The 162(m) Limitation on Executive Compensation

Section 162(m) of the Internal Revenue Code limits the corporate tax deduction for compensation paid by publicly held corporations to certain top executives to $1 million per year. The rule’s impact was broadened by the Tax Cuts and Jobs Act of 2017 (TCJA), which expanded which employees and types of pay are subject to the limit.

Scope of the Limitation

The Section 162(m) limitation applies to “publicly held corporations.” This term includes any corporation that issues a class of securities required to be registered under the Securities Exchange Act. This definition captures companies whose equity or debt is traded on a public exchange. The determination of whether a corporation is publicly held is made on the last day of its taxable year.

This includes not only domestic companies but also certain foreign private issuers whose securities are traded in the United States. The rule’s application extends to affiliated groups of corporations, meaning that the compensation paid by any member of a controlled group is aggregated. This prevents companies from avoiding the deduction cap by spreading an executive’s compensation across multiple subsidiary entities.

A “covered employee” includes the corporation’s principal executive officer (PEO or CEO), its principal financial officer (PFO or CFO), and the next three most highly compensated executive officers for the taxable year. This was a change from the pre-TCJA rules, which excluded the CFO from the list of covered individuals.

A provision of the rule is the “once a covered employee, always a covered employee” policy. Once an individual is identified as a covered employee for any taxable year beginning after December 31, 2016, they retain that status for all future years. The $1 million deduction limitation applies to all compensation paid to that individual by the company, even after they no longer serve in one of the specified roles or have retired.

A further expansion of the covered employee definition is set to take effect for taxable years beginning after December 31, 2026. This change will add the five highest-compensated employees to the list of covered individuals. However, this new group will be treated differently, as the “once a covered employee, always a covered employee” rule will not apply to them. Instead, their status will be determined on an annual basis.

Compensation Subject to the Limit

The $1 million deduction limitation applies to all forms of remuneration for services performed by a covered employee. This includes an executive’s base salary, annual cash bonuses, and various non-cash benefits. The timing of the deduction limitation is tied to the taxable year in which the compensation would otherwise be deductible by the corporation.

Equity-based compensation also falls under this umbrella. The value of stock options is generally included in the calculation at the time the options are exercised, not when they are granted. For other forms of equity like restricted stock units (RSUs), the value is counted toward the $1 million limit when the shares vest and are no longer subject to a substantial risk of forfeiture.

A defining feature of the changes made by the Tax Cuts and Jobs Act was the elimination of the exception for “qualified performance-based compensation.” Prior to the TCJA, companies could deduct compensation amounts well over $1 million if the pay was tied to the achievement of pre-established, objective performance goals. The removal of this exception for any new compensation arrangements made the $1 million cap a hard limit for most forms of executive pay.

Grandfathered Arrangements and Other Exceptions

Despite the broad changes introduced by the TCJA, certain pre-existing compensation agreements are not subject to the new rules. These arrangements are protected by a transition rule for any written binding contract that was in effect on November 2, 2017. To retain this “grandfathered” status, the contract must not have been materially modified after that date.

A “material modification” occurs if the contract is amended to increase the amount of compensation the executive could receive. For example, increasing an executive’s salary or granting a larger bonus than the contract required would be considered a material modification. Conversely, an action that does not enhance the compensation, such as an amendment to defer a payment, does not void the grandfathered status.

A few other narrow categories of compensation remain excluded from the $1 million limit. This includes company contributions to qualified retirement plans, such as a 401(k) plan. Amounts that are excludable from the executive’s gross income for tax purposes, like certain health benefits, are also not counted toward the cap.

Corporate Tax Planning and Reporting

With the elimination of the performance-based exception, many companies now regularly pay key executives far more than the $1 million deductible limit. These corporations have made a strategic decision to forgo the tax deduction as a necessary cost of attracting and retaining executive talent in a competitive market. The lost tax deduction is factored into the overall cost of the compensation package.

To manage the timing and impact of the deduction limitation, some companies utilize non-qualified deferred compensation plans. These plans allow an executive to earn compensation in one year but receive the payment in a future year, often after retirement. Deferral can help spread payments over multiple years, potentially allowing more of the total compensation to fall under the $1 million annual cap in the years it is paid out.

Publicly held corporations are also subject to specific disclosure requirements related to executive compensation. In annual proxy statements filed with the Securities and Exchange Commission (SEC), companies must identify their covered employees for the year. They are also required to report the total compensation for these executives, which ensures that shareholders are aware of the compensation arrangements.