The Federal Home Loan Mortgage Corporation (Freddie Mac) acquires mortgages and participation interests in residential mortgage loans (Mortgages) that were originated by unrelated financial institutions and deposits the Mortgages into a trust in exchange for Participation Certificates (PCs), which are sold to investors. Each PC is a pass-through certificate that is backed by the pool of Mortgages that are held in an arrangement that is classified as a trust under § 301.7701–4(c) of the Procedure and Administration Regulations for the benefit of the person that holds the PC. Freddie Mac acts as trustee, depositor, master servicer, administrator, and guarantor with respect to the PCs. As trustee for these trusts, Freddie Mac creates and issues under a trust agreement PCs representing undivided beneficial ownership interests in pools of mortgages and related assets held by those trust funds (Mortgage Pools).

Freddie Mac fulfills its duties as master servicer for the Mortgages by contracting with third parties to perform most servicing functions on Freddie Mac’s behalf in accordance with standards that Freddie Mac has established. PC holders receive a coupon with respect to the outstanding principal amount of the Mortgages. Payments on the PCs do not include the amounts of any fees, charges, or interest in excess of the applicable certificate coupon that may be paid on the Mortgages.

In its capacity as administrator of the PCs, Freddie Mac generally pays principal and interest to PC holders on a specified date (Payment Date) in the month following the month in which payments on the underlying Mortgage are received. The Payment Date is generally 45 days following the first day of such preceding month. This period from the time Freddie Mac collects payments from the mortgage servicers to the time that it remits payments to holders on the Payment Date is referred to as the Remittance Cycle. As guarantor of the PCs, Freddie Mac guarantees that PC holders receive timely payments of amounts provided for in the terms of the PC whether or not Freddie Mac receives payments from the servicers of the Mortgages.

The Federal National Mortgage Association (Fannie Mae) issues Mortgage-Backed Securities (MBSs) to the market. The terms and conditions of MBSs are substantially identical to PCs. In particular, the key features and terms of the MBSs largely align with the key features and terms of the PCs. A difference between PCs and MBSs is their respective Remittance Cycle. While the Remittance Cycle for PCs is 45 days, the Remittance Cycle for MBSs is 55 days, meaning that an MBS holder receives monthly payments 10 days later than a PC holder.

Freddie Mac and Fannie Mae are both regulated by the Federal Housing Finance Agency (FHFA). The FHFA proposes to standardize pass-through certificates issued by Freddie Mac and Fannie Mae. Accordingly, the FHFA will require Freddie Mac to cease issuing PCs and Fannie Mae to cease issuing MBSs, and will require both entities to issue Uniform Mortgage-Backed Securities (UMBSs) instead. UMBSs issued by Freddie Mac and Fannie Mae will have the same features and terms, including identical 55-day Remittance Cycles.

Freddie Mac will also permit holders of existing PCs the opportunity to exchange their PC for a UMBS that represents the same proportionate undivided beneficial interest in the pool of Mortgages as their existing PC on a voluntary basis (Conversion). Thus, a PC holder that agrees to the exchange will receive a UMBS that provides for the same coupon rate as the PC coupon rate and is guaranteed to the same extent as the PC they surrender, except that the UMBS will provide for Payment Dates that are determined under a 55-day Remittance Cycle instead of the 45-day Remittance Cycle associated with a PC and a UMBS that is issued in exchange for a PC will be given a new CUSIP number. Freddie Mac will not charge holders of PCs a fee for an exchange made pursuant to the Conversion.

Because a UMBS provides for a 55-day Remittance Cycle instead of the 45-day Remittance Cycle associated with the corresponding PC, the holder of a UMBS will receive scheduled payments of principal and interest 10 days later than the holder would receive those payments under the PC. Freddie Mac will make a one-time payment to PC holders that choose to participate in the Conversion (Make Whole Payment). The Make Whole Payment will be calculated based on the present value of 10 additional days of payment delay over the expected term of the relevant PC. At present market rates, the amount of the Make Whole Payment is expected to be between 5 and 15 basis points multiplied by the outstanding principal balance of the PC, though a compensation schedule has not been published and the exact amount of compensation is unknown at this time.

For a limited time when Freddie Mac first makes the Conversion available, Freddie Mac may also offer a holder of a PC a payment intended to induce the holder to participate in the Conversion (Inducement Fee). Any Inducement Fee, should it be offered, would be paid to any PC holder that agrees to participate in the Conversion within a timeframe prescribed by Freddie Mac.

The combined amount of the Make Whole Payment and any Inducement Fee will not be more than 25 basis points multiplied by the outstanding principal balance of the PC.

In the case of any exempt organization with more than one unrelated trade or business, § 512(a)(6)(A) requires the organization to calculate UBTI, including for purposes of determining any NOL deduction (discussed in section 9 of this notice), separately with respect to each such trade or business. In enacting § 512(a)(6), Congress did not provide criteria for determining whether an exempt organization has more than one unrelated trade or business or how to identify separate unrelated trades or businesses for purposes of calculating UBTI. The Treasury Department and the IRS intend to propose regulations for determining whether an exempt organization has more than one unrelated trade or business for purposes of § 512(a)(6) and how to identify separate trades or businesses for purposes of calculating UBTI under § 512(a)(6)(A).

Pending issuance of proposed regulations, and pursuant to additional interim guidance provided in section 6 of this notice, exempt organizations may rely on a reasonable, good-faith interpretation of §§ 511 through 514, considering all the facts and circumstances, when determining whether an exempt organization has more than one unrelated trade or business for purposes of § 512(a)(6). A reasonable, good-faith interpretation includes using the North American Industry Classification System 6-digit codes described in section 3.03.

The Treasury Department and the IRS note that the fragmentation principle in § 513(c) and § 1.513–1(b), and related guidance, may also provide helpful guidance. Prior to the passage of § 512(a)(6), the fragmentation principle was primarily used to separate unrelated trades or businesses from exempt activities, but it might also have utility in identifying separate trades or businesses for purposes of § 512(a)(6)(A). The fragmentation principle provides that an activity does not lose its identity as a trade or business merely because it is carried on within a larger aggregate of similar activities or within a larger complex of other endeavors which may, or may not, be related to the exempt purposes of an organization. For example, the regular sale of pharmaceutical supplies to the general public by a hospital pharmacy does not lose its status as a trade or business merely because the pharmacy also furnishes supplies to the hospital and patients of the hospital in accordance with its exempt purposes or in compliance with the terms of § 513(a)(2) (stating, in part, that the term “trade or business” does not include any trade or business that is carried on by an organization described in § 501(c)(3) or a state college or university primarily for the convenience of its members, students, patients, officers, or employees). See § 1.513–1(b). Similarly, activities of soliciting, selling, and publishing commercial advertising do not lose their statuses as trades or businesses even though the advertising is published in an exempt organization periodical that contains editorial matter related to the exempt purposes of the organization. Id. Additionally, several revenue rulings provide examples of how the fragmentation principle has been applied. See, e.g., Rev. Rul. 78–145, 1978–1 C.B. 169 (regarding the sale of blood products by a blood bank).

There is no general statutory or regulatory definition defining what constitutes a “trade or business” for purposes of the Internal Revenue Code. Whether an activity constitutes a trade or business may vary depending on which Code section is involved. See generally Commissioner v. Groetzinger, 480 U.S. 23, 27 (1987). The Treasury Department and the IRS request comments regarding rules to identify separate trades or businesses that achieve the intent of Congress in enacting § 512(a)(6) and are administrable for exempt organizations and the IRS.

Several Code sections describe factors for determining whether an organization is engaged in a trade or business or a line of business, including §§ 132, 162, 183, 414, and 469 (see also section 5.02 of this notice), and the regulations thereunder. The Treasury Department and the IRS have considered these Code sections and are concerned that they do not provide useful models for identifying separate trades or businesses for purposes of § 512(a)(6). Nonetheless, the Treasury Department and the IRS request comments describing whether and how these and other Code sections (and the regulations thereunder) may aid in determining how to identify an exempt organization’s separate trades or businesses for purposes of § 512(a)(6)(A).

Although some commenters have suggested the creation of a facts and circumstances test to identify separate trades or businesses for purposes of § 512(a)(6), the Treasury Department and the IRS would like to set forth a more administrable method than a facts and circumstances test alone for identifying separate trades or businesses for purposes of § 512(a)(6). A facts and circumstances test would increase the administrative burden on exempt organizations in complying with § 512(a)(6) because such organizations would have to perform a fact-intensive analysis with respect to each of their trades or businesses, document the analysis, and then track and keep records consistent with such analysis. Additionally, such a test would likely result in inconsistency across the exempt organization sector in light of differing approaches in budgeting and staffing and thus create unequal burdens and cause exempt organizations to make business decisions such as budgeting and staffing solely to avoid the requirements of § 512(a)(6). Finally, such a test would also increase the administrative burden on the IRS in implementing and enforcing § 512(a)(6) because verifying whether an exempt organization calculated its UBTI correctly would require a fact-intensive analysis of the organization’s trades or businesses and the determinations made with respect to identifying separate trades or businesses for purposes of calculating UBTI under § 512(a)(6)(A).

To provide additional guidance in proposed regulations for determining whether an exempt organization has more than one unrelated trade or business for purposes of § 512(a)(6) and how to identify separate trades or businesses for purposes of calculating UBTI under § 512(a)(6)(A), the Treasury Department and the IRS are considering the use of North American Industry Classification System (NAICS) codes. Prior to proposed regulations, the Treasury Department and the IRS will consider the use of NAICS 6-digit codes to be a reasonable, good-faith interpretation under section 3.02 of this notice.

The NAICS is an industry classification system for purposes of collecting, analyzing, and publishing statistical data related to the United States business economy. See EXECUTIVE OFFICE of the PRESIDENT, OFFICE of MANAGEMENT and BUDGET, NORTH AMERICAN INDUSTRY CLASSIFICATION SYSTEM (2017), available at https://www.census.gov/eos/www/naics/2017naics/2017_naics_manual.pdf. For example, under a NAICS 6-digit code, all of an exempt organization’s advertising activities and related services (NAICS code 541800) might be considered one unrelated trade or business activity, regardless of the source of the advertising income. Use of all 6 digits of the NAICS codes would result in more specific categories of trades or businesses whereas use of fewer than 6 digits of the NAICS codes would result in broader categories of trades or businesses. Exempt organizations filing Form 990–T, “Exempt Organization Business Income Tax Return,” already are required to use the 6-digit NAICS codes when describing the organization’s unrelated trades or businesses in Block E. The Treasury Department and the IRS request comments regarding whether using less than 6 digits of the NAICS codes, or combining NAICS codes with other criteria, would appropriately identify separate trades or businesses for purposes of achieving the objective of § 512(a)(6). The Treasury Department and the IRS also request comments on the utility of this method, other methods, or a combination of methods that could be used for making this determination.

Section 512(a)(1) permits an exempt organization with an unrelated trade or business to reduce the income from that trade or business by the deductions allowed by Chapter 1 of the Code that are directly connected with the carrying on of such trade or business. To be “directly connected” with a trade or business, an item of deduction must have a proximate and primary relationship to the carrying on of the unrelated trade or business generating the gross income. See § 1.512(a)–1(a). Expenses, depreciation, and similar items attributable solely to the conduct of an unrelated trade or business are proximately and primarily related to that trade or business and qualify to reduce income from such trade or business under § 512(a)(1) to the extent such items meet the requirements of §§ 162 (trade or business expenses), 167 (depreciation), and other relevant provisions.

To the extent that an exempt organization may have items of deduction that are shared between an exempt activity and an unrelated trade or business, the Treasury regulations at § 1.512(a)–1(c) and (d) provide special rules for allocating such expenses. For example, if facilities are used both to carry on exempt activities and to conduct unrelated trade or business activities, then expenses, depreciation, and similar items attributable to such facilities must be allocated between the two uses on a reasonable basis. See § 1.512(a)–1(c).

The Treasury Department and the IRS currently have an item on the Priority Guidance Plan regarding methods of allocating expenses relating to dual use facilities. The allocation issues under § 512(a)(1) also are relevant under § 512(a)(6) because an exempt organization with more than one unrelated trade or business must not only allocate indirect expenses among exempt and taxable activities as described in § 1.512(a)–1(c) and (d) but also among separate unrelated trades or businesses. The Treasury Department and the IRS therefore are considering modifying the underlying reasonable allocation method in § 1.512(a)–1(c) and providing specific standards for allocating expenses relating to dual use facilities and the rules under § 512(a)(6). The Treasury Department and the IRS are requesting comments regarding possible rules or defined standards for the allocation of indirect expenses between separate unrelated trades or businesses for purposes of calculating UBTI under § 512(a)(6)(A), and, in particular, regarding what allocation methods should be considered “reasonable.”

In general, for exempt organizations, the activities of a partnership are considered the activities of the partners.^[4] Section 512(c) requires an exempt organization that is a partner in a partnership that conducts a trade or business that is an unrelated trade or business with respect to the exempt organization to include in UBTI its distributive share of gross partnership income (and directly connected partnership deductions) from such unrelated trade or business. Whether a trade or business engaged in by the partnership is an unrelated trade or business with respect to the exempt organization is determined under §§ 511 through 514, and the regulations thereunder. Based on § 512(c) and the fragmentation principle, as discussed in section 3.02 of this notice, one interpretation of § 512(a)(6) might require an exempt organization to calculate UBTI separately with respect to each unrelated trade or business regularly carried on by the partnership in which the exempt organization is a direct or indirect partner. For example, if an exempt organization is a partner in a holding partnership that is a partner in multiple partnerships, many of which engage in one or more unrelated trades or businesses with respect to the exempt organization partner, the exempt organization may be engaged in multiple separate unrelated trades or businesses through its interest in the partnership.

The Treasury Department and the IRS have received comments regarding the potential significant reporting and administrative burden imposed by § 512(a)(6) on exempt organizations with various activities in the nature of an investment including ownership interests in multi-tier partnership structures that generate UBTI if the Treasury Department and the IRS adopt the interpretation of § 512(a)(6) discussed in section 5.01 of this notice. The administrative burden related to owning partnership interests would be heightened by the difficulty of obtaining sufficient information regarding the trade or business activities of lower-tier partnerships. Accordingly, as a matter of administrative convenience, the Treasury Department and the IRS intend to propose regulations treating certain activities in the nature of an investment (“investment activities”) of an exempt organization as one trade or business for purposes of § 512(a)(6)(A) in order to permit exempt organizations to aggregate gross income and directly connected deductions from such “investment activities.” The Treasury Department and the IRS expect that treating these “investment activities” as one trade or business for this purpose will reduce the reporting and administrative burden on organizations required to comply with § 512(a)(6) and will also reduce the burden the IRS may experience in implementing and enforcing § 512(a)(6).

The Treasury Department and the IRS request comments regarding the scope of the activities, both investment partnership interests or other activities in the nature of an investment that may generate unrelated business income, that should be included in the category of “investment activities” for purposes of § 512(a)(6). The Treasury Department and the IRS have received some comments suggesting the definition of material participation in § 469 could serve as a basis for separating investment activities from more active involvement in an unrelated trade or business. The Treasury Department and the IRS are concerned that the criteria for finding material participation under § 469 are more extensive than appropriate. With respect to partnership interests that could be included in the category of “investment activities” for purposes of § 512(a)(6), the Treasury Department and the IRS note that “investment activities” as discussed in section 6 of this notice should capture only partnership interests in which the exempt organization does not significantly participate in any partnership trade or business.

(1) In General. Except as provided in section 6.01(2) through (4) of this notice, exempt organizations with partnership investments should use a reasonable, good-faith interpretation of §§ 511 and 514, considering all the facts and circumstances, when identifying separate trades or businesses for purposes of § 512(a)(6)(A) until the issuance of proposed regulations (see section 3.02 of this notice).

(2) Interim Rule for Aggregation of Qualifying Partnership Interests under the De Minimis and Control Tests. Pending publication of proposed regulations, an exempt organization may aggregate its UBTI from its interest in a single partnership with multiple trades or businesses, including trades or businesses conducted by lower-tier partnerships, as long as the directly-held interest in the partnership meets the requirements of either the de minimis test (described in section 6.02 of this notice) or the control test (described in section 6.03 of this notice) (“qualifying partnership interest”). Additionally, under this interim rule, an exempt organization may aggregate all qualifying partnership interests and treat the aggregate group of qualifying partnership interests as comprising a single trade or business for purposes of § 512(a)(6)(A).

(3) Transition Rule. Pending publication of proposed regulations, an exempt organization may follow the transition rule (described in section 6.04 of this notice) for partnership interests with respect to which it is not applying the interim rule described in section 6.01(2) of this notice.

(4) Limitations. The interim rule and the transition rule do not apply to exempt organizations described in § 501(c)(7) that are subject to § 512(a)(3). See section 7 of this notice. Furthermore, these rules do not otherwise impact the application of § 512(c) and the fragmentation principle under § 513(c).

(1) In general. A partnership interest is a qualifying partnership interest that meets the requirements of the de minimis test if the exempt organization holds directly no more than 2 percent of the profits interest and no more than 2 percent of the capital interest. But see section 6.02(2)(b) of this notice for rules requiring the combining of related interests in certain circumstances.

(2) Percentage Interest. (a) Reliance on Schedule K-1. In determining the exempt organization’s percentage interest in a partnership, the exempt organization may rely on the Schedule K-1 it receives from the partnership. In Part II, line J, a partnership enters the partner’s share of profit, loss, and capital interests at the beginning and the ending of the partnership’s taxable year. An organization will be considered to have no more than 2 percent of the profits or capital interests in the case of a partnership, if the average of the organization’s percentage interest at the beginning and the end of the partnership’s taxable year, or, in the case of a partnership interest held for less than a year, the percentage interest held at the beginning and end of the period of ownership within the partnership’s taxable year, entered in Part II, line J, of Schedule K-1 is no more than 2 percent (without regard to the number of days each such percentage is held during the taxable year). For example, if an exempt organization acquires an interest in a partnership that files on a calendar year basis in May and the partnership reports in Part II, Line J, of Schedule K-1 that the partner held a 3 percent profits interest at the date of acquisition but held a 1 percent profits interest at the end of the calendar year, the exempt organization will be considered to have held 2 percent of the profits interest in that partnership for that year ((3 percent + 1 percent)/2 = 2 percent). To the extent that a specific profits interest is not identified in Part II, Line J, of Schedule K-1, an organization does not meet the de minimis test.

(b) Combining Related Interests. (i) In General. When determining an exempt organization’s percentage partnership interest, the interest of a disqualified person, a supporting organization, or a controlled entity in the same partnership will be taken into account. For example, if an exempt organization owns 1.5 percent of the profits interests in a partnership and a disqualified person with respect to the exempt organization owns an additional 1 percent profits interest in that partnership, the exempt organization would not meet the requirements of the de minimis test because its aggregate percentage interest exceeds 2 percent. However, the exempt organization may still be able to aggregate the income (and directly connected deductions) from that partnership interest with other qualifying partnership interests if the partnership interest meets the requirements of the control test (described in section 6.03 of this notice).

(ii) Disqualified Person. For purposes of section 6.02(2)(b)(i) of this notice, the term “disqualified person” has the same meaning as in § 4958(f).

(iii) Supporting Organization. For purposes of section 6.02(2)(b)(i) of this notice, the term “supporting organization” has the same meaning as in § 509(a)(3).

(iv) Controlled Entity. For purposes of section 6.02(2)(b)(i) of this notice, the term “controlled entity” has the same meaning as in § 512(b)(13)(D).

(1) In General. A partnership interest is a qualifying partnership interest that meets the requirements of the control test if the exempt organization (i) directly holds no more than 20 percent of the capital interest; and (ii) does not have control or influence over the partnership. The rules in section 6.02(2)(b) of this notice requiring the combination of related interests also apply for purposes of the control test.

(2) Reliance on Schedule K-1. When determining the exempt organization’s percentage interest in a partnership the exempt organization may rely on the Schedule K-1 it receives from the partnership. An organization will be considered to have no more than 20 percent of the capital interest, if the average of the organization’s percentage interest at the beginning and the end of the partnership’s taxable year, or, in the case of a partnership interest held for less than a year, the percentage interest held at the beginning and end of the period of ownership within the partnership’s taxable year, entered in Part II, line J, of Schedule K-1 is no more than 20 percent (without regard to the number of days each such percentage is held during the taxable year).

(3) Control or Influence. All facts and circumstances are relevant for determining whether an exempt organization has control or influence over a partnership. An exempt organization has control or influence if the exempt organization may require the partnership to perform, or may prevent the partnership from performing, any act that significantly affects the operations of the partnership. An exempt organization also has control or influence over a partnership if any of the exempt organization’s officers, directors, trustees, or employees have rights to participate in the management of the partnership or conduct the partnership’s business at any time, or if the exempt organization has the power to appoint or remove any of the partnership’s officers, directors, trustees, or employees.

A previously acquired partnership interest may be difficult to modify to meet the de minimis test (as described in section 6.02 of this notice) or control test (as described in section 6.03 of this notice) under the interim rule and the exempt organization may have to incur significant transactions costs to do so. Thus, an organization may choose to apply the following transition rule, if applicable, for a partnership interest acquired prior to August 21, 2018: an exempt organization may treat each such partnership interest as comprising a single trade or business for purposes of § 512(a)(6) whether or not there is more than one trade or business directly or indirectly conducted by the partnership or lower-tier partnerships. For example, if an organization has a thirty-five percent interest in a partnership prior to August 21, 2018, it can treat the partnership as being in a single unrelated trade or business even if the partnership’s investments generated UBTI from various lower-tier partnerships that were engaged in multiple types of trades or businesses.

.05 Unrelated Debt-Financed Income. The income from qualifying partnership interests permitted to be aggregated under the interim rule includes any unrelated debt-financed income (within the meaning of § 514) that arises in connection with the qualifying partnership interest that meets the requirements of either the de minimis test or the control test. See §§ 512(b)(4) and 514. For example, assume an exempt organization has an interest in a hedge fund that is treated as a partnership for federal income tax purposes, the interest is a qualifying partnership interest that meets the requirements of the de minimis test, and the hedge fund regularly trades stock on margin. Ordinarily, the dividends from such stock and any income (or loss) from the sale, exchange, or other disposition of such stock would be excluded from UBTI under § 512(b)(1) and (5). However, because all or a portion of the stock’s purchase is debt-financed, § 512(b)(4) requires that all of or a portion (depending on the debt-basis percentage applied) of the dividend income (if any) and any income (or loss) from the sale of the stock be included in UBTI. For the purpose of the interim rule, the exempt organization may aggregate unrelated debt-financed income generated by the hedge fund with any other UBTI generated by any of the hedge fund’s trades or businesses that are unrelated trades or businesses with respect to the exempt organization.

Similarly, any unrelated debt-financed income that arises in connection with a partnership interest that meets the requirements of the transition rule may be aggregated with the other UBTI that arises in connection with that partnership interest.

To determine total UBTI under § 512(a)(6)(B), an exempt organization takes the sum of the UBTI computed with respect to each separate trade or business under § 512(a)(6)(A), less a specific deduction under § 512(b)(12). However, in calculating total UBTI under § 512(a)(6)(B), § 512(a)(6)(C) provides that UBTI with respect to any trade or business cannot be less than zero.

Section 512(a)(7) increases UBTI by any amount for which a deduction is not allowable under this chapter by reason of § 274 and which is paid or incurred by such exempt organization for any qualified transportation fringe (as defined in § 132(f)), any parking facility used in connection with qualified parking (as defined in § 132(f)(5)(C)), or any on-premises athletic facility (as defined in § 132(j)(4)(B)). However, § 512(a)(7) does not apply to the extent the amount paid or incurred is directly connected with an unrelated trade or business that is regularly carried on by the organization. Unlike other paragraphs of § 512, § 512(a)(7) does not treat amounts included in UBTI as a result of that section as an item of gross income derived from an unrelated trade or business (see section 4 of this notice). Furthermore, the Treasury Department and the IRS do not believe that the provision of the fringe benefits described in § 512(a)(7) is an unrelated trade or business. Accordingly, any amount included in UBTI under § 512(a)(7) is not subject to § 512(a)(6).

Section 162(m)(2) defines the term “publicly held corporation” for purposes of identifying the entities subject to the deduction limitation of section 162(m)(1). Before the amendments made by section 13601(c) of the Act, section 162(m)(2) defined the term “publicly held corporation” as any corporation issuing any class of common equity securities required to be registered under section 12 of the Securities Exchange Act of 1934. Section 13601(c) of the Act amended the definition of “publicly held corporation” in section 162(m)(2) to mean any corporation which is an issuer (as defined in section 3 of the Securities Exchange Act of 1934) (A) the securities of which are required to be registered under section 12 of the Securities Exchange Act of 1934, or (B) that is required to file reports under section 15(d) of the Securities Exchange Act of 1934.

Section 162(m)(3) defines the term “covered employee” for purposes of identifying employees whose remuneration may be subject to the deduction limitation under section 162(m)(1). Before the amendments made by section 13601(b) of the Act, section 162(m)(3) defined the term “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 Securities Exchange Act of 1934 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 the Act amended the definition of “covered employee” in section 162(m)(3) to mean any employee of the taxpayer if (A) such 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 such employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than any individual described in subparagraph (A)), or (C) such employee was a covered employee of the taxpayer (or any predecessor) for any preceding taxable year beginning after December 31, 2016.

Section 13601(c) of the Act also added flush language to section 162(m)(3) providing that the term “covered employee” includes any employee who would be described in section 162(m)(3)(B) if the reporting described in such subparagraph were required as so described. The legislative history to section 13601 of the Act explains that the term “covered employee” includes “officers of a corporation not required to file a proxy statement but which otherwise falls within the revised definition of a publicly held corporation.” House Conf. Rpt. 115–466, 489. Furthermore, the legislative history provides that the term “covered employee” includes “officers of a publicly traded corporation that would otherwise have been required to file a proxy statement for the year (for example, but for the fact that the corporation delisted its securities or underwent a transaction that resulted in the nonapplication of the proxy statement requirement).” Id.

Section 162(m)(4) defines the term “applicable employee remuneration” for purposes of identifying the remuneration of a covered employee that may be subject to the deduction limitation under section 162(m)(1). Section 162(m)(4) generally provides that the term “applicable employee remuneration” means, with respect to any covered employee for any taxable year, 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 the amendments made by section 13601(a) of the Act, the term “applicable employee remuneration” did not include remuneration payable on a commission basis (as defined in section 162(m)(4)(B)) or qualified performance-based compensation (as described in section 162(m)(4)(C)). Section 13601(a) of the Act amended the definition of “applicable employee remuneration” in section 162(m)(4) to remove these two exclusions. Section 13601(d) of the Act also amended the definition of “applicable employee remuneration” by adding a special rule for remuneration paid to beneficiaries. As amended, 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.

Section 13601(e) of the Act generally provides that the amendments made to section 162(m) shall apply to taxable years beginning after December 31, 2017. However, section 13601(e) of the Act further provides that the amendments to section 162(m) shall not apply to remuneration which is provided pursuant to a written binding contract which was in effect on November 2, 2017, and which was not modified in any material respect on or after such date. The text of section 13601(e) of the Act is almost identical to the text of pre-amendment section 162(m)(4)(D), which provides a grandfather rule addressing the initial addition of section 162(m) to the Code and grandfathers remuneration payable under a written binding contract which was in effect on February 17, 1993, and which was not modified thereafter in any material respect before such remuneration was paid. Section 1.162–27(h) of the Income Tax Regulations (Regulations) provides guidance under pre-amendment section 162(m)(4)(D) on the definitions of “written binding contract” and “material modification” for purposes of applying that original grandfather provision.

Section 162(m)(3)(A)^[7] provides that the term “covered employee” includes any employee who is the PEO or PFO of the publicly held corporation at any time during the taxable year, or was an individual acting in such a capacity.

Section 162(m)(3)(B) provides that a “covered employee” also includes any employee whose total compensation for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 by reason of such employee being among the three highest compensated officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity). Stakeholders have asked whether an employee must have served as an executive officer at the end of the taxable year to be a covered employee under section 162(m)(3)(B). The statutory provisions do not impose an end-of-year requirement, and nothing in the legislative history indicates that Congress intended such a requirement to apply. Accordingly, the Treasury Department and the IRS have determined that there is no end-of-year requirement under section 162(m)(3)(B).

Some commenters have asserted that an end-of-year requirement should apply under section 162(m)(3)(B) because the Securities and Exchange Commission (SEC) rules relating to executive compensation disclosure under the Securities Exchange Act of 1934 require disclosure of the compensation of the registrant’s three most highly compensated executive officers other than the PEO and the PFO who were serving as executive officers at the end of the last completed fiscal year. See Item 402 of Regulation S-K, 17 CFR § 229.402(a)(3)(iii).^[8] The SEC rules, however, do not limit the disclosure of compensation by reason of an executive officer being among the highest compensated executive officers solely to executive officers who serve at the end of the last completed fiscal year. For example, in addition to requiring the disclosure of the three most highly compensated executive officers (other than the PEO and PFO) who were serving as executive officers at the end of the last completed fiscal year, the SEC rules also require disclosure of the compensation of up to two additional individuals for whom disclosure would have been required pursuant to 17 CFR § 229.402(a)(3)(iii) but for the fact that the individual was not serving as an executive officer of the registrant at the end of the last completed fiscal year. See Item 402 of Regulation S-K, 17 CFR § 229.402(a)(3)(iv).^[9] Moreover, as previously noted, the section 162(m)(3)(B) statutory language and legislative history do not impose an end-of-year requirement. While certain aspects of section 162(m) are interpreted consistent with the SEC rules, the SEC rules do not serve as the sole basis for interpreting section 162(m).

Stakeholders have also questioned whether an employee whose compensation is not required to be disclosed under the SEC rules could nevertheless be a covered employee under section 162(m)(3)(B). The flush language at the end of section 162(m)(3) provides that the term “covered employee” includes any employee who would be described in section 162(m)(3)(B) if the reporting described there were required. Although this flush language was added by a conforming amendment under section 13601(c) of the Act, which expanded the definition of publicly held corporation to include issuers required to file reports under section 15(d) of the Securities Exchange Act of 1934, the legislative history clarifies that the flush language was intended to apply more broadly, explaining that this language applies, for example, to a corporation that does not file a proxy statement for the year because it delists its securities. See House Conf. Rpt. 115–466, 489. Thus, executive officers of publicly held corporations can be covered employees under section 162(m)(3)(B) even when disclosure of their compensation is not required under the SEC rules.

Accordingly, the term “covered employee” for any taxable year means any employee who is among the three highest compensated executive officers for the taxable year (other than the PEO or PFO, or an individual acting in such capacity), 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. The determination of the amount of compensation used to identify the three most highly compensated executive officers for purposes of section 162(m)(3)(B) is made consistent with the Instructions to Item 402(a)(3) and the Instructions to Item 402(m)(2), 17 CFR § 229.402(a)(3), § 229.402(m)(2). In cases in which a publicly held corporation’s last completed fiscal year and the taxable year do not end on the same date (for example, due to a short taxable year as a result of a corporate transaction), the publicly held corporation will have three most highly compensated executive officers under section 162(m)(3)(B) for the taxable year. The Treasury Department and IRS request 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 last completed fiscal year. Until additional guidance is issued, to determine the three most highly compensated employees for purposes of section 162(m)(3)(B), taxpayers should base their determination upon a reasonable good faith interpretation of the statute, taking into account the guidance provided under this notice.

Pursuant to section 162(m)(3)(C), the term “covered employee” also 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. For taxable years beginning prior to January 1, 2018, “covered employees” are identified pursuant to section 162(m)(3) as in effect before the amendments made by section 13601(b) of the Act. Accordingly, covered employees identified for the taxable year beginning during 2017 (in accordance with the pre-amendment rules for identifying covered employees) will continue to be covered employees for taxable years beginning in 2018 and beyond.

The following examples illustrate how these rules apply under certain circumstances, including how their application may differ from the application of the SEC’s executive compensation disclosure requirements. For each example, assume that none of the employees were covered employees for the 2017 taxable year (since being a covered employee for the 2017 taxable year would provide a separate and independent basis for classifying that employee as a covered employee for the 2018 taxable year). For each example, assume that the corporation has a fiscal year ending December 31 for SEC reporting purposes.

Example 1. (i) Facts. Corporation Z is a calendar year taxpayer and a publicly held corporation within the meaning of section 162(m)(2). Corporation Z is not a smaller reporting company or emerging growth company under the SEC rules. For 2018, Employee A served as the sole PEO of Corporation Z and Employees B and C both served as the PFO of Corporation Z at different times during the year. Employees D, E, and F were, respectively, the first, second, and third most highly compensated executive officers of Corporation Z for 2018 other than the PEO and PFO, and all three retired before the end of 2018. Employees G, H, and I were, respectively, Corporation Z’s fourth, fifth, and sixth highest compensated executive officers other than the PEO and PFO for 2018, and all three were serving at the end of 2018. On March 1, 2019, Corporation Z filed its Form 10–K, Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 with the SEC. With respect to Item 11, Executive Compensation (as required by Part III of Form 10–K), Corporation Z disclosed the compensation of Employee A for serving as the PEO, Employees B and C for serving as the PFO, and Employees G, H, and I pursuant to Item 402 of Regulation S-K, 17 CFR § 229.402(a)(3)(iii). Corporation Z also disclosed the compensation of Employees D and E pursuant to Item 402 of Regulation S-K, 17 CFR § 229.402(a)(3)(iv).

(ii) Conclusion: PEO. Because Employee A served as the PEO during 2018, Employee A is a covered employee under section 162(m)(3)(A) for 2018.

(iii) Conclusion: PFO. Because Employees B and C served as the PFO during 2018, Employees B and C are covered employees under section 162(m)(3)(A) for 2018.

(iv) Conclusion: Three Highest Compensated Executive Officers. Even though the SEC rules require Corporation Z to disclose the compensation of Employees D, E, G, H, and I for 2018, Corporation Z’s covered employees for 2018 under section 162(m)(3)(B) are Employees D, E, and F, because these are the three highest compensated executive officers other than the PEO and PFO for 2018.

Example 2. (i) Facts. Assume the same facts as in Example 1, except that Corporation Z is a smaller reporting company or emerging growth company under the SEC rules. Accordingly, with respect to Item 11, Executive Compensation (as required by Part III of Form 10–K), Corporation Z disclosed the compensation of Employee A for serving as the PEO, Employees G and H pursuant to Item 402(m) of Regulation S-K, 17 CFR § 229.402(m)(2)(ii), and Employees D and E pursuant to Item 402(m) of Regulation S-K, 17 CFR § 229.402(m)(2)(iii).

(ii) Conclusion. The results are the same as in Example 1. For purposes of identifying a corporation’s covered employees under section 162(m)(3), it is not relevant whether the SEC rules for smaller reporting companies and emerging growth companies apply to the corporation, nor is it relevant whether the specific executive officers’ compensation must be disclosed under the SEC rules applicable to the corporation.

Example 3. (i) Facts. Corporation Y is a domestic publicly held corporation within the meaning of section 162(m)(2) for its 2018 taxable year and a calendar year taxpayer. Corporation X is a domestic corporation and a calendar year taxpayer; however, Corporation X is not a publicly held corporation within the meaning of section 162(m)(2) for its 2018 and 2019 taxable years. On July 31, 2019, Corporation X acquires for cash 80% of the only class of outstanding stock of Corporation Y. The group (comprised of Corporations X and Y) elects to file a consolidated income tax return. As a result of this election, Corporation Y has a short taxable year ending on July 31, 2019. Corporation Y does not change its fiscal year for SEC reporting purposes to correspond to the short taxable year. Corporation Y remains a domestic publicly held corporation within the meaning of section 162(m)(2) for its short taxable year ending on July 31, 2019 and its subsequent taxable year ending on December 31, 2019, for which it files a consolidated income tax return with Corporation X.

For Corporation Y’s taxable year ending July 31, 2019, Employee N serves as the only PEO, and Employee O serves as the only PFO. Employees J, K, and L are the three most highly compensated executive officers of Corporation Y for the taxable year ending July 31, 2019, other than the PEO and PFO. As a result of the acquisition, effective July 31, 2019, Employee N ceases to serve as the PEO of Corporation Y. Instead, Employee M begins serving as the PEO of Corporation Y on August 1, 2019. Employee N continues to provide services for Corporation Y and never serves as PEO again (or as an individual acting in such capacity). For Corporation Y’s taxable year ending December 31, 2019, Employee M serves as the only PEO, and Employee O serves as the only PFO. Employees J, K, and L continued to be the three most highly compensated executive officers of Corporation Y, other than the PEO and PFO, for the taxable year ending December 31, 2019.

(ii) Conclusion: Employee N. Because Employee N served as the PEO during Corporation Y’s taxable year ending July 31, 2019, Employee N is a covered employee for Corporation Y’s taxable year ending July 31, 2019. Furthermore, Employee N is a covered employee for Corporation Y’s taxable year ending July 31, 2019, even though Employee N’s compensation is required to be disclosed pursuant to the SEC executive compensation disclosure rules only for the fiscal year ending December 31, 2019. Because Employee N was a covered employee for Corporation Y’s taxable year ending July 31, 2019, Employee N is also a covered employee for Corporation Y’s taxable year ending December 31, 2019.

(iii) Conclusion: Employee O. Because Employee O served as the PFO during Corporation Y’s taxable years ending July 31, 2019, and December 31, 2019, Employee O is a covered employee for these taxable years. Furthermore, Employee O is a covered employee for Corporation Y’s taxable year ending July 31, 2019, even though Employee O’s compensation is required to be disclosed pursuant to the SEC executive compensation disclosure rules only for the fiscal year ending December 31, 2019. Employee O would be a covered employee for Corporation Y’s taxable year ending December 31, 2019 even if Employee O did not serve as the PFO during this taxable year because Employee O was a covered employee for Corporation Y’s taxable year ending July 31, 2019.

(iv) Conclusion: Employees J, K, and L. Employees J, K, and L are covered employees for Corporation Y’s taxable years ending July 31, 2019, and December 31, 2019, because these employees are the three highest compensated executive officers for these taxable years. Employees J, K, and L would be covered employees for Corporation Y’s taxable year ending December 31, 2019, even if Employees J, K, and L were not the three highest compensated executive officers during this taxable year because Employees J, K, and L were covered employees for Corporation Y’s taxable year ending July 31, 2019. Accordingly, Employees J, K, and L would be covered employees for Corporation Y’s taxable years ending July 31, 2019 and December 31, 2019, even if their compensation would not be required to be disclosed pursuant to the SEC executive compensation disclosure rules.

(v) Conclusion: Employee M. Because Employee M served as the PEO during Corporation Y’s taxable year ending December 31, 2019, Employee M is a covered employee for Corporation Y’s taxable year ending December 31, 2019.