Section 162(m): How the $1M Deduction Cap Shapes Executive Compensation

If you've ever wondered why your employer insists on performance conditions for bonuses above a certain amount, why your deferred comp plan has distribution timing provisions tied to "deductibility," or why your offer letter structures equity as RSUs instead of discretionary cash bonuses — Section 162(m) is a large part of the answer.

Section 162(m) of the Internal Revenue Code limits the federal income tax deduction a publicly held corporation can take for compensation paid to any single "covered employee" to $1 million per year. The company still pays you — but it loses the deduction on every dollar above $1M. For a C-corp paying 21% federal corporate tax, that's $210,000 of deduction lost per $1M of excess pay. Multiply that across five to ten covered employees and it's a material corporate tax cost.

As a named executive officer, understanding 162(m) helps you interpret why comp is structured the way it is — and surfaces a few planning dimensions that directly affect your own tax outcomes.

Who is a "covered employee"?

Post-TCJA (effective for tax years beginning after December 31, 2017), "covered employee" means any employee who, at any time during the taxable year, is:¹

• The principal executive officer (PEO) — the CEO, or whoever serves that function for SEC reporting purposes
• The principal financial officer (PFO) — the CFO
• Among the three other most highly compensated executive officers (excluding the PEO and PFO) whose total compensation is required to be disclosed in the annual proxy statement
• Any individual who was a covered employee in any taxable year beginning after December 31, 2016

That last bullet is the "once a covered employee, always a covered employee" rule — one of TCJA's most consequential changes. Before TCJA, the definition reset each year. Now it's permanent. A CFO who leaves the company in 2020 remains a covered employee in 2026, 2030, and beyond — meaning any compensation the company pays that former executive, including NQDC distributions from a prior deferral, is still subject to the $1M cap.

What compensation counts toward the $1M cap?

The limitation applies to "applicable employee remuneration" — essentially all forms of compensation paid by the publicly held corporation to the covered employee:²

• Base salary
• Cash bonuses (annual incentive plan payments, discretionary bonuses)
• RSU settlement (ordinary income included in W-2 at vest)
• Non-qualified stock option (NSO) spread at exercise
• Performance stock unit (PSU) settlement
• NQDC distributions (counted in the year of distribution, not deferral)
• Sign-on bonuses and change-of-control cash payments
• Severance and separation payments

The threshold is measured on a per-employee, per-year basis. If a CEO earns $800K base, $400K annual bonus, and $500K in RSU vesting in the same year, total applicable remuneration is $1.7M — $700K is non-deductible to the company.

What is excluded from the cap?

Not everything counts. The following are excluded from "applicable employee remuneration":

• Qualified plan contributions and benefits — employer 401(k) match, pension accruals, and benefits from tax-qualified plans are not subject to the cap
• Amounts excluded from the employee's income — employer-paid health insurance, HSA contributions, group term life insurance under statutory limits
• Grandfathered pre-TCJA performance-based compensation — compensation that qualifies under binding written contracts in place on November 2, 2017 and not materially modified since is still exempt (this exemption is narrowing as those contracts expire or are amended)
• Compensation from certain tax-exempt entities — different rules apply under § 4960 for non-profits

The TCJA overhaul: what changed in 2018

Before TCJA, there was a meaningful exception: compensation that qualified as "qualified performance-based compensation" — bonuses and equity awards tied to pre-established, objective performance goals certified by a compensation committee and disclosed to shareholders — was exempt from the $1M cap. That exception is why public companies spent decades building elaborate annual incentive plans with shareholder-approved performance conditions.

TCJA eliminated the performance-based exception entirely for tax years after 2017. The rules changed in three ways:³

1. Performance-based pay no longer exempt. A $3M performance bonus approved by the compensation committee and tied to earnings per share targets is now subject to 162(m) the same as base salary.
2. PFO added as a covered employee. Before TCJA, the CFO (PFO) was not covered — only the PEO and top-3-by-pay. Now the CFO is always covered, regardless of whether their total pay ranks in the top 3.
3. Once-covered, always-covered. The permanent status rule described above. Companies no longer get a deduction window for NQDC payouts to former covered employees in post-separation years with lower total comp.

OBBBA 2026: the controlled group expansion

The One Big Beautiful Bill Act (signed July 2025) made a significant structural change to 162(m), effective for tax years beginning after December 31, 2025 — meaning it applies to calendar-year companies starting in 2026.⁴

Prior to OBBBA, the 162(m) limitation applied to compensation paid by a "publicly held corporation" and its "affiliated group" under IRC § 1504 — generally, the consolidated return group of domestic corporations. This created a gap: compensation paid to a covered employee through a partnership, LLC, or foreign subsidiary was not fully captured.

OBBBA replaced "affiliated group" with "controlled group" under IRC §§ 414(b), (c), (m), and (o) — the same aggregation rules used for qualified retirement plan compliance. This is a much broader net. Now:

• Compensation paid to a covered employee by any member of the controlled group (including partnerships and LLCs the public corporation controls) counts toward the $1M cap
• For the purpose of identifying who counts as a covered employee, compensation from all controlled-group members is aggregated
• When multiple controlled-group members pay the same covered employee, the deduction limitation is allocated among them proportionally based on each member's share of total compensation paid

For executives at conglomerate structures, PE-backed spin-offs, or companies where significant comp flows through partnership structures, this change has direct bite. Compensation that previously "fell through" the affiliated-group gap now counts.

ARP 2021: the 2027 expansion to top-10 highest paid

The American Rescue Plan Act of 2021 added a second expansion that takes effect for tax years beginning after December 31, 2026 — meaning the 2027 tax year for calendar-year companies.⁵

Starting in 2027, "covered employee" will also include the five highest-compensated employees of the company who are not already covered under the existing PEO/PFO/top-3-officers rules. This expands the covered employee pool from 5 to up to 10 individuals per year.

An important difference: the "once covered, always covered" rule does not apply to this new expanded group. An employee who is among the top-5-highest-paid in 2027 but drops off that list in 2028 is no longer a covered employee going forward (unless they're also a covered employee for another reason).

For large companies, this could mean the deduction limitation reaches directors, senior VPs, and other high-earning employees who aren't proxy-listed NEOs but whose total compensation — salary, bonus, equity — lands in the top 10 company-wide.

How 162(m) shapes comp structure at public companies

Understanding 162(m) explains several structural features of executive comp packages:

Why equity is the dominant form for large compensation amounts

Grandfathered pre-TCJA equity awards (options and performance shares under plans approved before November 2, 2017) were performance-based and exempt. Even post-TCJA, equity grants that will vest over 3-4 years spread the income event — and the 162(m) exposure — across multiple years, reducing the single-year impact. A $4M RSU grant vesting ratably over 4 years creates $1M of 162(m) exposure per year rather than $4M in one year.

Why some NQDC plans have "deductibility" distribution provisions

Older NQDC plans sometimes include a provision stating that distributions will be deferred until a year in which the executive's total compensation falls below $1M — allowing the company to recapture the deduction. These provisions must satisfy 409A's strict election and distribution rules. Post-TCJA, the "once covered" rule limits how useful this is for executives who will always be covered, but the provision may still benefit lower-paid covered employees or former executives in lower-comp years.

Why annual cash bonus structures have performance conditions

Before TCJA, performance conditions were essential to preserve the deduction. Post-TCJA, performance conditions no longer provide a deductibility benefit — but companies kept them for governance and alignment reasons. The 162(m) deduction may be lost anyway if total comp exceeds $1M; the performance structure is now more about governance than tax.

Why companies sometimes accept the non-deductibility

For companies paying executives $3-10M annually, the 21% corporate tax cost on the excess above $1M is a real but manageable cost. A $5M total pay package means $4M is non-deductible — $840K of additional corporate tax. At the executive level, companies weigh this against talent retention. The tax cost is a factor in compensation committee decisions but not usually the determinative one.

What this means for your planning as an executive

Section 162(m) is primarily a corporate tax issue — it affects what your employer can deduct, not what you owe. But it creates a few indirect planning considerations:

NQDC distribution timing and employer deductibility

If your NQDC plan has a deductibility provision, the company may structure distributions to land in years where you're earning less other comp — reducing both your concentration of ordinary income and the company's non-deductible expense. Coordinate with your plan administrator if you're negotiating a distribution schedule change.

More importantly: if you're leaving a company and negotiating your exit package, the company's awareness of 162(m) can affect the form and timing of payments. Cash severance in a year when you're still accumulating base salary and RSU income from prior grants can push total comp far above $1M — the company absorbs a larger deduction loss. Some executives negotiate for lump-sum departures; others prefer spread payments that coincide with their lower-income years.

"Once covered" follows you to future compensation

Even after you leave a public company, NQDC distributions from that company are still subject to 162(m) in the distribution year. This is a corporate accounting issue, not a tax issue for you personally — but it can make NQDC plan administrators nervous about paying out in peak-income years. Understand this dynamic when scheduling distributions or negotiating payout elections.

Change-of-control packages and 162(m)

Change-of-control payments — severance, accelerated equity, NQDC trigger distributions — can stack multiple years of comp into a single year. In addition to the §4999 excise tax (the golden parachute issue covered in the 280G guide), the company may be absorbing a very large 162(m) non-deductibility charge on top of the cash outflow. At M&A negotiations, this is sometimes a factor in how acquirers structure golden parachute arrangements — gross-up provisions, in particular, create additional compensation (the gross-up itself) that is also subject to 162(m).

If you're the CFO (PFO)

Before TCJA, the PFO was not a covered employee under 162(m). Since 2018, you are — permanently. If you were CFO at a public company at any point since 2017, any compensation that company pays you going forward (including outstanding NQDC) is subject to the cap. This matters when evaluating future deferred comp arrangements at subsequent companies: you may be a covered employee there even if you're not yet in a senior enough role to qualify by current-year rank.