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Article | Executive Pay Memo North America

IRS issues proposed regulations on 2027 expansion of ‘covered employees’ under Code section 162(m)

By Stephen Douglas and Steve Seelig | January 29, 2025

IRC Section 162(m) is expanding to add five more employees who are subject to the $1 million deduction limit. Deferred compensation may provide a solution.
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The Internal Revenue Service has issued proposed guidance on how publicly held corporations would apply the expanded coverage of Internal Revenue Code section 162(m), which takes effect beginning in 2027.

In 2021, to help raise revenue, the American Rescue Plan Act (ARPA) expanded the number of covered employees subject to the $1 million deduction limit under Section 162(m). The expansion includes the five highest compensated employees – regardless of position in the organization – for the taxable year. This change means that a minimum of 10 employees will be covered by the $1 million deduction limitation for most corporations.

Under pre-2027 Section 162(m), a corporation’s “covered employees” included any principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year. It also included any employee who is among the three highest compensated officers for that taxable year (other than the PEO or PFO).

In 2017, Section 162(m) was amended to include a provision that said once an individual is a covered employee, they will remain a covered employee for as long as compensation is paid by the corporation on their behalf – even after leaving the company and for payments after death. This “once/always” rule does not apply to employees who become subject to Section 162(m) solely because of the ARPA 2017 expansion.

This means that paying deferred compensation to the ARPA group of covered employees after employment termination may avoid the application of the $1 million deduction limit. However, this technique generally would not work for pre-ARPA covered employees. That’s because the once/always rule means that deferred compensation earned during years while in that group generally are subject to the Section 162(m) limit, regardless of when paid, unless those deferrals took place in years before the once/always rule took effect.

As with any tax law, things can get complicated in complex corporate structures. The proposed regulations generally follow the existing regulations as to how:

  • Corporations in parent/subsidiary and brother/sister configurations apply the rules to determine who are covered employees 
  • To apportion compensation among corporations in which employees perform services for more than one entity to determine who are covered employees, including rules for controlled foreign corporations and
  • The deduction limit is calculated for acquired and divested corporations

The proposed regulations provide that they will take effect for taxable years beginning after the later of Dec. 31, 2026, or the date they are finalized. This does not mean that application of the new law can be delayed; rather, corporations would follow a good faith interpretation of the law until the final rules are published.

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Senior Director, Retirement and Executive Compensation

Senior Director, Executive Compensation

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