Section 162(m)’s $1 Million Limit on Executive Compensation

Section 162(m) of the Internal Revenue Code limits the tax deduction publicly held corporations can claim for compensation paid to their top executives. The regulation sets a $1 million annual cap on the amount of remuneration for each covered executive that a company can deduct from its corporate income taxes. This provision is designed to curb excessive executive pay by removing some of the tax advantages for the paying corporation.

The Tax Cuts and Jobs Act of 2017 (TCJA) broadened the reach of this deduction limitation. The TCJA expanded the pool of executives subject to the rule and eliminated the widely used exception for performance-based compensation. As a result, companies can no longer structure new pay agreements to bypass the deduction limit, which affects their tax liabilities and financial reporting.

Defining the Scope of the Limitation

The Section 162(m) deduction limit applies based on the definitions of a “publicly held corporation” and a “covered employee.” A company is considered publicly held if it has securities registered under Section 12 of the Securities Exchange Act of 1934, which includes companies on a national stock exchange. The TCJA expanded this to include corporations required to file reports under Section 15(d) of the Exchange Act, such as those with publicly traded debt.

The second component is identifying “covered employees.” For any tax year, this group includes:

• The Principal Executive Officer (PEO/CEO) and Principal Financial Officer (PFO/CFO).
• The three other most highly compensated executive officers for that year.
• For tax years after December 31, 2026, the five highest-compensated employees for the year, even if they are not executive officers.

A provision known as the “once a covered employee, always a covered employee” rule is also in effect. Once an individual is identified as a covered employee for any tax year beginning after December 31, 2016, they retain that status permanently. The $1 million deduction limit applies to all compensation paid to that person in all future years, requiring companies to track all individuals who have ever met the definition.

For example, if an executive is one of the top three highest-paid officers for one year, the company remains subject to the $1 million limit for that executive in all future years. This applies even to post-retirement payments like deferred compensation or consulting fees. However, this permanent status does not apply to individuals covered solely because they are among the five highest-compensated employees added in the post-2026 expansion; they must re-qualify for that group each year.

Compensation Subject to the Deduction Cap

The $1 million deduction limit applies to a broad range of remuneration, including base salary, bonuses, commissions, and non-cash benefits. The value of equity-based awards is also included when the executive recognizes the income for tax purposes. For example, the value of restricted stock units (RSUs) is counted in the year they vest, and the spread on non-qualified stock options is counted when they are exercised.

The TCJA eliminated the “performance-based compensation” exception. Before this change, companies could deduct compensation over $1 million if it was tied to achieving pre-established performance goals. This exception was widely used for bonuses and equity awards, allowing for large tax-deductible payments to executives.

With the repeal of this exception, nearly all forms of executive pay are aggregated and subject to the $1 million cap. A company must combine an executive’s salary, bonuses, and income from equity awards in a single year to determine the non-deductible amount. For instance, if a CEO has a $900,000 salary and vests in RSUs valued at $500,000, the total compensation is $1.4 million, and the corporation loses the tax deduction for the $400,000 excess.

This change altered how companies design executive compensation programs. The tax-driven incentive to structure pay around specific performance metrics to ensure deductibility has been removed for new arrangements. While performance metrics remain a part of compensation philosophy for aligning executive and shareholder interests, the direct tax benefit under Section 162(m) no longer exists.

Grandfathered Plans and Other Special Rules

Certain pre-existing compensation arrangements may be exempt from the expanded rules. A “grandfather” provision protects compensation payable under a written binding contract that was in effect on November 2, 2017. Compensation paid under such a contract can remain subject to the pre-TCJA rules, which included the performance-based compensation exception.

This grandfathered status is lost if the contract is “materially modified” after November 2, 2017. A material modification is any change that increases the amount of compensation the executive could receive, such as an unscheduled salary increase or accelerated vesting of an equity award. Once a contract is materially modified, all future payments under it become subject to the new rules.

Conversely, an increase in compensation from a pre-existing formula, such as a cost-of-living adjustment specified in the original contract, is not considered a material modification.

A transition rule also applies to companies that become publicly held, such as through an initial public offering (IPO). These companies are provided a transition period where the deduction limit does not apply to compensation plans that existed before the company went public. This relief gives private companies time to adjust their compensation structures as they transition to public status.

Corporate Reporting and Financial Statement Impact

Compensation exceeding the $1 million limit has direct consequences for a corporation’s tax filings and financial statements. The non-deductible amount creates a permanent book-tax difference, as the full compensation expense is recorded on the financial statements, but only $1 million is deducted on the tax return. This difference increases the company’s effective tax rate.

The lost deduction results in a higher taxable income and a larger income tax liability. For example, if a company in a 21% corporate tax bracket pays an executive $500,000 over the limit, it loses a $500,000 deduction, resulting in an additional $105,000 in federal income tax.

On financial statements, this impact is reflected in the income tax provision calculation, which increases the current tax expense. Companies are often required to disclose significant permanent differences in the footnotes to their financial statements, providing transparency to investors about factors affecting the company’s tax rate.