Navigating the Executive Compensation Deductibility Limits: IRC Section 162(m)
For publicly held corporations, designing competitive executive compensation packages requires careful attention to tax deductibility. Under Internal Revenue Code (IRC) Section 162(m), public companies are statutorily barred from deducting more than $1 million in annual compensation paid to "covered employees." With corporate tax rates representing a substantial cost of business, the loss of these deductions can significantly increase a company's effective tax rate (ETR) and cash tax liabilities.
The Historical Evolution: From TCJA to ARPA
Historically, Section 162(m) contained a major exemption for "qualified performance-based compensation" (such as stock options and performance share units). This allowed corporations to deduct unlimited amounts of compensation, provided they met rigorous performance criteria and shareholder approval requirements. However, the Tax Cuts and Jobs Act (TCJA) of 2017 completely repealed the performance-based exception for tax years beginning after December 31, 2017. TCJA also introduced the strict **"once a covered employee, always a covered employee"** rule, which dictates that any individual classified as a covered employee for any tax year beginning after 2016 remains covered forever.
The Major 2026 Shift: The American Rescue Plan Act (ARPA) Expansion
Beginning in the 2026 tax year (specifically for taxable years beginning after December 31, 2025), the American Rescue Plan Act (ARPA) of 2021 dramatically expands the scope of Section 162(m). Instead of covering only five executives (the CEO, the CFO, and the three next highest-compensated officers), Section 162(m) now covers **ten executives** per year. The law adds the **next five highest-compensated employees** for the taxable year to the list of covered employees.
This 2026 expansion will drag many non-executive VP-level employees into the 162(m) net, resulting in significant disallowed deductions for mid-to-high level executives whose compensation crosses $1 million due to stock vesting or sales commissions.
A Crucial Distinction: Perpetual vs. Year-by-Year Coverage
Fortunately, ARPA was drafted with a key structural difference for the new "Next 5" employees compared to the original 5 covered employees:
- CEO, CFO, and Top 3 (and Historic Covered Employees): Subject to the "once covered, always covered" rule. Once an executive is designated in this group, any compensation paid to them—including deferred compensation, severance, and retirement benefits paid years later—is permanently capped at $1 million.
- ARPA Next 5 (Employees 6-10): NOT subject to the "once covered, always covered" rule. They are evaluated on a year-by-year basis. If they fall out of the top ten highest-paid employees in a subsequent year, their compensation in that year is fully deductible without the $1 million limit.
Strategic Tax Planning: Maximizing Deductibility with NQDC Deferrals
Because the ARPA "Next 5" employees are subject to year-by-year evaluation, corporations can use **Nonqualified Deferred Compensation (NQDC)** plans under Section 409A as a powerful tax planning shield:
If a VP's salary and equity vesting in 2026 are scheduled to reach $1.5 million, the $500,000 excess is non-deductible, costing the company $129,000 in lost tax shields (assuming a 25.8% combined tax rate). If, however, the executive is allowed to defer that $500,000 under a NQDC plan to be paid out post-retirement, and in that retirement year they are no longer in the Top 10 active earners, the full $500,000 becomes corporate-deductible when paid.
This strategy does not work for the CEO or CFO, because their post-retirement payouts remain permanently capped under the perpetual covered employee rules. Tax departments must separate these two classes of covered employees to optimize corporate deductions.
The Written Binding Contract Grandfathering Exception
Under the TCJA transition relief, compensation paid under a **written binding contract in effect on November 2, 2017**, which was not materially modified after that date, is grandfathered. Grandfathered compensation is not subject to the post-TCJA Section 162(m) rules. This means grandfathered compensation can continue to use the old "qualified performance-based" exception and does not count towards the $1 million cap on non-grandfathered compensation. Corporate tax teams must rigorously track and document these pre-2017 agreements to defend these deductions on audit.