Section 162(m): $1M Deduction Cap, Covered Employees, Grandfather Rule

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 each of its covered executives. The Section 162(m) $1 million compensation deduction limit applies no matter how the pay is structured — salary, cash bonuses, stock options, restricted stock, or anything else. Performance-based pay used to be exempt. The Tax Cuts and Jobs Act killed that exception for tax years beginning after December 31, 2017, so the cap now bites on virtually all compensation paid to covered employees.¹

The mechanics matter because the disallowance is a permanent book-to-tax difference. A company that pays its CEO $10 million loses the deduction on $9 million; at a 21% federal rate, that is roughly $1.89 million in additional tax on one employee, every year.

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 are in scope: companies whose securities must be registered under Section 12 of the Exchange Act (which sweeps in companies listed on a national securities exchange), and companies required to file periodic reports under Section 15(d).² That second bucket is broader than most people assume. It brings in companies that have only publicly traded debt and no publicly traded stock.

Foreign private issuers are covered if they hit either the registration or the reporting threshold. And the IRS’s proposed regulations treat the “publicly held corporation” as the entire affiliated group when the parent is publicly held, so subsidiaries do not sit outside the rule.³

A company that goes private or delists mid-year does not escape cleanly. The deduction limit generally applies to companies publicly held on the last day of the taxable year, but the covered-employee status of the executives who worked there does not reset. That is the point of the “once covered, always covered” rule discussed below.⁴

Who Counts as a Covered Employee

The cap does not apply to the entire workforce. It applies only to “covered employees.” Under current law there are three routes into that status:

The principal executive officer or principal financial officer — anyone serving as CEO, CFO, or in an acting capacity at any point during the tax year.
The three highest-compensated officers (other than the PEO and PFO) whose compensation must be reported to shareholders under the Exchange Act. The statute also captures anyone who would have been in this group if proxy disclosure had been required, so companies cannot design around the disclosure rules to shrink the covered group.⁴
Anyone who was a covered employee for any tax year beginning after December 31, 2016. Once you are in, you stay in — through retirement, termination, or death.²

That third category, the “once covered, always covered” rule, was added by the TCJA. The pool of covered employees at a 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 $1 million cap still applies to whatever is paid out that year.

Expansion to Ten Covered Employees

The American Rescue Plan Act of 2021 added a fourth route to covered-employee status: the five highest-compensated employees for the tax year, excluding anyone already captured as PEO, PFO, or one of the three highest-compensated officers. This effectively doubles the covered group from five to ten.²

The statute makes this effective for taxable years beginning after December 31, 2026. The proposed regulations issued in January 2025 state that the rules will not take effect until the later of that date or the date the final regulations are published, so if finalization slips, so does the effective date.³ Two features to watch: the five additional covered employees can be any common-law employee, not just officers, and they will be subject to the same permanent covered-employee status going forward.

What Compensation Counts

The statute defines “applicable employee remuneration” as the total amount otherwise deductible for services performed by the covered employee during the tax year.² In practice, that captures nearly everything:

Base salary, annual bonuses, commissions, and signing bonuses.
The spread realized on stock option exercises and the fair market value of restricted stock or RSUs at vesting. One large option exercise can push a covered employee well past $1 million in a single year.
Cash payouts under non-equity incentive plans tied to corporate performance.
Dividends and dividend equivalents on restricted stock and RSUs, if paid regardless of whether performance goals are met. Before the TCJA, dividends that vested only on satisfaction of performance goals could be excluded; that distinction is largely gone for compensation paid after 2017.⁵
Payments to a covered employee who also provides services as an independent contractor. Reclassification does not create an escape hatch.

The exclusions are narrow. Employer contributions to tax-qualified retirement plans (401(k) matches, pension contributions, and similar payments referenced in Section 3121(a)(5)) do not count. Neither do fringe benefits the employee can reasonably be expected to exclude from gross income, such as employer-provided health coverage.² Set against total pay packages for covered executives, these carve-outs are small.

The Grandfather Rule for Pre-TCJA Contracts

Eliminating the performance-based exception was the biggest change to Section 162(m) in its history. Congress paired it with 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 and can still qualify for the pre-TCJA performance-based deduction.⁴ The grandfather is narrow and shrinks each year as legacy arrangements pay out.

What “Binding” Means

A contract counts as binding only to the extent the company was legally obligated under applicable state law to pay once the employee performed the services or satisfied the vesting conditions. If the company kept unilateral authority to reduce or cancel the payment, only the floor is binding. IRS Notice 2018-68 gives the example: if a bonus plan allows a payout up to $1.5 million but the board can cut it to no less than $400,000, only the $400,000 minimum is grandfathered; the discretionary $1.1 million above it is treated as new compensation under the post-TCJA rules.⁴

Failing to exercise negative discretion is a separate question. Simply choosing not to reduce a payout the board had authority to reduce does not, by itself, count as a material modification.⁴ Having the power to reduce pay limits how much is binding; using or not using that power afterward does not retroactively blow up the grandfather.

What Counts as Material Modification

Any amendment that increases the amount payable destroys the grandfather for the entire contract, not just the incremental increase. A salary bump not contemplated by the original terms, an increase in the number of shares under an equity award, or a favorable change to an exercise price all qualify. Timing changes can be fatal too: accelerating a payment is a modification unless the payout is discounted for the time value of money, and delaying a payment is a modification if the deferred amount grows by more than a reasonable interest rate.

Interaction With Section 280G Golden Parachutes

When a covered employee receives change-in-control payments large enough to trigger Section 280G, the two deduction limits stack. Section 280G disallows the deduction for “excess parachute payments,” roughly the portion of a change-in-control payment exceeding 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 remaining 162(m) deduction cap for that person’s other compensation drops to $400,000.

For reporting, compensation subject to both limitations goes on the Section 280G line of Schedule M-3, Part III, Line 14, rather than the 162(m) line.⁷ Deals need to model both provisions together, because the combined disallowance can wipe out the deduction on a large share of change-in-control pay.

Timing and Deferred Compensation

The cap applies in the year the company claims the deduction, which generally tracks when compensation is paid or, for equity awards, when the award vests or is exercised. That timing rule matters most for deferred compensation. An executive who defers $3 million in bonuses does not run into the 162(m) cap on that amount until it is actually paid, potentially many years later.

The “once covered, always covered” rule closes the obvious workaround. A company cannot simply wait for an executive to retire and shed covered status, because covered status never ends. What Section 409A does allow is delaying a scheduled payment if the company reasonably anticipates the payment would be non-deductible under Section 162(m). That opens a narrow window to spread payments across tax years so that up to $1 million lands in each year against a person whose other pay is lower.

How It Shows Up on the Tax Return and in the Proxy

The disallowance is reported on Schedule M-3 of Form 1120. Part III, Line 15 is labeled “Compensation With Section 162(m) Limitation.” Total compensation expense for covered officers goes in column (a), the non-deductible amount over $1 million in column (b) or (c), and the deductible portion in column (d).⁷ Companies that received financial assistance under the Troubled Asset Relief Program have a $500,000 cap in place of the $1 million figure. Because the excess is a permanent difference rather than a timing difference, it raises the company’s effective tax rate and draws consistent audit attention.

The same numbers show up, in a different form, in the annual proxy statement. 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 pay rather than the deductible portion, a $15 million CEO compensation figure is effectively a public disclosure that at least $14 million is non-deductible. That gap between reported and deductible compensation is where the cost of Section 162(m) lives.

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)