Section 162(m): Covered Employees and the $1M Deduction Cap

Under Section 162(m) of the Internal Revenue Code, a publicly held corporation cannot deduct more than $1 million per year in compensation paid to any one of its covered executives. The cap applies regardless of how the pay is structured — salary, bonus, stock options, restricted stock, or anything else. Before 2018, performance-based compensation was exempt from the limit, but the Tax Cuts and Jobs Act eliminated that carve-out. The result is a permanent gap between what companies pay their top people and what they can write off, and that gap costs corporations billions of dollars a year in lost deductions.¹

Which Companies Are Subject to the Cap

Section 162(m) reaches any corporation that qualifies as a “publicly held corporation” under the Securities Exchange Act of 1934. Two categories fall inside that definition: companies whose securities must be registered under Section 12 of the Exchange Act, which covers those listed on a national securities exchange, and companies required to file periodic reports under Section 15(d).² The second category is easy to overlook. It pulls in companies that have publicly traded debt but no publicly traded stock.

Foreign private issuers meeting either the registration or reporting threshold are covered. So are corporate affiliates and subsidiaries once the parent qualifies: the IRS proposed regulations define the publicly held corporation to include the entire affiliated group when the parent is publicly held.³

Going private mid-year does not clean the slate. The deduction limit generally applies to companies that are publicly held on the last day of the taxable year, and the TCJA’s legislative history makes clear that the covered-employee definition still captures individuals who would have appeared in a proxy statement had the company not delisted.⁴

Who Counts as a Covered Employee

The cap does not apply to every employee. It applies only to “covered employees,” and the statute currently defines that group in three ways:

The principal executive officer or principal financial officer — anyone serving as CEO, CFO, or in an acting capacity during the tax year.
The three highest-compensated officers other than the PEO and PFO whose compensation must be reported to shareholders under the Securities Exchange Act of 1934.
Anyone who was a covered employee for any tax year beginning after December 31, 2016, permanently — including after retirement, termination, or death.

That third category is the “once covered, always covered” rule added by the TCJA. The pool of covered employees at any given company only grows. A CEO who retires in 2024 and collects deferred compensation in 2030 is still a covered employee in 2030, and the company still cannot deduct more than $1 million for that person in that year.² The statute also captures anyone who would have been among the three highest-compensated officers had proxy disclosure been required, so structuring around disclosure obligations does not work.⁴

The 2027 Expansion to Ten Covered Employees

The American Rescue Plan Act of 2021 added a fifth category: the five highest-compensated employees for the tax year, excluding anyone already captured as the PEO, PFO, or one of the three highest-compensated officers. That effectively doubles the number of people subject to the cap from five to ten.²

The statutory effective date is taxable years beginning after December 31, 2026. The IRS proposed regulations issued in January 2025 state, however, that the rules will not take effect until the later of that date or the date the final regulations are published in the Federal Register.³ If final regulations are not out before 2027, the effective date slides. Two features of the new category deserve attention. The five additional covered employees can include any common-law employee, not just officers. And once someone lands in that group, the permanent “once covered, always covered” rule attaches to them too.

What Compensation Counts Toward the Cap

“Applicable employee remuneration” reaches virtually every form of pay. The statute defines it as the total amount otherwise deductible for services performed by the covered employee during the tax year.² That sweep includes:

Cash compensation: base salary, annual bonuses, commissions, and signing bonuses.
Equity awards: the value realized from exercising stock options and the fair market value of restricted stock units at vesting. A single large option exercise can push a covered employee well past the cap in one year.
Non-equity incentive payouts tied to corporate performance metrics.
Dividends on restricted stock and RSUs, if paid regardless of whether performance goals are met. Before the TCJA killed the performance-based exception, dividends that vested only on satisfaction of performance goals could be excluded; that distinction no longer matters for most post-2017 compensation.⁵
Payments to a covered employee acting as an independent contractor. Reclassifying the relationship does not create an end-run.

A narrow set of items is excluded. Employer contributions to tax-qualified retirement plans (401(k) matches, pension contributions, and similar payments referenced in Section 3121(a)(5)) do not count, and neither do fringe benefits the employee can reasonably be expected to exclude from gross income, such as employer-provided health insurance.² These exclusions are modest against the total pay packages typical of covered employees.

The Grandfather Rule for Pre-TCJA Contracts

Elimination of the performance-based compensation exception was the single biggest change to Section 162(m) in its history. Before 2018, companies could deduct unlimited amounts of performance-based pay so long as it met strict requirements for outside director approval and shareholder disclosure. That exception vanished for tax years beginning after December 31, 2017.

Congress carved out a transition rule. Compensation paid under a written, binding contract that was in effect on November 2, 2017, and has not been materially modified since, remains subject to the old rules.⁴ If the compensation qualified as performance-based under the pre-TCJA rules, it can still be fully deductible. The provision is narrow and getting narrower as legacy contracts run their course.

What Makes a Contract Binding

A contract qualifies only if the company was legally obligated under applicable state law to pay the compensation once the employee performed the required services or satisfied vesting conditions. If the company retained unilateral authority to reduce or cancel the payment, the contract is not binding for the full amount. IRS Notice 2018-68 gives the classic example: if a bonus plan allows a payout of up to $1.5 million but the board can reduce it to no less than $400,000, only the $400,000 floor is grandfathered.⁴ The discretionary portion above that floor is treated as new compensation.

Choosing not to exercise negative discretion — paying the full amount when the board had the power to reduce it — does not by itself constitute a material modification.⁴ The power to reduce limits how much is binding. Actually paying does not retroactively blow up the grandfather.

What Counts as a Material Modification

Any amendment that increases the amount payable destroys the grandfather for the entire contract, not just the increase. A salary bump not contemplated in the original terms, an increase in the shares under an equity award, or a favorable change to an exercise price all qualify. Payment timing matters too. Accelerating a payment is a modification unless the amount is discounted for the time value of money. Delaying a payment is a modification if the deferred amount grows by more than a reasonable interest rate. Stock options and stock appreciation rights granted before November 2, 2017 are generally grandfathered if they were not subject to further board approval. RSUs granted before that date are grandfathered only if they independently satisfied the old performance-based requirements.

Interaction With the Section 280G Golden Parachute Rules

When a covered employee receives a change-in-control payment large enough to trigger the golden parachute rules under Section 280G, the two deduction limits stack. Section 280G disallows any deduction for “excess parachute payments,” roughly the portion of a change-in-control payment that exceeds three times the executive’s average annual compensation.⁶ On top of that, the IRS treats excess parachute payments as reducing the $1 million cap available under Section 162(m). If a covered employee has $600,000 in excess parachute payments, the 162(m) cap for that employee’s remaining compensation drops to $400,000.

For return reporting, the IRS directs companies to report compensation subject to both limitations on the Section 280G line of Schedule M-3 rather than the Section 162(m) line.⁷ Companies in the middle of an acquisition need to model both provisions together. The combined effect can leave an enormous portion of change-in-control compensation entirely non-deductible.

Timing and Deferred Compensation

The cap applies in the year the company claims the deduction, which generally aligns with when the compensation is paid or, for equity awards, when the award vests or is exercised. Timing matters most for deferred compensation arrangements under Section 409A. An executive who defers $3 million in bonuses does not trigger the 162(m) limit until the money is actually paid out, which could be years or decades later.

The “once covered, always covered” rule undercuts the most obvious planning move. A company cannot wait for an executive to retire and lose covered-employee status before paying out deferred amounts, because that status never expires. The 409A regulations do allow a company to delay a scheduled payment if it reasonably anticipates the payment would be non-deductible under Section 162(m). That gives a narrow window to spread payments across tax years — for example, paying up to $1 million in one year and deferring the excess to a later year in which the executive’s other compensation is lower.

Where the Disallowance Shows Up

The gap between what a company expenses on its financial statements and what it deducts on its tax return is reconciled on Schedule M-3 of Form 1120. Section 162(m) is one of the most common permanent book-to-tax differences for large public companies, and the IRS dedicates a specific line to it. Part III, Line 15 is labeled “Compensation With Section 162(m) Limitation,” where companies report the total compensation expense for covered officers, the non-deductible amount exceeding $1 million, and the deductible portion.⁷ For companies that received financial assistance under the Troubled Asset Relief Program, the cap drops to $500,000 instead of $1 million.

Because the non-deductible amount is a permanent difference rather than a timing difference that reverses in future years, it raises the company’s effective tax rate. A company paying its CEO $10 million loses the deduction on $9 million. At a 21% corporate rate, that is roughly $1.89 million in additional tax the company would not owe if the compensation were fully deductible. Multiplied across five or ten covered employees, the annual tax cost becomes a meaningful line item.

The tax calculation runs parallel to a separate set of SEC disclosure requirements. Publicly held companies must describe their executive compensation practices in the annual proxy statement, including the Compensation Discussion and Analysis section, which is expected to address how the company handles the tension between paying competitive compensation and losing the deduction above $1 million. The Summary Compensation Table reports total compensation for the Named Executive Officers, which typically aligns closely with the IRS definition of covered employees. Because the table shows total compensation rather than the deductible portion, a shareholder reading the proxy can see exactly how much pay exceeds the cap. A company reporting $15 million in total CEO compensation is effectively disclosing that at least $14 million of that pay is non-deductible.

1
U.S. Department of the Treasury. Revenue Consequences of 162(m)
2
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
3
Internal Revenue Service. Certain Employee Remuneration in Excess of $1,000,000 Under Internal Revenue Code Section 162(m)
4
Internal Revenue Service. Guidance on the Application of Section 162(m) Notice 2018-68
5
Internal Revenue Service. Section 162(m)(4)(C) – Dividends and Dividend Equivalents on Restricted Stock and Restricted Stock Units
6
Office of the Law Revision Counsel. 26 USC 280G – Special Rules for Golden Parachute Payments
7
Internal Revenue Service. Instructions for Schedule M-3 (Form 1120) (Rev. June 2025)