1124 (Fed. Cir. 1983), the Federal Circuit denied a taxpayer’s charitable contribution deduction for the value of land the taxpayer donated for construction of a school. The court’s analysis focused on the taxpayer’s expectation of benefits, and not on the source of such benefits. The court found that the taxpayer had reason to believe that construction of a school would result in the construction of new roads that would in turn increase the value of the taxpayer’s retained land. The court recognized that although the taxpayer did not receive an agreement from any party that the roads would be built, the expectation of this benefit was a sufficient reason to deny the charitable contribution deduction. More recently, in Wendell Falls Develop- ment, LLC v. Commissioner, T.C. Memo. 2018-45, a taxpayer contributed a conservation easement that essentially restricted land for use as a park. The taxpayer expected this restriction to increase the value of the taxpayer’s adjacent property. The Tax Court disallowed the taxpayer’s claimed charitable contribution deduction for the easement, finding that the taxpayer contributed the easement with the expectation of receiving a substantial benefit (increased value of taxpayer’s adjacent property) from the contribution, even though the expected benefit would not come from the donee. In accordance with these authorities, the source of the return benefit is immaterial in determining whether the donee at the time of the contribution expects to receive substantial benefits in return.

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who make payments to section 170(c) entities in return for state or local tax credits. However, individuals may rely on these proposed regulations for payments made after August 27, 2018, the applicability date of the final regulations, and before the date regulations finalizing these proposed regulations are published in the Federal Register.

Finally, the proposed amendments contained in §§1.170A-1(h)(1), (h)(2)(i)(B), (h)(3)(iii), and (h)(4)(i), and 1.170A-13(f) (7) clarifying “in consideration for” for purposes of applying §1.170A-1(h) are proposed to apply to payments or transfers on or after December 17, 2019.

Special Analyses

Regulatory Planning and Review – Economic Analysis

Executive Orders 13563 and 12866 direct agencies to assess costs and benefits of available regulatory alternatives and, if regulation is necessary, to select regulatory approaches that maximize net benefits (including potential economic, environmental, public health and safety effects, distributive impacts, and equity). Executive Order 13563 emphasizes the importance of quantifying both costs and benefits, of reducing costs, of harmonizing rules, and of promoting flexibility. This proposed rule is expected to be an EO 13771 regulatory action. Details on the estimated costs of this proposed rule can be found in the rule’s economic analysis.

These proposed regulations have been designated as subject to review under Executive Order 12866 pursuant to the Memorandum of Agreement (April 11, 2018) between the Treasury Department and the Office of Management and Budget (OMB) regarding review of tax regulations. The Office of Information and Regulatory Affairs has designated these regulations as significant under section 1(b) of the MOA. Accordingly, the OMB has reviewed these regulations.

A. Background

Section 164 of the Code allows a deduction for certain state and local taxes paid, including state or local income and property taxes. Section 164(b)(6), added by the

The quid pro quo principle is thus equally applicable regardless of whether the donor expects to receive the benefit from the donee or from a third party. In either case, the donor’s payment is not a charitable contribution or gift to the extent that the donor expects a substantial benefit in return. Accordingly, the Treasury Department and the IRS propose amendments to §1.170A-1(h) that address a donor’s payments in exchange for consideration in order for the regulation to reflect existing law. Specifically, these proposed amendments revise paragraph (h)(4) to provide definitions of “in consideration for” and “goods and services” for purposes of applying the rules in §1.170A-1(h). Under the proposed regulations, a taxpayer will be treated as receiving goods and services in consideration for a taxpayer’s payment or transfer to an entity described in section 170(c) if, at the time the taxpayer makes the payment or transfer, the taxpayer receives or expects to receive goods or services in return.

The proposed regulations do not amend the language of §1.170A-13(f)(6) which discusses “in consideration for” for purposes of determining whether the taxpayer provides proper substantiation of its charitable contribution. Section 1.170A-13(f) details the requirements of a contemporaneous written acknowledgment, including a statement of whether the donee organization provides any goods or services in consideration for any cash or other property transferred to the donee organization and a description and a good faith estimate of the value of those goods or services. See §1.170A-13(f)(2)(ii) and (iii). These substantiation provisions refer only to written acknowledgments from donee organizations and do not address the application of quid pro quo principles to benefits received from parties other than donees. The Treasury Department and the IRS request comments on whether guidance concerning substantiation and reporting of quid pro quo benefits provided or expected to be provided by third parties, including state governments, would be beneficial to taxpayers in demonstrating that they have given more than they received or expected to receive and to the IRS in administering the proposed regulation. In addition, the Treasury Department and the IRS request comments regarding the manner by which

donors, donees, or third parties may report or provide substantiation for the value or type of consideration received or expected to be received from third parties.

For additional clarity, the proposed regulation amends the language in §1.170A-1(h)(2)(i)(B) to clarify that the fair market value of goods and services includes the value of goods and services provided by parties other than the donee. Also, the proposed regulation adds a definition of “goods and services” that is the same as the definition in §1.170A-13(f) (5). Finally, the proposed regulation revises the cross-references defining “in consideration for” and “goods and services” in paragraphs (h)(1) and (h)(3)(iii) to be consistent with the proposed definitions provided in paragraph (h)(4).

Proposed Applicability Dates

The proposed amendments contained in §§1.162-15(a)(1) and (2) and 1.170A-1(c) (5), regarding the application of section 162 to taxpayers that make payments or transfers to entities described in section 170(c), are proposed to apply to payments or transfers on or after December 17, 2019. However, a taxpayer may rely on these proposed regulations for payments and transfers made on or after January 1, 2018 and before the date regulations finalizing these proposed regulations are published in the Federal Register.

The proposed amendment contained in §1.162-15(a)(3), regarding safe harbors for C corporations and specified passthrough entities making payments to or for the use of section 170(c) entities in exchange for state or local tax credits, is proposed to apply to payments on or after December 17, 2019. However, prior to this date, a taxpayer may continue to apply Rev. Proc. 2019-12, which applies to payments made on or after January 1, 2018. The proposed amendments contained in §§1.164-3(j) and 1.170A-1(h)(3)(ix), regarding the safe harbor for payments by certain individuals to or for the use of section 170(c) entities, are proposed to apply to payments made on or after June 11, 2019, the date that the IRS issued Notice 2019-12, announcing it intended to publish proposed regulations with a safe harbor under section 164 for individuals

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TCJA, generally limits an individual’s deduction of these taxes to $10,000 ($5,000 in the case of a married individual filing a separate return). The limitation does not apply to foreign income taxes or to property taxes that are paid or incurred in carrying on a trade or business or an activity described in section 212. Section 162 allows a deduction for ordinary and necessary expenses paid or incurred in carrying on a trade or business. Section 170 allows a deduction for charitable contributions, specifically for payments or transfers to an entity described in section 170(c); however, the deduction must be reduced by any quid pro quo benefit that the taxpayer receives or expects to receive in return.

After the enactment of the TCJA, questions arose regarding the interaction of these deductions. To clarify the application of these provisions, the Treasury Department and the IRS issued guidance including: 1) Final regulations (T.D. 9864, 84 FR 27513) providing that a tax credit received or expected to be received in return for a payment or transfer to an entity described in section 170(c) (hereafter referred to as a charitable entity) is a return benefit to the taxpayer, resulting in the reduction of the charitable contribution deduction; 2) Notice 2019-12 announcing the intent to issue proposed regulations providing a safe harbor for individuals under which a charitable contribution that is disallowed because of a return benefit of a state or local tax credit may be treated as a payment of state or local tax; and 3) Rev. Proc. 2019-12 providing a safe harbor allowing as a deductible business expense certain payments by businesses to charitable organizations.

B. Need for the proposed regulations

The Treasury Department and the IRS believe that it is appropriate to propose as regulations and seek additional public comment on the safe harbors provided in Notice 2019-12 and Rev. Proc. 2019-12. In addition, comments received in response to Notice 2018-54 and the 2018 proposed regulations (guidance preceding the final regulations T.D. 9864) indicate that taxpayers will benefit from additional guidance regarding contributions to a charitable entity resulting in a return benefit from a third party.

C. Overview of the proposed regulations

First, these proposed regulations reflect the guidance in Notice 2019-12. Under the safe harbor an individual who itemizes deductions and who makes a payment to a charitable entity in exchange for a state or local tax credit may be able to claim a state and local tax deduction for the portion of the payment for which a charitable contribution deduction is or will be disallowed as a return benefit. The safe harbor for individuals applies only to payments of cash and cash equivalents. In addition, these payments are subject to the overall limitation on state and local deductions added by the TCJA. Further, any payment may be deducted under only one provision of the Code. Thus, an individual who has total state and local tax liability of $10,000 or less, and who makes a payment to a charitable entity and receives a state tax credit in return resulting in the disallowance of a charitable contribution deduction, may claim an itemized deduction for the disallowed amount, subject to other requirements of the Code.

Second, the proposed regulations incorporate into the regulations under section 162 longstanding principles from case law and existing section 170 regulations regarding a taxpayer’s payment or transfer to a charitable entity. Specifically, the proposed regulations confirm that, when a taxpayer’s transfer or payment bears a direct relationship to its trade or business, and that transfer or payment is made with a reasonable expectation of commensurate financial return, the transfer or payment to the charitable entity may constitute an allowable deduction under section 162, rather than under section 170. In addition, the proposed regulations incorporate the safe harbors provided by Rev. Proc. 201912 for certain payments by C corporations and specified passthrough entities, for cases in which the financial return is a tax credit. Thus, under the proposed regulations, a C corporation may treat the portion of the payment to a charitable entity that is equal to the amount of tax credit received or expected to be received in return as a deductible business expense under section 162. Consistent with Rev. Proc. 2019-12, the proposed regulations also provide that a specified passthrough entity may treat a payment resulting in a tax credit as a busi

ness expense if the business is regarded as separate from its owner for Federal tax purposes, if it operates a trade or business within the meaning of section 162, if it is subject to state or local tax incurred in carrying on its trade or business that is imposed directly on the passthrough entity, and if it receives or expects to receive a state or local tax credit in return for the payment.

Third, the proposed regulations clarify that a payment to a charitable entity that results in a return benefit is a quid pro quo for purposes of section 170, regardless of whether the donor expects to receive the benefit from the donee or from a third party. As a result, the contribution is reduced by the amount of the return benefit for purposes of determining the amount allowable as a charitable contribution deduction.

D. Economic Analysis

Baseline

The Treasury Department and the IRS have assessed the benefits and costs of these proposed regulations compared to a no-action baseline that reflects anticipated Federal income tax-related behavior in the absence of these proposed regulations.

Summary of Economic Effects

The proposed regulations reflect existing, published, Treasury Department and IRS policies. As a result, they provide some additional clarity to taxpayers by clearly articulating these existing policies as regulations. The Treasury Department does not expect any noticeable change in taxpayer behavior resulting from these regulations, but requests comments on their potential economic effects. The increased clarity, in particular the provision of safe harbors, is expected to reduce compliance burdens.

As described in the Special Analyses for the final regulations (T.D. 9864), allowing a payment that is disallowed as a charitable contribution deduction because of the receipt or expected receipt of a tax credit to be deducted as a payment of state or local tax means that payments by taxpayers with state and local tax liabilities of $10,000 or less are subject to the same

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tax treatment under these proposed regulations as under the TCJA (in absence of any guidance) and as under the law prior to the TCJA. (See Example 2, Table 1, T.D. 9864.) It also means that such taxpayers are not treated less favorably than taxpayers with state and local tax liabilities in excess of $10,000 or taxpayers subject to the Alternative Minimum Tax. (See Examples 1 and 3 of Table 1, T.D. 9864.)

The Treasury Department and the IRS request comments on the economic effects of the proposed regulations.

Regulatory Flexibility Act

Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it is hereby certified that this proposed rule will not have a significant economic impact on a substantial number of small entities. Although data are not readily available for the IRS and the Treasury Department to assess the number of small entities that are likely to be directly affected by the regulations, the economic impact is unlikely to be significant.

As discussed elsewhere in this preamble, the proposed rule largely updates the regulations to reflect existing law and policy. The proposed amendments would update the section 162 and section 170 regulations to reflect current law. In addition, the proposed amendments add to the regulations safe harbors under section 162 and section 164, regarding deductions when payments are made to entities described in section 170(c) and the donor receives or expects to receive a state or local tax credit in return; these safe harbors were provided previously in Internal Revenue Bulletin guidance. These regulations are expected to provide some additional certainty to taxpayers but are not expected to result in any noticeable change in taxpayer behavior. The increased certainty, and in particular the provision of safe harbors, is expected to reduce compliance burdens. Accordingly, the Treasury Department and the IRS certify that the proposed rule will not have a significant economic impact on a substantial number of small entities.

Notwithstanding this certification, the Treasury Department and the IRS invite comments about the potential impact of this proposed rule on small entities.

Pursuant to section 7805(f), the proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small businesses.

Comments and Requests and Public Hearing

Before the regulations proposed herein are adopted as final regulations, consideration will be given to any electronic and written comments that are submitted timely to the IRS as prescribed in this preamble under the ADDRESSES heading. All comments submitted will be made available at http://www.regulations.gov or upon request. A public hearing has been scheduled for February, 20, 2020, beginning at 10 a.m. in the Auditorium of the Internal Revenue Building, 1111 Constitution Avenue, N.W., Washington, DC 20224. Due to building security procedures, visitors must enter at the Constitution Avenue entrance. In addition, all visitors must present photo identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who wish to present oral comments at the hearing must submit an outline of the topics to be discussed and the time to be devoted to each topic by January 31, 2020. Submit a signed paper or electronic copy of the outline as prescribed in this preamble under the “Addresses” heading. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing.

Statement of Availability of IRS Documents

IRS Revenue Procedures, Revenue Rulings, Notices, and other guidance cited in this document are published in the Internal Revenue Bulletin (or Cumulative Bulletin) and are available from the Su

perintendent of Documents, U.S. Government Publishing Office, Washington, DC 20402, or by visiting the IRS website at http://www.irs.gov .

Drafting Information

The principal author of these proposed regulations is the Office of the Associate Chief Counsel (Income Tax and Accounting). However, other personnel from the IRS and the Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.162-15 is amended by revising paragraph (a) to read as follows:

§1.162-15 Contributions, dues, etc. (a) Payments and transfers to entities de- scribed in section 170(c) —(1) In general . A payment or transfer to or for the use of an entity described in section 170(c) that bears a direct relationship to the taxpayer’s trade or business and that is made with a reasonable expectation of financial return commensurate with the amount of the payment or transfer may constitute an allowable deduction as a trade or business expense rather than a charitable contribution deduction under section 170. For payments or transfers in excess of the amount deductible under section 162(a), see §1.170A-1(h).

(2) Examples . The following examples illustrate the rules of paragraph (a)(1) of this section:

(i) Example 1 . A, an individual, is a sole proprietor who manufactures musical instruments and sells them through a website. A makes a $1,000 payment to a local church (which is a charitable organization described in section 170(c)) for a half-page advertisement in the church’s program for a concert. In the program, the church thanks its concert sponsors, including A . A ’s advertisement includes the URL for the website through which A sells its instruments. A

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tax credit to be applied to P ’s state excise tax liability incurred by P in carrying on its trade or business. Under applicable state law, the state’s excise tax is imposed at the entity level (not the owner level). Under paragraph (a)(3)(ii) of this section, P may treat the $1,000 as an expense of carrying on a trade or business under section 162.

(D) Example 4: S corporation that receives or expects to receive percentage-based state or local tax credit . S is an S corporation engaged in a trade or business and is owned by individuals C and D . S makes a payment of $1,000 to an entity described in section 170(c). In return for the payment, S expects to receive a local tax credit equal to 80 percent of the amount of this payment ($800) to be applied to S ’s local real property tax liability incurred by S in carrying on its trade or business. Under applicable state and local law, the real property tax is imposed at the entity level (not the owner level). Under paragraph (a)(3)(ii) of this section, S may treat $800 of the payment as an expense of carrying on a trade or business under section 162. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by paragraph (a)(3)(ii) of this section.

(v) Applicability of section 170 to pay- ments in exchange for state or local tax benefits . For rules regarding the availability of a charitable contribution deduction under section 170 where a taxpayer makes a payment or transfers property to or for the use of an entity described in section 170(c) and receives or expects to receive a state or local tax benefit in return for such payment, see §1.170A-1(h)(3).

(4) Applicability dates . Paragraphs (a) (1) and (2) of this section, regarding the application of section 162 to taxpayers making payments or transfers to entities described in section 170(c), apply to payments or transfers on or after December 17, 2019. However, taxpayers may choose to apply paragraphs (a)(1) and (2) to payments and transfers on or after January 1, 2018. Paragraph (a)(3) of this section, regarding the safe harbors for C corporations and specified passthrough entities making payments to section 170(c) entities in exchange for state or local tax credits applies to payments made by these entities on or after December 17, 2019. However, taxpayers may choose to apply the safe harbors of paragraph (a)(3) to payments on or after January 1, 2018.

Par. 3. Section 1.164-3 is amended by adding paragraph (j) to read as follows:

§1.164-3 Definitions and special rules .

(j) Safe harbor for payments by indi- viduals in exchange for state or local tax credits —(1) In general . An individual

reasonably expects that the advertisement will attract new customers to A ’s website and will help A to sell more musical instruments. A may treat the $1,000 payment as an expense of carrying on a trade or business under section 162.

(ii) Example 2 . P, a partnership, operates a chain of supermarkets, some of which are located in State N. P operates a promotional program in which it sets aside the proceeds from one percent of its sales each year, which it pays to one or more charities described in section 170(c). The funds are earmarked for use in projects that improve conditions in State N. P makes the final determination on which charities receive payments. P advertises the program. P reasonably believes the program will generate a significant degree of name recognition and goodwill in the communities where it operates and thereby increase its revenue. As part of the program, P makes a $1,000 payment to a charity described in section 170(c). P may treat the $1,000 payment as an expense of carrying on a trade or business under section 162. This result is unchanged if, under State N’s tax credit program, P expects to receive a $1,000 income tax credit on account of P ’s payment, and under State N law, the credit can be passed through to P ’s partners.

(3) Safe harbors for C corporations and specified passthrough entities making payments in exchange for state or local tax credits —(i) Safe harbor for C corpora- tions . If a C corporation makes a payment to or for the use of an entity described in section 170(c) and receives or expects to receive in return a state or local tax credit that reduces a state or local tax imposed on the C corporation, the C corporation may treat such payment as meeting the requirements of an ordinary and necessary business expense for purposes of section 162(a) to the extent of the amount of the credit received or expected to be received.

(ii) Safe harbor for specified passthrough entities —(A) Definition of specified passthrough entity . For purposes of this paragraph (a)(3)(ii), an entity is a specified passthrough entity if each of the following requirements is satisfied—

( 1 ) The entity is a business entity other than a C corporation and is regarded for all Federal income tax purposes as separate from its owners under §301.7701-3 of this chapter;

( 2 ) The entity operates a trade or business within the meaning of section 162;

( 3 ) The entity is subject to a state or local tax incurred in carrying on its trade or business that is imposed directly on the entity; and

( 4 ) In return for a payment to an entity described in section 170(c), the entity described in paragraph (a)(3)(ii)(A)( 1 ) of this section receives or expects to receive

a state or local tax credit that this entity applies or expects to apply to offset a state or local tax described in paragraph (a)(3) (ii)(A)( 3 ) of this section.

(B) Safe harbor . Except as provided in paragraph (a)(3)(ii)(C) of this section, if a specified passthrough entity makes a payment to or for the use of an entity described in section 170(c), and receives or expects to receive in return a state or local tax credit that reduces a state or local tax described in paragraph (a)(3) (ii)(A)( 3 ) of this section, the specified passthrough entity may treat such payment as meeting the requirements of an ordinary and necessary business expense for purposes of section 162(a) to the extent of the amount of credit received or expected to be received.

(C) Exception . The safe harbor described in this paragraph (a)(3)(ii) does not apply if the credit received or expected to be received reduces a state or local income tax.

(iii) Definition of payment . For purposes of this paragraph (a)(3), payment is defined as a payment of cash or cash equivalent.

(iv) Examples . The following examples illustrate the rules of paragraph (a)(3) of this section.

(A) Example 1: C corporation that receives or expects to receive dollar-for-dollar state or local tax credit . A, a C corporation engaged in a trade or business, makes a payment of $1,000 to an entity described in section 170(c). In return for the payment, A expects to receive a dollar-for-dollar state tax credit to be applied to A ’s state corporate income tax liability. Under paragraph (a)(3)(i) of this section, A may treat the $1,000 payment as an expense of carrying on a trade or business under section 162.

(B) Example 2: C corporation that receives or expects to receive percentage-based state or local tax credit . B, a C corporation engaged in a trade or business, makes a payment of $1,000 to an entity described in section 170(c). In return for the payment, B expects to receive a local tax credit equal to 80 percent of the amount of this payment ($800) to be applied to B ’s local real property tax liability. Under paragraph (a)(3)(i) of this section, B may treat $800 as an expense of carrying on a trade or business under section 162. The treatment of the remaining $200 will depend upon the facts and circumstances and is not affected by paragraph (a)(3)(i) of this section.

(C) Example 3: Partnership that receives or ex- pects to receive dollar-for-dollar state or local tax credit . P is a limited liability company classified as a partnership for Federal income tax purposes under §301.7701-3 of this chapter. P is engaged in a trade or business and makes a payment of $1,000 to an entity described in section 170(c). In return for the payment, P expects to receive a dollar-for-dollar state

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who itemizes deductions and who makes a payment to or for the use of an entity described in section 170(c) in consideration for a state or local tax credit may treat as a payment of state or local tax for purposes of section 164 the portion of such payment for which a charitable contribution deduction under section 170 is disallowed under §1.170A-1(h)(3). This treatment as payment of state or local tax under section 164(a) is allowed in the taxable year in which the payment is made to the extent that the resulting credit is applied, consistent with applicable state or local law, to offset the individual’s state or local tax liability for such taxable year or the preceding taxable year.

(2) Credits carried forward . To the extent that a state or local tax credit described in paragraph (j)(1) of this section is not applied to offset the individual’s applicable state or local tax liability for the taxable year of the payment or the preceding taxable year, any excess state or local tax credit permitted to be carried forward may be treated as a payment of state or local tax under section 164(a) in the taxable year or years for which the carryover credit is applied in accordance with state or local law.

(3) Limitation on individual deduc- tions . Nothing in this paragraph (j) may be construed as permitting a taxpayer who applies this safe harbor to avoid the limitations of section 164(b)(6) for any amount paid as a tax or treated under this paragraph (j) as a payment of tax.

(4) No safe harbor for transfers of property . The safe harbor provided in this paragraph (j) applies only to a payment of cash or cash equivalent.

(5) Coordination with other deduc- tions . An individual who deducts a payment under section 164 may not also deduct the same payment under any other Code section.

(6) Examples . In the following examples, assume that the taxpayer is an individual who itemizes deductions for Federal income tax purposes.

(i) Example 1 . In year 1, Taxpayer A makes a payment of $500 to an entity described in section 170(c). In return for the payment, A receives a dollar-for-dollar state income tax credit. Prior to application of the credit, A ’s state income tax liability for year 1 was more than $500. A applies the $500 credit to A ’s year 1 state income tax liability. Under paragraph (j)(1) of this section, A treats the $500 payment as a payment of state income tax in year 1. To determine A ’s deduction amount, A must apply the provisions of

section 164 applicable to payments of state and local taxes, including the limitation in section 164(b)(6). See paragraph (j)(3) of this section.

(ii) Example 2 . In year 1, Taxpayer B makes a payment of $7,000 to an entity described in section 170(c). In return for the payment, B receives a dollar-for-dollar state income tax credit, which under state law may be carried forward for three taxable years. Prior to application of the credit, B ’s state income tax liability for year 1 was $5,000; B applies $5,000 of the $7,000 credit to B ’s year 1 state income tax liability. Under paragraph (j)(1) of this section, B treats $5,000 of the $7,000 payment as a payment of state income tax in year 1. Prior to application of the remaining credit, B ’s state income tax liability for year 2 exceeds $2,000. B applies the excess credit of $2,000 to B ’s year 2 state income tax liability. For year 2, under paragraph (j) (2) of this section, B treats the $2,000 as a payment of state income tax under section 164. To determine B ’s deduction amounts in years 1 and 2, B must apply the provisions of section 164 applicable to payments of state and local taxes, including the limitation under section 164(b)(6). See paragraph (j)(3) of this section.

(iii) Example 3 . In year 1, Taxpayer C makes a payment of $7,000 to an entity described in section 170(c). In return for the payment, C receives a local real property tax credit equal to 25 percent of the amount of this payment ($1,750). Prior to application of the credit, C ’s local real property tax liability in year 1 was more than $1,750. C applies the $1,750 credit to C ’s year 1 local real property tax liability. Under paragraph (j)(1) of this section, for year 1, C treats $1,750 of her $7,000 payment as a payment of local real property tax for purposes of section 164. To determine C ’s deduction amount, C must apply the provisions of section 164 applicable to payments of state and local taxes, including the limitation under section 164(b)(6). See paragraph (j) (3) of this section.

(7) Applicability date . This paragraph (j) applies to payments made to section 170(c) entities on or after June 11, 2019. However, a taxpayer may choose to apply this paragraph (j) to payments made to section 170(c) entities after August 27, 2018. Par. 4. Section 1.170A-1 is amended as follows:

Paragraph (c)(5) is revised.
In paragraph (h)(1), remove the cross-references to “§1.170A-13(f) (6)” and “§1.170A-13(f)(5)” and add in their places “paragraph (h)(4)(i) of this section” and “paragraph (h)(4)(ii) of this section”, respectively.
Paragraphs (h)(2)(i)(B) and (h)(3)(iii) are revised.
Paragraph (h)(3)(viii) is redesignated as paragraph (h)(3)(x).
New paragraph (h)(3)(viii) and paragraph (h)(3)(ix) are added.
Paragraphs (h)(4) through (6) are redesignated as paragraphs (h)(5) through (7).
New paragraph (h)(4) is added. The revisions and additions read as follows:

§1.170A-1 Charitable, etc., contribu- tions and gifts; allowance of deduction .

(c) * * * (5) For payments or transfers to an entity described in section 170(c) by a taxpayer carrying on a trade or business, see §1.162-15(a).

(h) * * * (2) * * * (i) * * * (B) The fair market value of the goods or services received or expected to be received in return.

(3) * * * (iii) In consideration for . For purposes of paragraph (h) of this section, the term in consideration for has the meaning set forth in paragraph (h)(4)(i) of this section.

(viii) Safe harbor for payments by C corporations and specified passthrough entities . For payments by a C corporation or by a specified passthrough entity to an entity described in section 170(c), where the C corporation or specified passthrough entity receives or expects to receive a state or local tax credit that reduces the charitable contribution deduction for such payments under paragraph (h)(3) of this section, see §1.162-15(a)(3) (providing safe harbors under section 162(a) to the extent of that reduction).

(ix) Safe harbor for individuals . Under certain circumstances, an individual who itemizes deductions and makes a payment to an entity described in section 170(c) in consideration for a state or local tax credit may treat the portion of such payment for which a charitable contribution deduction is disallowed under paragraph (h)(3) of this section as a payment of state or local taxes under section 164. See §1.164-3(j), providing a safe harbor for certain payments by individuals in exchange for state or local tax.

(4) Definitions . For purposes of this paragraph (h), the following definitions apply:

(i) In consideration for . A taxpayer receives goods or services in consideration

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for a taxpayer’s payment or transfer to an entity described in section 170(c) if, at the time the taxpayer makes the payment to such entity, the taxpayer receives or expects to receive goods or services from that entity or any other party in return.

(ii) Goods or services . Goods or services means cash, property, services, benefits, and privileges.

(iii) Applicability date . The definitions provided in this paragraph (h)(4) are applicable for amounts paid or property transferred on or after December 17, 2019.

§1.170A-13 [Amended] Par. 5. Section 1.170A-13(f)(7) is amended by removing the cross-reference to “§1.170A-1(h)(5)” and adding in its place “§1.170A-1(h)(6).”

tion 162(m). Section 162(m)(1) disallows the deduction by any publicly held corporation for applicable employee remuneration paid with respect to any covered employee to the extent that such remuneration for the taxable year exceeds $1,000,000. Section 162(m) was added to the Code by section 3211(a) of the Omnibus Budget Reconciliation Act of 1993, Public Law 103-66. Proposed regulations under section 162(m) were published in the Federal Register on December 20, 1993 (58 FR 66310) (1993 proposed regulations). On December 2, 1994, the Treasury Department and the IRS issued amendments to the proposed regulations (59 FR 61884) (1994 proposed regulations). On December 20, 1995, the Treasury Department and the IRS issued final regulations under section 162(m) (TD 8650) (60 FR 65534) (final regulations).

Section 162(m) was amended by section 13601 of the Tax Cuts and Jobs Act (TCJA) (Pub. L. 115-97, 131 Stat. 2054, 2155 (2017)). Section 13601 of TCJA amended the definitions of covered employee, publicly held corporation, and applicable employee remuneration in section 162(m). Section 13601 also provided a transition rule applicable to certain outstanding compensatory arrangements (commonly referred to as the grandfather rule).

On August 21, 2018, the Treasury Department and the IRS released Notice 2018-68 (2018-36 I.R.B. 418), which provides guidance on certain issues under section 162(m). Specifically, the notice provides guidance on the amended rules for identifying covered employees. Furthermore, the notice provides guidance on the operation of the grandfather rule, including when a contract will be considered materially modified so that it is no longer grandfathered. Notice 2018-68 requested comments on the following issues:

the application of the definition of publicly held corporation to foreign private issuers, including the reference to issuers that are required to file reports under section 15(d) of the Securities Exchange Act of 1934,
the application of the definition of covered employee to an employee who was a covered employee of a predecessor of the publicly held corporation,

Sunita Lough Deputy Commissioner for Services

and Enforcement.

tax purposes. These proposed regulations implement the amendments made to section 162(m) by the Tax Cuts and Jobs Act. These proposed regulations would affect publicly held corporations. This document also provides a notice of a public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by February 18, 2020 . Outlines of topics to be discussed at the public hearing scheduled for March 9, 2020, at 10 a.m. must be received by Feb- ruary 18, 2020 .

ADDRESSES: Submit electronic submissions via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG–122180–18) by following the online instructions for submitting comments. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:LPD:PR (REG–122180–18), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG–122180–18), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning these proposed regulations, Ilya Enkishev at (202) 3175600; concerning submissions of comments, the hearing, and/or being placed on the building access list to attend the hearing, Regina Johnson at (202) 3176901 (not toll-free numbers) or fdms.database@irscounsel.treas.gov.

SUPPLEMENTARY INFORMATION:

Background

This document sets forth proposed amendments to the Income Tax Regulations (26 CFR part 1) under sec

(Filed by the Office of the Federal Register on December 13, 2019, 4:15 p.m., and published in the issue of the Federal Register for December 17, 2019, 84 F.R. 68833)

Notice of Proposed Rulemaking and Notice of Public Hearing

Certain Employee Remuneration in Excess of $1,000,000 under Internal Revenue Code Section 162(m)

REG-122180-18

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

SUMMARY: This document sets forth proposed regulations under section 162(m) of the Internal Revenue Code (Code), which limits the deduction for certain employee remuneration in excess of $1,000,000 for federal income

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the application of section 162(m) to corporations immediately after they become publicly held either, through an initial public offering or a similar business transaction, and
the application of the Securities and Exchange Commission (SEC) executive compensation disclosure rules for determining the three most highly compensated executive officers for a taxable year that does not end on the same date as the last completed fiscal year. In drafting these proposed regulations, the Treasury Department and the IRS have considered all comments received on the notice. See §601.601(d)(2)(ii)(b). Commenters noted that the many examples in Notice 2018-68 were helpful in illustrating the guidance in the notice. In light of these comments, the Treasury Department and the IRS have included numerous examples in these proposed regulations to illustrate the proposed rules.

Explanation of Provisions

I. Overview

Section 13601 of TCJA significantly amended section 162(m). This document adds a section to the Income Tax Regulations (26 CFR part 1) to reflect these amendments. The amended section 162(m) applies to taxable years beginning after December 31, 2017, except to the extent the grandfather rule applies. Because the final regulations continue to apply to deductions related to amounts of remuneration that are grandfathered, the final regulations are retained as a separate section in the Income Tax Regulations under section 162(m).

II. Publicly Held Corporation

A. In General

Section 162(m)(2) defines the term “publicly held corporation.” Before the amendments made by section 13601(c) of TCJA, section 162(m)(2) defined publicly held corporation as any corporation issu

ing any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934 (Exchange Act). In defining a publicly held corporation, §1.162-27(c)(1) adds that whether a corporation is publicly held is determined based solely on whether, as of the last day of its taxable year, the corporation is subject to the reporting obligations of section 12 of the Exchange Act.

Section 13601(c) of TCJA amended the definition of publicly held corporation in section 162(m)(2) to provide that the term means any corporation which is an issuer (as defined in section 3 of the Exchange Act) the securities of which are required to be registered under section 12 of the Exchange Act, or that is required to file reports under section 15(d) of the Exchange Act. Thus, section 13601(c) of TCJA expanded the definition of publicly held corporation in two ways to include: (1) A corporation with any class of securities (rather than only a class of common equity securities) that is required to be registered under section 12 of the Exchange Act, and (2) a corporation that is required to file reports under section 15(d) of the Exchange Act.

The proposed regulations similarly define a publicly held corporation as any corporation that issues securities required to be registered under section 12 of the Exchange Act or that is required to file reports under section 15(d) of the Exchange Act. Unlike the final regulations, the proposed regulations do not focus on whether the corporation is subject to the reporting obligations of section 12 of the Exchange Act. Rather, tracking the statutory text as amended, the proposed regulations focus on whether a corporation’s securities are required to be registered under section 12, or whether a corporation is required to file reports under section 15(d).

Consistent with the statutory expansion of section 162(m), Congress provided in the legislative history to TCJA that the definition of a publicly held corporation “may include certain additional corporations that are not publicly traded, such as large private C or S corporations.” H. Rep. 115-466, at 490 (2017) (Conf. Rep.). See

also Staff of the Joint Committee on Taxation, General Explanation of Public Law 115-97 (Blue Book), at 261 (December 20, 2018). As a result, these proposed regulations make clear that an S corporation (as defined in section 1361(a)(1)) would qualify as a publicly held corporation if it (1) issues securities required to be registered under section 12(b) of the Exchange Act, or (2) is required to file reports under section 15(d) of the Exchange Act (for example, because the S corporation has issued publicly traded debt). See Proposed §1.162-33(c)(1)(i). Accordingly, the proposed regulations also provide that an S corporation parent of a qualified subchapter S subsidiary (as defined in section 1361(b)(3)(B)) (QSub) that issues securities required to be so registered, or is required to file such reports, likewise would qualify as a publicly held corporation. See part II.G of this Explanation of Provisions section. See also Proposed §1.162-33(c) (1)(iv).

For ease of administration, the proposed regulations follow the approach in the final regulations and use the last day of a corporation’s taxable year to determine whether it is publicly held. Accordingly, the proposed regulations provide that a corporation is publicly held if, as of the last day of its taxable year, its securities are required to be registered under section 12 of the Exchange Act or it is required to file reports under section 15(d) of the Exchange Act.

A corporation is required to register its securities under section 12 of the Exchange Act in two circumstances. First, section 12(b) of the Exchange Act requires a corporation to register its securities in order to list them for trading on a national securities exchange (15 U.S.C. 78l(b)). Second, section 12(g) of the Exchange Act requires an issuer with total assets exceeding $10 million to register a class of equity securities that is held of record by either 2,000 or more persons, or 500 or more persons who are not accredited investors (as that term is defined by the SEC) (15 U.S.C. 78l(g)). ¹

A corporation is required to file reports under section 15(d) of the Exchange

1 In the case of an issuer that is a bank, savings and loan holding company, or bank holding company, section 12(g) of the Exchange Act requires registration if the issuer has assets exceeding $10 million and a class of equity securities held of record by 2,000 or more persons. See Exchange Act Rule 12g-1 (17 CFR 240.12g-1) regarding the requirements of section 12(g) generally, and Exchange Act Rule 12g5-1 (17 CFR 240.12g5-1) for determining record ownership of securities for purposes of Exchange Act sections 12(g) and 15(d).

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Act when it offers securities for sale in a transaction subject to the registration requirements of the Securities Act of 1933 (Securities Act) and its registration statement is declared effective by the SEC. A corporation’s section 15(d) filing obligation is automatically suspended when certain statutory requirements are met, and a corporation that meets other requirements established by rule may file a form with the SEC to suspend its section 15(d) filing obligation. ² A commenter suggested that a corporation should not be considered publicly held if its obligation to file reports under section 15(d) of the Exchange Act is suspended. The proposed regulations adopt this suggestion.

In defining the term publicly held corporation under pre-amended section 162(m)(2), the final regulations included examples illustrating whether a corporation, as of the last day of its taxable year, is subject to the reporting obligations of the Exchange Act. Similarly, these proposed regulations include examples illustrating when a corporation, as of the last day of its taxable year, is either required to file reports under section 15(d) of the Exchange Act or required to register its securities under section 12 of the Exchange Act. Even though the examples in these proposed regulations illustrate the application of the Securities Act and the Exchange Act and the rules thereunder (17 CFR Part 240) for purposes of section 162(m), the examples are not intended to provide any guidance on how an issuer should apply the requirements of the Securities Act, the Exchange Act, and the rules thereunder (17 CFR Part 240). Questions regarding those requirements should be directed to the SEC.

B. Subsidiaries That File Reports under Section 15(d) of the Exchange Act

Pursuant to the definition of publicly held corporation in the proposed regulations, a corporation is publicly held if, as of the last day of its taxable year, it is required to file reports under section 15(d)

of the Exchange Act. A commenter suggested that if a wholly-owned subsidiary corporation of a publicly held corporation subject to section 162(m) is required to file reports under section 15(d) of the Exchange Act, then it should not be considered a publicly held corporation separately subject to section 162(m) because its parent corporation is already subject to section 162(m). According to the commenter, to consider the subsidiary a publicly held corporation would result in two sets of covered employees—one for the parent corporation and one for the subsidiary corporation. The commenter was concerned that there would be too many covered employees for the group of corporations. The proposed regulations do not adopt this suggestion because not treating the subsidiary corporation as a separate publicly held corporation is inconsistent with the text of amended section 162(m)(2), which defines a publicly held corporation as a corporation that is required to file reports under section 15(d) of the Exchange Act. This conclusion is consistent with the affiliated group rule in the final regulations (which is retained in these proposed regulations and discussed in section II.E of this preamble) providing that a publicly held subsidiary is separately subject to section 162(m) and, therefore, has its own set of covered employees.

C. Foreign Private Issuers

Foreign issuers ³ may access the U.S. capital markets to raise capital or establish a trading presence for their securities. There are specific rules under the Federal securities laws that apply if a foreign issuer meets the regulatory definition of “foreign private issuer” (FPI). “Foreign private issuer” is defined in 21 CFR 240.3b-4(c). A foreign private issuer is any foreign issuer other than a foreign government, except for an issuer that has (1) more than 50% of its outstanding voting securities held of record by U.S. residents and (2) any of the following: (i) a majority of its officers and directors are citizens or residents of

the United States, (ii) more than 50% of its assets are located in the United States, or (iii) its business is principally administered in the United States.

A FPI may access the U.S. capital markets or establish a trading presence in the U.S. by offering or listing its securities, often in the form of American Depositary Receipts (ADRs). An ADR is a negotiable certificate that evidences ownership of a specified number (or fraction) of the FPI’s securities held by a depositary (typically, a U.S. bank). Depending on the FPI’s level of participation in the U.S. capital market or trading presence, the FPI may be required to register its deposited securities (underlying the ADRs) under section 12 of the Exchange Act.

Commenters recommended that the proposed regulations provide that section 162(m) does not apply to FPIs. Before TCJA, the IRS ruled in several private letter rulings that section 162(m) does not apply to FPIs because FPIs are not required to file a summary compensation table pursuant to the reporting obligations under the Exchange Act. ⁴ The rationale of the rulings is that section 162(m) does not apply to FPIs because they do not have covered employees as a result of not being required to file a summary compensation table with the SEC. Commenters suggested that section 162(m) should continue to be inapplicable to FPIs because they are not required to disclose compensation of their officers on an individual basis under the Exchange Act, unless that disclosure is required by their home country. The commenters asserted that determining compensation on an individual basis (in order to determine the three most highly compensated executive officers) would require the FPIs to expend significant time and money in adopting the necessary internal legal and compliance procedures to comply with the Exchange Act requirements that are otherwise inapplicable to them.

The proposed regulations do not adopt the recommendation to exclude FPIs from the application of section 162(m). Pursuant to the definition of publicly held cor

2 See Exchange Act Section 15(d) (15 U.S.C. 78o(d)), and Exchange Act Rules 15d-6 (17 CFR 240.15d-6) and 12h-3 (17 CFR 240.12h-3).

3 The term “foreign issuer” means any issuer which is a foreign government, a national of any foreign country or a corporation or other organization incorporated or organized under the laws of any foreign country. 21 CFR 240.3b-4(b).

4 A private letter ruling may be relied upon only by the taxpayer to whom the ruling was issued, and does not constitute generally applicable guidance. See section 11.02 of Revenue Procedure 2019-1, 2019-01 I.R.B. 157.

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poration in amended section 162(m)(2), a FPI is a publicly held corporation if it is required either to register its securities under section 12 of the Exchange Act or to file reports under section 15(d) of the Exchange Act. The legislative history to TCJA indicates that Congress intended for section 162(m) to apply to FPIs. ⁵ Furthermore, the rationale of the private letter rulings, which conclude that section 162(m) does not apply to FPIs because they are not required to file a summary compensation table, is inconsistent with the definition of covered employee in amended section 162(m)(3). As discussed in section III of this preamble, under the definition of covered employee as amended by TCJA, a publicly held corporation has covered employees regardless of whether it is required to file a summary compensation table, and regardless of whether the employees appear on a summary compensation table that is filed. Accordingly, the proposed regulations do not adopt the suggestion to exclude FPIs from the application of section 162(m). The proposed regulations include examples illustrating when a FPI is a publicly held corporation. Because the calculation of compensation to determine the three highest compensated executive officers for a taxable year is made in accordance with the SEC executive compensation disclosure rules under the Exchange Act, the Treasury Department and the IRS request comments on whether a safe harbor for that determination is appropriate for FPIs that are not required to disclose compensation of their officers on an individual basis in their home countries and, if so, how that safe harbor should be designed.

D. Publicly Traded Partnerships

Partnerships may issue equity interests that are required to be registered under section 12 of the Exchange Act because they are traded on an established securities market. These partnerships are known as publicly traded partnerships (PTPs). Under section 7704(a), a PTP generally is treated as a corporation for purposes of the Code, unless its gross income meets the

requirement of section 7704(c)(2). Stakeholders have asked whether a PTP that is treated as a corporation under that provision would be considered a publicly held corporation. As described in the preamble to the 1993 proposed regulations, stakeholders previously raised this issue: Questions have arisen as to the application of section 162(m) to certain master limited partnerships whose equity interests are required to be registered under the Exchange Act and that, beginning in 1997, may be treated as corporations for Federal income tax purposes. Whether these partnerships would be publicly held corporations within the meaning of section 162(m) and, if so, the manner in which they would satisfy the exception for performance-based compensation is currently under study and is not addressed in these proposed regulations. If necessary, guidance as to the application of section 162(m) to these entities will be provided in the future. (58 FR 66310, 66311). The Treasury Department and the IRS have concluded that, for purposes of section 162(m), a PTP that is treated as a corporation under section 7704 (or otherwise) is a publicly held corporation if, as of the last day of its taxable year, its securities are required to be registered under section 12 of the Exchange Act or it is required to file reports under section 15(d) of the Exchange Act. A PTP that is not treated as a corporation for Federal tax purposes (for example, because it satisfies the gross income requirement under section 7704(c)(2) and is not otherwise treated as a corporation for Federal tax purposes) is not a publicly held corporation for purposes of section 162(m).

E. Affiliated Groups

In defining the term “publicly held corporation,” §1.162-27(c)(1)(ii) provides that a publicly held corporation includes an affiliated group of corporations, as defined in section 1504 (determined without regard to section 1504(b)). The proposed

regulations retain this rule with a modification described below. Because an affiliated group may include more than one publicly held corporation, §1.162-27(c) (1)(ii) provides that an affiliated group of corporations does not include any subsidiary that is itself a publicly held corporation. In that case, pursuant to the final regulations, the publicly held subsidiary and its subsidiaries (if any) are separately subject to section 162(m). Therefore, the parent corporation that is a publicly held corporation and the publicly held subsidiary each has its own set of covered employees. However, the final regulations do not specifically address the situation in which a parent corporation is privately held and the subsidiary is publicly held. Because the amended definition of publicly held corporation includes a corporation that is required to file reports under section 15(d) of the Exchange Act, this type of affiliated group may be more common post-TCJA. Accordingly, unlike the final regulations, which provide that a publicly held subsidiary is excluded from an affiliated group, with the result that a privately held parent is not part of an affiliated group with its publicly held subsidiary, these proposed regulations provide that an affiliated group includes a parent corporation that is privately held and its subsidiary that is publicly held. Furthermore, because an affiliated group of corporations is determined without regard to section 1504(b), an affiliated group may also include a domestic parent corporation that is publicly held and its foreign subsidiary that is not publicly held.

A covered employee of a publicly held corporation may also perform services for another member of the affiliated group. In these situations, §1.162-27(c)(1)(ii) provides that

[i]f a covered employee is paid compensation in a taxable year by more than one member of an affiliated group, compensation paid by each member of the affiliated group is aggregated with compensation paid to the covered employee by all other members of the group. Any amount disallowed as a deduction by this

5 The legislative history to TCJA provides that the amendment to the definition of publicly held corporation under section 162(m) “extends the applicability of section 162(m) to include … all foreign companies publicly traded through ADRs.” House Conf. Rpt. 115-466, 489 (2017). The Blue Book similarly states that “the provision extends the applicability of section 162(m) to include all foreign companies publicly traded through ADRs.” Blue Book at page 261.

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section must be prorated among the payor corporations in proportion to the amount of compensation paid to the covered employee by each such corporation in the taxable year. The proposed regulations retain this rule and include additional rules addressing the proration of the deduction disallowance in situations in which a covered employee is paid compensation in a taxable year by more than one publicly held corporation in an affiliated group. Under these rules, the amount disallowed as a deduction is determined separately with respect to each publicly held payor corporation of which the individual is a covered employee. Accordingly, in determining the deduction disallowance with respect to compensation paid to a covered employee by one publicly held payor corporation of an affiliated group, compensation paid to the covered employee by another publicly held payor corporation of the affiliated group (of which the individual is also a covered employee) is not aggregated for purposes of the deduction disallowance proration.

F. Disregarded Entities

Generally under §301.7701-2(c)(2)(i), a business entity that has a single owner and is not a corporation under §301.77012(b) is disregarded as an entity separate from its owner for Federal tax purposes (disregarded entity). All of the activities of a disregarded entity are therefore treated in the same manner as a sole proprietorship or as a branch or division of its owner under §301.7701-2. Section 301.77012(c)(2)(iv) provides that §301.7701-2(c) (2)(i) does not apply to taxes imposed under Subtitle C—Employment Taxes and Collection of Income Tax (Chapters 21, 22, 23, 23A, 24, and 25 of the Code). Because section 162(m) is in Subtitle A, the general rule in §301.7701-2(c)(2)(i) applies for purposes of section 162(m).

Nonetheless, a disregarded entity that is owned by a privately held corporation may be an issuer of securities that are required to be registered under section 12(b) of the Exchange Act or may be required to file reports under section 15(d) of the Exchange Act. The Treasury Department and the IRS have concluded that, for purposes of section 162(m), a corporation that is the

owner of a disregarded entity is treated as issuing any securities issued by its disregarded entity. Accordingly, if a disregarded entity that is owned by a privately held corporation is an issuer of securities that are required to be registered under section 12(b) of the Exchange Act or is required to file reports under section 15(d) of the Exchange Act, these proposed regulations treat the privately held corporation as a publicly held corporation for purposes of section 162(m).

The Treasury Department and the IRS are aware that a corporation could form a partnership with a minority partner in an attempt to circumvent the proposed rules treating a corporation that wholly-owns a disregarded entity that issues certain securities as a publicly held corporation for purposes of section 162(m). In these circumstances, the corporation may be treated as a publicly held corporation by reason of the application of §1.701-2 or other federal income tax principles. The Treasury Department and the IRS also note that, in addition to the above-described fact pattern involving disregarded entities, §1.701-2 and other federal income tax principles may apply to any transaction in which a corporation forms a partnership in an attempt to circumvent the proposed rules.

G. Qualified Subchapter S Subsidiaries

Section 1361(b)(3)(B) defines a QSub as any domestic corporation that is not an ineligible corporation (as defined in section 1361(b)(2)) if an S corporation owns 100 percent of the stock of such corporation and the S corporation elects to treat the corporation as a QSub. Under section 1361(b)(3)(A), unless otherwise provided by regulations, a QSub is not treated as a separate corporation, and therefore all of its assets, liabilities, and items of income, deduction, and credit are treated as assets, liabilities, and such items (as the case may be) of its parent S corporation.

Like a disregarded entity, a QSub may issue securities required to be registered under section 12(b) of the Exchange Act, or be required to file reports under section 15(d) of the Exchange Act. The Treasury Department and the IRS have concluded that, for purposes of section 162(m), an S corporation that is the owner of a QSub

is treated as issuing any securities that are issued by its QSub. Accordingly, if a QSub is an issuer of securities that are required to be registered under section 12(b) of the Exchange Act, or is required to file reports under section 15(d) of the Exchange Act, these proposed regulations treat the QSub’s S corporation parent as a publicly held corporation for purposes of section 162(m). See Proposed §1.16233(c)(1)(iv).

III. Covered Employee

A. In General

Section 162(m)(3) defines the term “covered employee.” Before TCJA, section 162(m)(3) defined a 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 13601(b) of TCJA amended the definition of covered employee in section 162(m)(3) to provide that a covered employee means any employee of the taxpayer if (a) the employee is the principal executive officer (PEO) or principal financial officer (PFO) of the taxpayer at any time during the taxable year, or was an individual acting in such a capacity, (b) the total compensation of the employee for the 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 and PFO), or (c) the individual was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016. Section 13601(c) of TCJA also added flush language to provide that a covered employee includes any employee whose total compensation for the taxable year places the individual among the three highest compensated officers for the taxable year (other than any individual who is the PEO or PFO of the taxpayer at any time during the

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taxable year, or was an individual acting in such a capacity) even if the compensation of the officer is not required to be reported to shareholders under the Exchange Act.

The SEC executive compensation disclosure rules generally require disclosure of compensation of the three most highly compensated executive officers if they were employed at the end of the taxable year and up to two executive officers whose compensation would have been disclosed but for the fact that they were not employed at the end of the taxable year. See Item 402 of Regulation S-K, 17 CFR 229.402(a)(3). After TCJA amended the definition of covered employee, stakeholders submitted comments indicating that they would benefit from initial guidance on whether amended section 162(m)(3)(B) and the flush language to section 162(m)(3) require an employee to be employed at the end of the taxable year to qualify as a covered employee. Notice 2018-68 provided that a covered employee for any taxable year means any employee who is among the three highest compensated executive officers for the taxable year, regardless of whether the executive officer is serving at the end of the publicly held corporation’s taxable year, and regardless of whether the executive officer’s compensation is subject to disclosure for the last completed fiscal year under the applicable SEC rules. To reach this conclusion, consistent with Notice 2018-68, the proposed regulations rely on the flush language to section 162(m)(3), the legislative history, ⁶ and the SEC executive compensation disclosure rules that do not necessarily require an executive officer to be employed at the end of the fiscal year for his or her compensation to be disclosed for the year. Based on these considerations, the proposed regulations adopt the position set forth in Notice 2018-68. ⁷

B. Taxable Years Not Ending on Same Date as Fiscal Years

The SEC executive compensation disclosure rules are based on a corporation’s fiscal year. Usually, a corporation’s fiscal and taxable years end on the same date; however, this is not always the case (for

example, due to a short taxable year as a result of a corporate transaction that does not result in a short fiscal year). In these cases, the publicly held corporation will have three most highly compensated executive officers under section 162(m)(3) (B) for the short taxable year (instead of the fiscal year). In Notice 2018-68, the Treasury Department and IRS requested comments on the application of the SEC executive compensation disclosure rules to determine the three most highly compensated executive officers for a taxable year that does not end on the same date as the fiscal year for purposes of section 162(m)(3)(B). The notice provided that until additional guidance is issued, taxpayers should base their determination of the three most highly compensated executive officers for purposes of section 162(m)(3) (B) upon a reasonable good faith interpretation of the statute.

A commenter suggested that the determination of the three highest compensated executive officers should be based on the total amount of otherwise deductible remuneration. The proposed regulations do not adopt this approach. In defining covered employee, section 162(m)(3)(B) provides that the three most highly compensated executive officers are officers whose compensation is required to be (or would be required to be) reported to shareholders under the Exchange Act. Therefore, under the statutory text, the determination of the three most highly compensated executive officers is made pursuant to the rules under the Exchange Act. Accordingly, the proposed regulations provide that the amount of compensation used to identify the three most highly compensated executive officers is determined pursuant to the executive compensation disclosure rules under the Exchange Act using the taxable year as the fiscal year for purposes of making the determination. Thus, for example, if a publicly held corporation uses a calendar year fiscal year for SEC reporting purposes, but has a taxable year beginning July 1, 2019, and ending June 30, 2020, then the three most highly compensated executive officers are determined for the taxable year ending June 30, 2020, by applying the executive compensation disclosure

rules under the Exchange Act as if the fiscal year ran from July 1, 2019 to June 30, 2020. The same rule applies to short taxable years. Assume in the previous example that, due to a corporate transaction, the corporation’s taxable year ran from July 1, 2019, to March 31, 2020. In that situation, the three most highly compensated executive officers would be determined for the taxable year ending March 31, 2020 by applying the disclosure rules as if the fiscal year began July 1, 2019, and ended March 31, 2020. For a discussion of the proposed special applicability dates related to the determination of the three most highly compensated executive officers for a corporation whose fiscal year and taxable year do not end on the same date, see section VIII.B of this preamble.

C. Covered Employees Limited to Executive Officers

The SEC executive compensation disclosure rules require disclosure of compensation for certain executive officers. The term executive officer is defined in 17 CFR 240.3b-7 as follows: The term executive officer, when used with reference to a registrant, means its president, any vice president of the registrant in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy making function or any other person who performs similar policy making functions for the registrant. Executive officers of subsidiaries may be deemed executive officers of the registrant if they perform such policy making functions for the registrant. Under the amended definition of covered employee, a PEO and PFO are covered employees by virtue of having those positions or acting in those capacities. The three highest compensated officers (other than the PEO or PFO) are covered employees by reason of their compensation. With respect to the three highest compensated officers for a taxable year, a commenter asked whether only an executive officer (as defined in 17 CFR 240.3b-7)

6 See House Conf. Rpt. 115-466, 489 (2017).

7 Furthermore, in explaining the amended definition of covered employee, the Blue Book concurred with the guidance provided in Notice 2018-68. Blue Book at page 260.

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may qualify as a covered employee. Because the SEC executive compensation disclosure rules that require disclosure of the three highest compensated executive officers apply only to executive officers, only an executive officer may qualify as a covered employee under section 162(m) (3)(B).

A publicly held corporation may own an interest in a partnership as discussed in section IV.B. of this preamble. Consistent with the definition of the term executive officer in 17 CFR 240.3b-7, an officer of a partnership is deemed to be an executive officer of a publicly held corporation that owns an interest in such partnership if the officer performs a policy making function for the publicly held corporation. As a deemed executive officer of the publicly held corporation, the officer of the partnership may be a covered employee under section 162(m)(3)(B) if the officer is one of the three highest compensated executive officers of the publicly held corporation.

D. Covered Employees after Separation from Service

Consistent with section 162(m)(3)(C), as amended by TCJA, Notice 2018-68 provides that a covered employee identified for taxable years beginning after December 31, 2016, will continue to be a covered employee for all subsequent taxable years. Accordingly, if an individual is a covered employee for a taxable year, the individual remains a covered employee for all subsequent taxable years, even after the individual has separated from service. For example, if a publicly held corporation makes nonqualified deferred compensation (NQDC) payments to a former PEO after separation from service, then the deduction for the payments generally would be subject to section 162(m). Notice 2018-68 based this conclusion on the statutory text in section 162(m)(3)(C) and the legislative history, which provides that if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual remains

a covered employee for all future years. Thus, an individual remains a covered employee with respect to compensation otherwise deductible for subsequent years, including for years during which the individual is no longer employed by the corporation and years after the individual has died. (House Conf. Rpt. 115-466, 489 (2017)). The Blue Book reiterated the legislative history in explaining the amended definition of covered employee. ⁸

One commenter suggested that a covered employee ceases to be a covered employee for taxable years following the taxable year in which the individual separates from service because the statutory text uses the term “employee” instead of “individual” in defining covered employee. In other words, the commenter asserted that the term “employee” in the statute should be interpreted as referring to a “current employee” instead of a “current or former employee.” The commenter suggested that because this is the plain reading of the statute, the legislative history should be ignored. The proposed regulations do not adopt this suggestion. The statute gives no indication that the term “employee” is limited to a current employee, and a reference in the Code to an “employee” has frequently been interpreted in regulations as a reference to a current or a former employee. ⁹ Given the ambiguity in the meaning of “employee” and the legislative intent in this context to include a former employee, as evidenced by the legislative history and the Blue Book explanation of the term covered employee, the proposed regulations define employee to include a former employee.

E. Predecessor Corporation

Section 162(m)(3)(C) provides that the term “covered employee” means any employee who was a covered employee of the taxpayer for any preceding taxable year beginning after December 31, 2016. The term “covered employee” also means any employee who was a covered employee of any predecessor of the taxpayer for

any preceding taxable year beginning after December 31, 2016. For clarity, these proposed regulations use the term “predecessor of a publicly held corporation” instead of “predecessor.” An individual who is a covered employee for one taxable year (including a taxable year of a predecessor of a publicly held corporation) remains a covered employee for subsequent taxable years.

In certain circumstances, the term “predecessor of a publicly held corporation” includes the publicly held corporation itself if it was a publicly held corporation for a prior taxable year. Specifically, the proposed regulations provide that a predecessor of a publicly held corporation includes a publicly held corporation that, after becoming privately held, again becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the corporation’s U.S. Federal income tax return (excluding any extensions) for the last taxable year for which the corporation was previously publicly held. For a discussion of the proposed special applicability date related to the definition of predecessor of a publicly held corporation as applied to a privately held corporation that was previously a publicly held corporation and again becomes a publicly held corporation, see section VIII.B of this preamble.

The proposed regulations also provide that the term “predecessor of a publicly held corporation” includes a publicly held corporation that is acquired (target corporation), or the assets of which are acquired, by another publicly held corporation (acquiror corporation) in certain transactions. Accordingly, the covered employees of the target corporation in those transactions are also covered employees of the acquiror corporation.

The proposed regulations define the term “predecessor of a publicly held corporation” by reference to the type of corporate acquisition in which a publicly held corporation is acquired. The proposed regulations describe corporate acquisitions in four categories: (1) Corporate reorganizations, (2) corporate divisions, (3) stock acquisitions, and (4) asset acquisitions.

8 The Blue Book states that, “[i]n addition, if an individual is a covered employee with respect to a corporation for a taxable year beginning after December 31, 2016, the individual remains a covered employee for all future years. Thus, an individual remains a covered employee with respect to compensation otherwise deductible for subsequent years, including for years during which the individual is no longer employed by the corporation and years after the individual has died.” Blue Book at page 260.

9 For example, under §1.105-11(c)(3)(iii), the nondiscrimination rules of section 105(h)(3) apply to former employees even though the Code uses only the term “employees.”

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Certain transactions may fall within more than one category, but this redundancy is intended to provide certainty as to the application of these rules if a taxpayer is unsure which category covers the acquisition in question.

With respect to corporate reorganizations, the proposed regulations provide that a predecessor of a publicly held corporation includes a publicly held corporation that is acquired or that is the transferor corporation in a corporate reorganization described in section 368(a)(1). For example, if a publicly held target corporation merges into a publicly held acquiror corporation, then any covered employee of the target corporation would become a covered employee of the acquiror corporation.

With respect to corporate divisions, the proposed regulations provide that a predecessor of a publicly held corporation includes a publicly held distributing corporation that distributes or exchanges the stock of one or more controlled corporations in a transaction described in section 355(a)(1) (a 355(a)(1) transaction) if the controlled corporation is a publicly held corporation. This rule applies to the distributing corporation only with respect to covered employees of the distributing corporation who are hired by the controlled corporation (or by a corporation affiliated with the controlled corporation that received stock of the controlled corporation as a shareholder of the distributing corporation in the 355(a)(1) transaction) within the period beginning 12 months before and ending 12 months after the distribution. For example, if a publicly held distributing corporation exchanges with its shareholders the stock of a controlled corporation for stock of the distributing corporation in a 355(a)(1) transaction, and the controlled corporation is a publicly held corporation after the exchange, then any covered employee of the distributing corporation would become a covered employee of the controlled corporation if hired by the controlled corporation within the period beginning 12 months before and ending 12 months after the exchange. Furthermore, a covered employee of the distributing corporation who becomes a covered employee of the controlled corporation will remain a covered employee of the distributing corporation for all

subsequent taxable years because, as discussed in section III.D of this preamble, if an individual is a covered employee for a taxable year, the individual remains a covered employee for all subsequent taxable years.

With respect to stock acquisitions, a predecessor of a publicly held corporation includes a publicly held corporation that becomes a member of an affiliated group (as defined in proposed §1.16233(c)(1)(ii)). For example, if an affiliated group that is considered a publicly held corporation pursuant to proposed §1.16233(c)(1)(ii) in the proposed regulations acquires a publicly held target corporation that becomes a member of the affiliated group, then the target corporation would be considered a predecessor of the affiliated group. Therefore, any covered employee of the target corporation would become a covered employee of the affiliated group.

With respect to asset acquisitions, if an acquiror corporation or one or more members of an affiliated group (acquiror group) acquires at least 80% of the operating assets (determined by fair market value on the date of acquisition) of a publicly held target corporation, then the target corporation is a predecessor of the acquiror corporation or group. For example, if an acquiror corporation acquires 80% or more of the operating assets of a publicly held target corporation, then any covered employees of the target corporation that become employees of the acquiror corporation would become covered employees of the acquiror corporation. For acquisitions of assets that occur over time, the proposed regulations provide that generally only acquisitions that occur within a 12-month period are taken into account to determine whether at least 80% of the target corporation’s operating assets were acquired.

Similarly, this asset acquisition rule provides that the target is a predecessor of a publicly held corporation only with respect to a covered employee of the target corporation who is hired by the acquiror (or a corporation affiliated with the acquiror) within the period beginning 12 months before and ending 12 months after the date on which all events necessary for the acquisition have occurred.

These proposed regulations provide that the rules for determining predeces

sors are applied cumulatively, with the result that a predecessor of a corporation includes each predecessor of the corporation and the predecessor or predecessors of any prior predecessor or predecessors.

Also, in a similar manner to the rule for a publicly held corporation that becomes privately held, and subsequently becomes publicly held, these proposed regulations provide that a target corporation may be a predecessor corporation in certain circumstances. For example, the proposed regulations provide that if a target corporation was a publicly held corporation, subsequently becomes privately held, is then acquired by an acquiror that is not a publicly held corporation, and the acquiror becomes a publicly held corporation for a taxable year ending before the 36-month anniversary of the due date for the target corporation’s U.S. Federal income tax return (excluding any extensions) for the last taxable year for which the target corporation was publicly held, then the target corporation is a predecessor of the publicly held corporation. The proposed regulations also provide a similar rule for asset acquisitions.

These proposed regulations further clarify that, in the case of an election to treat as an asset purchase either the sale, exchange, or distribution of stock pursuant to regulations under section 336(e) or the purchase of stock pursuant to regulations under section 338, the corporation is treated as the same corporation before and after the transaction for which the election is made. Similar exceptions are made to the general treatment of an election under section 336(e) and section 338 that would treat the post-election corporation as a new corporation for purposes of other rules regarding various compensation tax provisions (see §1.338-1(b) (2)(i)). These exceptions align with the other predecessor rules in these proposed regulations by treating a substantial continuation of the earlier business in the post-election corporation as continuing the pre-election corporation, so that the covered employees continue to be covered employees.

F. Disregarded Entities

Under section 162(m)(3), only employees of the taxpayer may be covered

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employees. When a corporation owns an entity that is disregarded as an entity separate from its owner under §301.7701-2(c) (2)(i), the corporation that is a publicly held corporation (and not its wholly-owned entity) is the taxpayer for purposes of section 162(m)(3). In that case, the covered employees of the publicly held corporation are identified pursuant to the rules discussed in sections III.A through III.E of this preamble. Accordingly, a PEO, PFO, or executive officer of a disregarded entity wholly-owned by a corporation is generally not treated as a PEO, PFO, or executive officer of the corporate owner (the publicly held corporation). However, consistent with the definition of the term executive officer in 17 CFR 240.3b-7 that treats executive officers of subsidiaries as executive officers of the registrant if the executive officers perform policy making functions for the registrant, an executive officer of a disregarded entity is treated as an executive officer of its corporate owner for the taxable year if the executive officer performs policy making functions for the corporate owner during the taxable year. These proposed regulations include examples illustrating how to determine whether employees of a disregarded entity are treated as covered employees of its publicly held corporate owner for purposes of section 162(m).

The Treasury Department and the IRS are aware that, in an attempt to circumvent the proposed rules treating a corporation that wholly-owns a disregarded entity that issues certain securities as a publicly held corporation for purposes of section 162(m), a corporation could form a partnership with a minority partner and the partnership could then employ an individual who otherwise would have been a covered employee of the corporation. In these circumstances, §1.701-2 and other federal income tax principles may apply to a transaction in which a corporation forms a partnership in an attempt to circumvent the proposed rules.

G. Qualified Subchapter S Subsidiaries

Like the case when a corporation owns a disregarded entity, when an S corporation that is a publicly held corporation

owns a QSub, the S corporation, and not its QSub, is the taxpayer for purposes of section 162(m)(3). Therefore, pursuant to the rules discussed in sections III.A through III.E of this preamble, a PEO, PFO, or executive officer of such QSub generally is not treated as a PEO, PFO, or executive officer of the S corporation owner (that is, the publicly held corporation). Under these proposed regulations, an executive officer of a QSub is treated as an executive officer of its S corporation owner for the taxable year if the executive officer performs policy making functions for the S corporation owner during the taxable year. See Proposed §1.162-33(c) (2)(iv). This treatment is consistent with the definition of the term executive officer in 17 CFR 240.3b-7, which treats executive officers of subsidiaries as executive officers of the registrant if the executive officers perform policy making functions for the registrant.

IV. Applicable Employee Remuneration

A. In General

Section 162(m)(4) defines the term “applicable employee remuneration” with respect to any covered employee for any taxable year as the aggregate amount allowable as a deduction for such taxable year (determined without regard to section 162(m)) for remuneration for services performed by such employee (whether or not during the taxable year). Before TCJA, applicable employee remuneration did not include remuneration payable on a commission basis (as defined in section 162(m)(4) (B)) or performance-based compensation (as defined in section 162(m)(4)(C)). Section 13601(a) of TCJA amended the definition of applicable employee remuneration to eliminate these exclusions, while section 13601(d) of TCJA added a special rule for remuneration paid to beneficiaries. This special rule, set forth in section 162(m)(4) (F), provides that remuneration shall not fail to be applicable employee remuneration merely because it is includible in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.

For simplicity, when incorporating the amendments TCJA made to the definition of applicable employee remuneration, these proposed regulations use the term “compensation” instead of “applicable employee remuneration.” Consistent with the amendments made by TCJA, these proposed regulations provide that compensation means the aggregate amount allowable as a deduction under chapter 1 of the Code for the taxable year (determined without regard to section 162(m)) for remuneration for services performed by a covered employee, whether or not the services were performed during the taxable year. The proposed regulations also clarify that compensation includes an amount that is includible in the income of, or paid to, a person other than the covered employee, including after the death of the covered employee.

B. Compensation Paid by a Partnership to a Covered Employee

These proposed regulations address the issue of compensation paid by a partnership (as defined for Federal tax purposes) to a covered employee of a publicly held corporation; this issue has been subject to a no-rule position for private letter rulings since 2010. Between 2006 and 2008, the IRS issued four private letter rulings addressing specific situations in which a publicly held corporation was a partner in a partnership. As part of the analysis, the private letter rulings stated that if a publicly held corporation is a partner in a partnership, then section 162(m) does not apply to the corporation’s distributive share of the partnership’s deduction for compensation paid by the partnership for services performed for it by a covered employee of the corporation. Therefore, the private letter rulings ruled on the facts presented that section 162(m) did not limit the otherwise deductible compensation expense of the publicly held corporation for compensation the partnership paid the covered employee. Upon further consideration, and recognizing the potential for abuse, the IRS stopped issuing private letter rulings involving section 162(m) and partnerships. ¹⁰ Stakeholders have asked

10 Initially, the IRS announced the no-rule position in 2010 in section 5.06 of Revenue Procedure 2010-3, 2010-1 I.R.B. 110, which provided that “[w]hether the deduction limit under § 162(m) applies to compensation attributable to services performed for a related partnership” was an area under study in which rulings or determination letters will not be issued until the IRS resolves the issue through publication of a revenue ruling, revenue procedure, regulations, or otherwise. Most recently, section 4.01(13) of Revenue Procedure 2019-3, 2019-01 I.R.B. 130, provides that this issue is an area in which rulings or determination letters will not ordinarily be issued.

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the Treasury Department and the IRS to address this issue in these proposed regulations.

In relevant part, section 162(m)(1) provides that “[i]n the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee.” This language does not limit the application of section 162(m) to deductions for compensation paid by the publicly held corporation; it also covers the deduction for compensation paid to the corporation’s covered employees by another party to the extent the corporation is allocated a share of the otherwise deductible item. For instance, if a publicly held corporate partner is allocated a distributive share of the partnership’s deduction for compensation paid by the partnership, the allocated distributive share of the deduction is subject to section 162(m) even though the corporation did not directly pay the compensation to the covered employee. Thus, the publicly held corporation must take into account its distributive share of the partnership’s deduction for compensation expense paid to the publicly held corporation’s covered employee and aggregate that distributive share and the corporation’s otherwise allowable deduction for compensation paid directly to that employee in determining the amount allowable to the corporation as a deduction for compensation under section 162(m). See §1.702-1(a)(8)(ii) and (iii).

The Treasury Department and the IRS are aware that this issue has not been addressed in generally applicable guidance and understand taxpayers may have taken positions contrary to those set forth in these proposed regulations. Accordingly, the proposed regulations provide transition relief for current compensation arrangements, but also prohibit the formation or expansion of these types of structures for the purpose of avoiding the application of section 162(m) prior to the issuance of final regulations. Specifically, in order to ensure that compensation agreements are not formed or otherwise structured to circumvent this rule after publication of

these proposed regulations and prior to the publication of the final regulations, the proposed regulations propose that the rule with respect to compensation paid by a partnership will apply to any deduction for compensation that is otherwise allowable for a taxable year ending on or after December 20, 2019 but will not apply to compensation paid pursuant to a written binding contract in effect on December 20, 2019 that is not materially modified after that date. The Treasury Department and the IRS request comments on whether similar rules should apply to trusts.

C. Compensation for Services in a Capacity other than an Executive Officer

A commenter suggested that, if a covered employee separates from service as an executive officer and subsequently performs services as a director of the publicly held corporation, then the compensation paid to the individual as a director should not be considered applicable employee remuneration for purposes of section 162(m)(4). These proposed regulations do not adopt this suggestion.

Since the enactment of section 162(m) in 1993, director fees were considered applicable employee remuneration for purposes of section 162(m)(4). In describing compensation for which the deduction is limited by section 162(m), the legislative history to the enactment of section 162(m) states: Unless specifically excluded, the deduction limitation applies to all remuneration for services, including cash and the cash value of all remuneration (including benefits) paid in a medium other than cash. If an individual is a covered employee for a taxable year, the deduction limitation applies to all compensation not explicitly excluded from the deduction limitation, regardless of whether the compensation is for services as a covered employee and regardless of when the compensation was earned. House Conf. Rpt. 103-213, 585 (1993). Thus, in enacting section 162(m), Congress did not exclude compensation for

services not performed as a covered employee from the deduction limitation. As stated in the preamble to the 1993 proposed regulations, “[t]he deduction limit of section 162(m) applies to any compensation that could otherwise be deducted in a taxable year, except for enumerated types of payments set forth in section 162(m)(4)” (58 FR 66310, 66310). Compensation earned by a covered employee through a non-employee position, such as director fees, was never one of the “enumerated types of payments set forth in section 162(m)(4)” and so this compensation does not fall within the exception and has always been considered applicable employee remuneration for which the deduction is limited by section 162(m). ¹¹ The amendments to section 162(m)(4) made by TCJA did not change this aspect of the definition of applicable employee remuneration; accordingly, the proposed regulations do not adopt the commenter’s suggestion.

Pursuant to the amended definition of covered employee in section 162(m)(3) (C), a covered employee includes any individual who was a covered employee of the publicly held corporation (or any predecessor) for any taxable year beginning after December 31, 2016. Therefore, a covered employee remains a covered employee after separation from service. If, after separation from service as an employee, a covered employee returns to provide services to the publicly held corporation in any capacity, including as a common law employee, a director, or an independent contractor, then any deduction for compensation paid to the covered employee is subject to section 162(m).

V. Privately Held Corporations that Become Publicly Held

Section 162(m) applies to the deduction for compensation paid to a covered employee that is otherwise deductible for a taxable year of a publicly held corporation. These proposed regulations provide that, in the case of a corporation that is a privately held corporation that becomes a publicly held corporation, section 162(m)

11 Furthermore, as explained in section II.E of this preamble, the final regulations provide that all compensation paid to a covered employee by more than one member of an affiliated group is aggregated for purposes of prorating the amount disallowed as a deduction by section 162(m). For purposes of aggregating the total compensation paid by the affiliated group, the final regulations do not exclude compensation paid for services performed by a covered employee in a capacity other than an employee (for example, as an independent contractor).

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applies to the deduction for any compensation that is otherwise deductible for the taxable year ending on or after the date that the corporation becomes a publicly held corporation. Furthermore, the proposed regulations provide that a corporation is considered to become publicly held on the date that its registration statement becomes effective either under the Securities Act or the Exchange Act.

Commenters suggested that these proposed regulations retain the transition relief provided in the final regulations for privately held corporations that become publicly held. Commenters reasoned that corporations that become publicly held corporations need time to adjust compensation arrangements to take into account section 162(m). The proposed regulations do not adopt this suggestion.

As background, in enacting section 162(m) in 1993, Congress excepted performance-based compensation from the definition of applicable employee remuneration and, thus, the section 162(m) deduction limitation. Before TCJA, section 162(m)(4)(C) defined performance-based compensation as “any remuneration payable solely on account of the attainment of one or more performance goals, but only if— (i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of 2 or more outside directors, (ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before the payment of such compensation, and (iii) before any payment of such remuneration, the compensation committee referred to in clause (i) certifies that the performance goals and any other material terms were in fact satisfied. These requirements are also set forth in §§1.162-27(e)(2) through (e)(5). In enacting section 162(m), Congress recognized that privately held corporations may have difficulty adopting compensation arrangements that satisfy the requirements for performance-based compensation. Specifically, Congress was concerned about the

shareholder approval requirement. Congress also recognized that, when a corporation becomes a publicly held corporation in connection with an initial public offering (IPO), prospective shareholders who read the corporation’s prospectus are aware of the compensation arrangements adopted prior to the IPO. Accordingly, Congress thought that shareholders who read the prospectus and purchase the corporation’s shares are, in effect, approving the corporation’s compensation arrangements. The 1993 legislative history provides as follows:

[I]n the case of a privately held company that becomes publicly held, the prospectus is subject to the rules similar to those applicable to publicly held companies. Thus, if there has been disclosure that would satisfy the rules described above, persons who buy stock in the publicly held company will be aware of existing compensation arrangements. No further shareholder approval is required of compensation arrangements existing prior to the time the company became public unless there is a material modification of such arrangements. House Conf. Rpt. 103-213, 588 (1993). Based on the legislative history, the final regulations provided transition relief for corporations that become publicly held. Section 1.162-27(f)(1) provides that in the case of a corporation that was not a publicly held corporation and then becomes a publicly held corporation, section 162(m) “does not apply to any remuneration paid pursuant to a compensation plan or agreement that existed during the period in which the corporation was not publicly held.” If a corporation becomes publicly held in connection with an IPO, then the relief provided in §1.162-27(f)(1) applies only to the extent that the prospectus accompanying the IPO disclosed information concerning the existing compensation plans or agreements and satisfied all applicable securities laws.

Section 13601(a) of TCJA amended the definition of applicable employee remuneration in section 162(m)(4) to eliminate the exception for performance-based compensation, which among other things, made shareholder approval of compensation arrangements irrelevant with respect to entitlement to the deduction. Accord

ingly, these proposed regulations do not retain the transition relief provided in the final regulations.

For a discussion of rules applicable to privately held corporations that previously were publicly held corporations, see section III.E. of this preamble.

VI. Grandfather Rules

A. In General

Section 13601(e) of TCJA generally provides that TCJA amendments to section 162(m) apply to taxable years beginning after December 31, 2017. However, it further provides that those amendments do not apply to remuneration that is provided pursuant to a written binding contract that was in effect on November 2, 2017, and that was not modified in any material respect on or after such date.

As discussed in Notice 2018-68, the text of section 13601(e) of the TJCA is almost identical to the text of pre-TCJA section 162(m)(4)(D), which provided a grandfather rule in connection with the enactment of section 162(m) in 1993. Under that grandfather rule, section 162(m) did not apply to remuneration payable under a written binding contract that was in effect on February 17, 1993, and that was not modified thereafter in any material respect before such remuneration was paid. Section 1.162-27(h) provides guidance on the definitions of written binding contract and material modification for purposes of applying the original grandfather rule, and Notice 2018-68 adopted those definitions for purposes of the grandfather rule in connection with section 13601(e) of TCJA. The proposed regulations likewise adopt those definitions. Notice 2018-68 also provided examples illustrating the use of these definitions, and many of those examples are incorporated in these proposed regulations. However, to increase clarity, the proposed regulations replace some examples from Notice 2018-68 with other examples. This replacement with new examples does not reflect a substantive change from the definitions of written binding contract and material modification provided in Notice 2018-68.