Who Qualifies as a 162(m) Covered Employee? Categories and ARPA Rules

A 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 Internal Revenue Code Section 162(m). The status attaches to the company’s principal executive officer, its principal financial officer, and the next three highest-paid officers for the year, and it sticks: once someone lands in one of those roles for any tax year beginning after December 31, 2016, they remain a covered employee for the rest of the corporation’s existence. Starting with tax years after December 31, 2026, five additional highly compensated employees join the list each year.¹

The consequence is straightforward. Every dollar of pay above $1 million that the corporation delivers to one of these people in a given year is not deductible, no matter what form the compensation takes.

The Three Current Categories

For tax years through 2026, the statute names covered employees through three separate definitions.

The Principal Executive Officer and Principal Financial Officer

Anyone serving as the corporation’s PEO or PFO at any point during the taxable year is a covered employee. The statute explicitly includes people “acting in such a capacity,” so interim and acting officers count. The PEO is typically the CEO and the PFO is typically the CFO, matching how these roles are reported to the SEC. 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 picks up the three highest-compensated officers 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 appearing in the Summary Compensation Table of the company’s proxy statement. The measure is total compensation for the year, and the person does not need to be employed on the last day of the taxable year to qualify.

There is also a catch-all: an employee who would fall into this top-three group if proxy disclosure were required is still a covered employee even when the company’s actual SEC reporting obligations don’t reach them.¹

Once Covered, Always Covered

The fourth piece of the definition is a permanent-status rule rather than a new category. Anyone who was a PEO, PFO, or one of the three highest-compensated officers for any tax year beginning after December 31, 2016, remains a covered employee forever. That is true whether the individual is later demoted, moves to a lower-paid role, leaves the company, or retires.¹

The status also survives the individual’s death. Deferred compensation, severance installments, and other amounts paid to a former covered employee’s estate or beneficiaries after death remain subject to the $1 million cap. The statute refers to anyone who “was” a covered employee, with no expiration tied to the person’s lifetime. If someone became a covered employee in 2018 and a large deferred compensation payment hits ten years later, the corporation’s deduction on that payment is still limited to $1 million for the year.

Because of this permanence, companies need tracking systems that follow former covered employees indefinitely, not just current officers.

The ARPA Expansion: Five More Employees Starting in 2027

The American Rescue Plan Act of 2021 added a new category. For taxable years beginning after December 31, 2026, the five highest-compensated employees of the corporation — other than anyone already picked up as PEO, PFO, or one of the top-three officers — also become covered employees.¹ For calendar-year taxpayers, the first year this applies is 2027.

Two features set this group apart from the existing categories. First, these five employees do not have to be officers. A highly paid engineer, banker, trader, or portfolio manager with no corporate-officer title can be pulled in based on compensation alone. Second, membership is not permanent. The “once covered, always covered” rule references only the PEO/PFO category and the top-three-officer category, not the ARPA five. So this group is redetermined each year, and an employee who lands in it one year may fall out the next if compensation shifts relative to peers.

The IRS published proposed regulations in January 2025 to implement the expansion. Under those proposed rules, the compensation used to identify the ARPA five is the amount that would be deductible before applying the 162(m) cap, rather than the SEC proxy disclosure figure used for the top-three officers. Compensation from all members of an affiliated group is aggregated when identifying the five.² As of mid-2025, the 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 Corporations This Applies To

Covered-employee status only exists inside 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.¹³ That captures the obvious cases — companies with stock listed on a national exchange — and also companies that have only publicly traded debt or that trigger SEC reporting requirements without actively traded equity.

Foreign private issuers meeting these registration or reporting requirements are included. So are affiliated groups: if even one member of an affiliated group of corporations is publicly held, each publicly held member within the group applies the $1 million cap independently to its own covered employees.⁴

Companies that went public after December 20, 2019, face the full rules immediately. The old IPO transition rule that once gave newly public companies a grace period was tied to the pre-TCJA performance-based compensation exception, and the final regulations repealed the transition rule for any company becoming publicly held after that date. SPAC transactions closing after December 20, 2019, get no transition relief either.

What Compensation Counts Against the Cap

Once an individual is identified as a covered employee, the corporation totals the “applicable employee remuneration” paid to that person for the year, and everything above $1 million is non-deductible. The definition is broad: it covers compensation in any form, cash or non-cash, for services performed in any year.¹

Timing is as important as amount. The $1 million limit applies in the year the compensation would otherwise be deductible. A stock option isn’t tested against the cap when it’s granted; it’s tested in the year it’s exercised, because that’s when the deduction arises. Non-qualified deferred compensation is tested in the year it’s paid out. A single large exercise or deferred payout can consume the whole $1 million allowance for the year, leaving every other dollar of that employee’s pay non-deductible.

Two categories of pay escape the cap. Contributions to and distributions from qualified retirement plans (such as 401(k) plans and defined benefit pensions) are excluded, and benefits the employee can exclude from gross income — employer-provided health insurance and other tax-free fringe benefits — are also excluded.¹ These exclusions are narrow. Stock options, restricted stock, bonuses, and deferred compensation — the items that actually push executive pay above $1 million — are all fully within the cap.

The pre-2018 exclusion for qualified performance-based compensation is gone. The Tax Cuts and Jobs Act repealed it for tax years beginning after December 31, 2017.⁴ Awards specifically designed as performance-based, which would have been fully deductible under the old regime, now count against the cap like anything else. A narrow grandfathering rule preserves the old treatment for compensation paid under written binding contracts in effect on November 2, 2017, provided those contracts have not been materially modified.⁵

Covered-Employee Status in Mergers and Departures

The permanence of covered-employee status makes M&A due diligence part of the compliance picture. An acquiring public company inherits the covered-employee status of a target’s executives. Diligence teams need to identify every individual who was a covered employee of the target (or any predecessor) going back to 2017, because the “once covered, always covered” obligation transfers to the successor entity.

The stakes are highest when a publicly held company is acquired by a private buyer. Transaction-related payments — golden parachute cash-outs, accelerated equity vesting, deal bonuses — are often the largest single-year compensation events in an executive’s career, and they run straight into the $1 million cap during the final short tax year of the target. The regulations make clear that 162(m) applies to that short tax year and that the three highest-compensated officers are identified using the short year as the measurement period. Even after a target goes private as a subsidiary, the covered-employee designation follows those individuals, so any future compensation the successor or its affiliates pay them remains capped.

Identifying Covered Employees Is Not the Same as Calculating the Cap

A subtlety worth flagging: the compensation figure used to decide who the covered employees are is not the same figure used to apply the $1 million cap.

For the three highest-compensated officers, the measurement follows SEC proxy disclosure rules, essentially the total compensation column in the Summary Compensation Table, which includes salary, bonus, non-equity incentive pay, and the grant-date fair value of equity awards. For the ARPA five (starting in 2027), the proposed regulations use a different measure: the amount that would be deductible by the corporation before the 162(m) limit is applied.²

Once someone is identified, the separate “applicable employee remuneration” calculation controls how much of their pay is non-deductible. That second calculation captures all compensation for services in any year, measured when the deduction would otherwise be taken, not the current year’s grant-date values. So an executive whose grant-date compensation looks modest can still be a covered employee based on proxy rules, while a non-officer with enormous option exercises may be caught by the ARPA five test but not the proxy-based top-three test. Both determinations need to run separately each year.

1
Office of the Law Revision Counsel. 26 USC 162 – Trade or Business Expenses
2
Federal Register. Certain Employee Remuneration in Excess of $1,000,000 Under Internal Revenue Code Section 162(m)
3
Office of the Law Revision Counsel. 15 USC 78l – Registration Requirements for Securities
4
Internal Revenue Service. Section 162(m) Audit Technique Guide
5
Internal Revenue Service. Notice 2018-68 – Guidance on the Application of Section 162(m)