Code Section 162(m): Change on the Horizon for 2027 – Expansion of public company employees whose compensation will be subject to deduction limit

Key Takeaway

Currently, Section 162(m) of the Internal Revenue Code (“Section 162(m)”) limits the deductibility of compensation paid by publicly held corporations to certain “covered employees,” which can generally be thought of as the corporation’s named executive officers. Beginning January 1, 2027, the “covered employee” definition under Section 162(m) will be expanded to include an additional five employees who are not required to be executive officers of the company. Public companies should be mindful of the change for tax planning purposes.

Explanation of the Change

Section 162(m) limits the amount a publicly held corporation may deduct for compensation paid to a “covered employee” to no more than $1,000,000 per year. A “covered employee” under Section 162(m) currently includes a publicly held corporation’s chief executive officer, chief financial officer, and the next three highest compensated officers in the taxable year, as well as anyone who met any of these criteria in any taxable year beginning after December 31, 2016. As a result, once an officer falls into this category for one taxable year, the officer will remain a “covered employee” for every year after that (such officers, the “Covered Officers”).

In 2021, the American Rescue Plan Act of 2021 amended the definition of “covered employee” under Section 162(m) to include an additional five employees (referred to here as the “Additional 5”), but this amendment was not to take effect until taxable years beginning after December 31, 2026. The Additional 5 consists of the next five highest compensated employees following the Covered Officers, and unlike Covered Officers, there is no requirement that members of the Additional 5 are officers of the publicly held corporation. Another notable difference between the Additional 5 and the Covered Officers is that a “covered employee” in the Additional 5 in one taxable year will not automatically remain a “covered employee” for every taxable year that follows, so an employee in the Additional 5 may be a “covered employee” one year but not the next. 

In January 2025, the IRS released proposed regulations to provide guidance on the “Additional 5” in preparation for it to take effect in 2027. The proposed regulations include the following key items:

• Fleshing out the definition of “employee” by stating that it will have the meaning under section 3401(c) of the Internal Revenue Code, which includes common-law employees and corporate officers, and making clear that the Additional 5 is not limited to executive officers;
• Clarifying that the Additional 5 can include an employee who is also picked up by the “once covered, always covered” rule, so a member of the Additional 5 could already be a “covered employee” as a Covered Officer;
• Defining “compensation” as set forth in the current regulations (i.e., amounts otherwise deductible but for Section 162(m)) to determine the Additional 5, rather than compensation as disclosed under the Exchange Act, given that the Additional 5 is not limited to executive officers;
• Providing that an employee of any corporation within the publicly held corporation’s affiliated group can count as one of the Additional 5 even if the employee is not employed by or providing services for the publicly held corporation, so a company cannot evade Section 162(m) by employing highly compensated employees at subsidiaries, and further explaining that a publicly held corporation’s affiliated group includes foreign corporations; and
• Making clear that an individual who is technically employed by a professional employer organization or other unaffiliated organization is still an employee of the publicly held corporation if the individual performs substantially all services for the publicly held corporation, such that Section 162(m) cannot be evaded through third-party payor arrangements.

As of this writing, the final regulations have not yet been published, and though there has been some indication that further guidance from the IRS in respect of Section 162(m) is anticipated this fall, it remains unknown if these regulations will be finalized before the end of 2026.  

Regardless of whether the final regulations are published before year-end, however, the Additional 5 will be coming in 2027, so public companies need to be prepared for this change. And the proposed regulations will be a useful resource for guidance on how the Additional 5 should be determined.  

With 2027 right around the corner, public companies need to be thinking about who the Additional 5 may include and what the impact will be on the company. Given the expansive nature of the “covered employee” definition for purpose of the Additional 5, it will be important to make sure that the full universe of potential “covered employees” is being considered, such as employees at subsidiaries or other entities within the publicly held corporation’s affiliated group. In the immediate near-term, public companies may want to consider whether there are any future year payments to expected members of the Additional 5 that could be made before year-end 2026. Additionally, thought may be given to who the Covered Officers are already and how the Additional 5 will impact the total number of “covered employees” for purposes of Section 162(m).

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