The Rapidly Expanding Scope of the
IRC §162(m) Limit on Deductibility of
Compensation in Excess of $1 Million
By Charles C. Shulman, Esq.
Executive Summary. The federal tax landscape for executive compensation has shifted dramatically over the last few years. While the $1 million deduction limit under IRC §162(m) was once a predictable math exercise for public companies, a number of developments significantly widened the regulatory net: (i) the One Big Beautiful Bill Act of 2025 (“OBBBA”) expansion pulls in private entities and non-corporate businesses that are affiliated with publicly held corporations; (ii) the American Rescue Plan Act of 2021 (“ARPA”) “Next Five” rules targets non-officers; and (iii) the September 2024 IRS Audit Technique Guide threatens legacy contracts. Starting in 2026, many previously exempt private entities find themselves subject to these limits for the first time. This memo outlines the critical changes that must be addressed to avoid unexpected tax hits.
1. The Internal Revenue Code § 162(m) $1 Million Deduction Limit if Publicly Held Corporation in the Group. Businesses can usually deduct the full amount of salaries and bonuses they pay to their employees as a necessary business expense. However, Section 162(m) of the tax code creates a very significant exception for public companies. It provides that once a “covered employee” (typically a top executive) makes more than $1 million in a single year, the company can no longer deduct any pay above that $1 million threshold. This means the company must pay corporate income taxes on that “excess” pay as if it were profit, which effectively increases the cost of employing top talent. While this rule was once a simple calculation for the CEO and a few top officers, recent laws have expanded it to cover more employees and even private companies that’re part of a larger business group.
2. The OBBBA Expansion: Non-Corporate Affiliates Also Included (Effective 2026). The One Big Beautiful Bill Act of 2025 (OBBBA § 70603), signed into law on July 4, 2025, significantly broadens the reach of IRC § 162(m). Prior to this legislation, the $1 million deduction limit applied only to publicly held corporations and their corporate affiliates as defined in IRC § 1504. IRC § 162(m)(2); Treas. Reg. §§ 1.162-27(c)(1) (1995) & 1.162-33(c)(1) (2020). This did not include affiliated partnerships, LLCs, or other non-corporate entities. For taxable years beginning after December 31, 2025, OBBBA adds IRC § 162(m)(7), which expands the limitation to any entity within a publicly held corporation’s “controlled group” under IRC § 414(b), (c), (m), and (o). Because § 414 encompasses unincorporated trades or businesses under common control, partnerships and LLCs are now pulled into the regulatory net. Consequently, the public company’s $1 million limit must be shared across every member of the controlled group that pays the executive. Companies can no longer preserve a deduction by isolating compensation in a private, non-corporate subsidiary.
3. The Tier 2 Revolution: The Next Five (Effective 2027). Under the American Rescue Plan Act of 2021 (ARPA § 9708), the definition of a “covered employee” expands for tax years beginning after December 31, 2026 (i.e., 2027 for calendar-year corporations). ARPA creates a two-tiered system for tracking high earners. Specifically: Tier 1 includes the CEO, CFO, and the three other highest-compensated executive officers (as determined under SEC rules). IRC §162(m)(3)(A) & (B). (This has not changed.) Tier 1 employees remain “covered employees” permanently under the “once a covered employee, always a covered employee” rule of IRC §162(m)(3)(D), as added by the Tax Cuts & Jobs Act of 2017 (TCJA § 13601), effective for taxable years beginning after 2016. Under ARPA 2021, a “Tier 2” was added to “covered employees” for purposes of §162(m), with such Tier 2 employees including the next five highest-paid employees who are not Tier 1 employees, and Tier 2 employees need not be officers. IRC §162(m)(3)(C) as added by ARPA 2021, effective for taxable years beginning after December 31, 2026. ARPA also provides that unlike Tier 1, Tier 2 employees remain covered only for the years in which they rank among the top five highest-paid employees. IRC §162(m)(3)(D) as amended by ARPA 2021.
4. 2025 Proposed Regulations. The January 2025 proposed amendments to Treas. Reg. § 1.162-33 (90 Fed. Reg. 4691 (Jan. 16, 2025)) provide interpretive guidance on how Tier 2 employees are identified and ranked. The proposed regulations clarify that Tier 2 employees are ranked using tax-based compensation principles (e.g., Form W-2 Box 1 wages), rather than the SEC proxy disclosure framework used for Tier 1 determinations. They also include an anti-avoidance rule under which individuals are treated as employees if they perform “substantially all” services for the corporation, even if they are technically paid by a Professional Employer Organization (PEO). In addition, multinational groups must aggregate foreign-paid compensation from Controlled Foreign Corporations (CFCs) when determining the “Next Five.” Because Tier 2 status is not permanent, a one-time compensation spike does not result in a lifetime deduction limitation for that employee.
5. IRS Audit Focus: The Death of Negative Discretion. For companies still relying on “grandfathered” contracts in effect on November 2, 2017, the margin for error has vanished. The September 2024 IRS Section 162(m) Audit Technique Guide (Publication 6014) imposes rigorous scrutiny on these legacy awards. The guide clarifies that negative discretion is the legal right of the committee not to pay all or a portion of the compensation. It also states that amounts subject to this discretion aren’t eligible to be grandfathered because the corporation wasn’t obligated to pay them. Finally, the guide states that any material modification, like moving up a payment date without a discount for the time value of money, will eliminate the grandfathered status and lose the deduction. One should be very careful with any changes to these old deals to ensure no inadvertent modifications have occurred.
6. Immediate Action Items. To prepare for these shifts, we recommend the following steps: (i) map out your entire organizational structure under the §414 controlled group rules to identify every entity now subject to proration; (ii) begin “shadow tracking” your top five non-officer earners now to prepare for the 2027 Tier 2 list; (iii) have counsel review any remaining grandfathered awards against the 2024 Audit Guide; and (iv) identify any high-earners formally employed by third parties (like PEOs) who may now be subject to the limit. Early coordination among payroll, benefits, and finance teams is essential. Systems must be ready for the transition before year-end as many provisions go into effect in January 2026.
