A Section 162(m) covered employee is any current or former executive of a publicly held corporation whose compensation is subject to the $1 million annual deduction cap. Under the rules in effect through 2026, the designation reaches the company’s principal executive officer, its principal financial officer, and the three next-highest-compensated officers for the year, plus anyone who held one of those roles in any tax year beginning after December 31, 2016. Beginning with tax years after December 31, 2026, five additional highly paid employees are added to the list. Because the status is generally permanent once attached, the group of covered employees at a mature public company grows year after year.
The Three Current Categories
For tax years through 2026, the Internal Revenue Code identifies covered employees through three separate rules.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses An individual who falls into any one of them is covered for the year.
Principal Executive Officer and Principal Financial Officer
Anyone who serves as the corporation’s PEO or PFO at any point during the taxable year is a covered employee. The PEO is typically the CEO and the PFO is typically the CFO, consistent with how the roles are reported to the SEC. Interim and acting officers count: the statute explicitly includes individuals “acting in such a capacity.” If two people share the CEO role during the year because of a mid-year transition, both are covered employees for that year.
The Three Highest-Compensated Officers
The next category captures the three highest-compensated officers for the taxable year, other than the PEO and PFO, whose total compensation must be reported to shareholders under the Securities Exchange Act of 1934. In practice, these are the executives who appear in the company’s Summary Compensation Table in its proxy statement. The determination is based on total compensation for the year, and the officer does not need to be employed on the last day of the taxable year to qualify.
A catch-all backs this up: any employee who would fall into the top-three group if proxy disclosure were required is still a covered employee, even when the company’s actual reporting obligations do not reach them.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses Technical gaps in SEC reporting do not create an exit from 162(m).
Once Covered, Always Covered
The third rule is a permanent status rule rather than a yearly test. Any individual who was a PEO, PFO, or one of the three highest-compensated officers for any taxable year beginning after December 31, 2016, remains a covered employee indefinitely, regardless of whether they are later demoted, leave the company, or retire.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses The $1 million cap continues to apply to every future payment the corporation or any affiliated entity makes to that person.
This status survives the individual’s death. Deferred compensation, severance installments, or other amounts paid to a former covered employee’s estate or beneficiaries after death remain subject to the cap. The statute references anyone who “was” a covered employee, and the rule carries no expiration tied to the person’s lifetime. An officer who became covered in 2018 and whose large deferred compensation payout hits ten years later still generates only $1 million of deductible compensation in the payout year.
The practical consequence is that corporations need tracking systems that follow former covered employees indefinitely. In most mature public companies, the list of former covered employees already outnumbers the list of current ones, and it only grows.
The 2027 Expansion: Five Additional Employees
The American Rescue Plan Act of 2021 added a new category to the covered-employee definition. For taxable years beginning after December 31, 2026, the five highest-compensated employees of the corporation, other than anyone already captured as PEO, PFO, or one of the top-three officers, also become covered employees.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses For calendar-year taxpayers, the first affected year is 2027.
Two features make this group meaningfully different from the three existing categories. First, these five employees do not need to be officers at all. A highly paid software engineer, investment banker, portfolio manager, or trader with no corporate-officer title can land in this group on compensation alone. Second, the status is not permanent. The “once covered, always covered” rule only references the PEO/PFO and top-three-officer categories, not the ARPA five. These five are redetermined each year, and an employee in the group one year may fall out the next if their compensation drops relative to peers.
The IRS published proposed regulations in January 2025 to implement the expansion. Under the proposed rules, the compensation used to identify these five is based on the amount that would be deductible by the corporation before applying the 162(m) cap, rather than on the SEC proxy disclosure rules used for the top-three officers.2Federal Register. Certain Employee Remuneration in Excess of $1,000,000 Under Internal Revenue Code Section 162(m) Compensation from all members of an affiliated group is aggregated for this purpose. As of mid-2025, these regulations remain in proposed form. They are set to apply for taxable years beginning after the later of December 31, 2026, or the date the final regulations are published.
Which Companies This Applies To
Covered-employee status only exists at a publicly held corporation. The statute defines that term as any issuer whose securities must be registered under Section 12 of the Securities Exchange Act of 1934, or any issuer required to file reports under Section 15(d) of that Act.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses That obviously captures companies with stock listed on a national exchange, but it also reaches companies with only publicly traded debt and companies that trigger SEC reporting without having actively traded equity.3Office of the Law Revision Counsel. 15 USC 78l – Registration Requirements for Securities Foreign private issuers that meet the registration or reporting requirements are included.
The definition reaches through affiliated groups. If even one member of an affiliated group of corporations is publicly held, each publicly held member within that group applies the $1 million cap independently to its own covered employees.4Internal Revenue Service. Section 162(m) Audit Technique Guide
Companies that went public after December 20, 2019, are subject to the full rules immediately. An IPO transition rule that once gave newly public companies a grace period was tied to the old performance-based compensation exception. When the Tax Cuts and Jobs Act eliminated that exception, the final regulations repealed the transition rule for any company becoming publicly held after that date. SPAC-formed public companies closing after that cutoff get no transition relief either.
Executives at private companies, nonprofits, and partnerships that are not themselves publicly held issuers are not covered employees under Section 162(m), though separate rules may apply to their compensation under other Code provisions.
What Covered-Employee Status Actually Costs
The designation itself does not change what the employee earns. It changes what the corporation can deduct. Once someone is identified as a covered employee, the corporation must calculate the total “applicable employee remuneration” paid to that individual for the year, and everything above $1 million is non-deductible.1Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses The definition of remuneration is broad, covering compensation in any form, cash or non-cash, for services performed in any year.
Timing matters as much as amount. The $1 million limit applies in the year the compensation would otherwise be deductible by the corporation. A stock option grant does not hit the cap when granted; it hits in the year the option is exercised, when the deduction arises. Non-qualified deferred compensation is tested against the limit in the year it is paid out. A single large exercise or distribution can easily consume the entire $1 million allowance for the year, pushing every other dollar of that employee’s compensation that year into non-deductible territory.
Two narrow exclusions exist. Contributions to and distributions from qualified retirement plans, such as 401(k) plans and defined benefit pensions, are excluded. Benefits the employee can exclude from gross income, such as employer-provided health insurance and other tax-free fringe benefits, are also excluded. These exclusions do not reach the big-ticket items that drive executive pay above $1 million. Stock options, restricted stock, bonuses, and deferred compensation are all fully within the cap.
The performance-based compensation exception that used to shelter many of these awards is gone. Before 2018, stock options, stock appreciation rights, and performance-vesting awards could avoid the cap if they met specific requirements. The Tax Cuts and Jobs Act repealed that exception for tax years beginning after December 31, 2017.4Internal Revenue Service. Section 162(m) Audit Technique Guide Awards designed specifically to qualify as performance-based under the old rules are now subject to the cap like any other compensation, unless they are covered by the grandfather for written binding contracts in effect on November 2, 2017.5Internal Revenue Service. Notice 2018-68 – Guidance on the Application of Section 162(m)
Covered Status in Mergers and Acquisitions
Covered-employee status transfers through corporate transactions, which catches both executives and acquirers off guard.
When a publicly held target is acquired mid-year, the resulting short tax year is subject to 162(m), and the three highest-compensated officers are identified using the short tax year as the measurement period. This matters most when a public company is taken private. Transaction-related payments to executives — golden parachute cash-outs, accelerated equity vesting, deal bonuses — are often the largest single-year compensation events in those executives’ careers, and they run straight into the $1 million cap during the final short tax year.
The “once covered, always covered” rule then follows those individuals into the successor organization. If a target’s executives were covered employees in any post-2016 tax year, the acquiring public company inherits that permanent designation. Even if the target becomes a private subsidiary, future compensation the successor or its affiliates pay to those former executives remains subject to the cap. Diligence teams on public-company acquisitions typically need to identify every individual who was a covered employee of the target, or any predecessor, going back to 2017.