Internal Revenue Code (IRC) Section 162(m) limits the tax deduction that publicly held corporations can claim for compensation paid to certain executives and highly paid officers (and, in limited cases, certain nonpublic entities subject to similar executive compensation limitations, such as specific health insurance providers). These federal tax limitations differ from U.S. GAAP reporting requirements that govern the same compensation, creating book-tax differences that must be analyzed and properly documented in accordance with Accounting Standards Codification Topic (ASC) 740, Income Taxes. Calculating and documenting these book-tax differences will be particularly challenging over the next few years, as several significant changes to Section 162(m) will take effect on overlapping timelines. For many organizations, these changes will require new coordination between tax, accounting, and executive compensation teams well before year-end.
To better navigate both current and upcoming changes, it’s helpful to understand how the deductibility of executive compensation has evolved over time, with particular attention to the modifications taking effect in 2026 and 2027 that will affect tax provisions and tax returns for publicly held corporations.
A brief history of Section 162(m)
Congress first enacted the limit on deductibility for executive compensation over 30 years ago. Section 162(m) disallows a tax deduction for remuneration in excess of $1 million paid by a publicly held corporation to a “covered employee” during a taxable year. At the time of enactment, “covered employees” included the CEO and the next four highest-paid officers. The law further provided that performance-based compensation was exempt, permitting companies to deduct these amounts without limitation.
The Tax Cuts and Jobs Act of 2017 (TCJA) introduced substantial modifications to Section 162(m), including the addition of the chief financial officer as a specifically covered officer. Consequently, the limit on deductibility applies to annual remuneration in excess of $1 million paid to the chief executive officer, CFO, and the next three highest-paid officers. The TCJA also removed the exception for performance-based compensation.
Lastly, the TCJA implemented a “once covered, always covered” provision. This rule provides that if an officer becomes subject to the 162(m) limitation at any point during their tenure, all compensation paid to them thereafter remains subject to the $1 million cap. For example, if a CEO transitions into a consulting or board position, amounts paid in excess of $1 million remain nondeductible to the corporation. This “once covered, always covered” rule applies to the CEO, CFO, and the next three highest-paid officers.
At the close of 2025, Section 162(m):
- Limits a publicly held corporation’s annual federal tax deduction for compensation paid to covered employees to $1 million each.
- Includes among “covered employees” the CEO, the CFO, the next three highest-paid officers, and any “once covered, always covered” individual who qualified as a covered employee after 2016.
- Applies to all forms of compensation, including salaries, bonuses, equity awards, and deferred compensation. Additionally, no exception exists for performance-based compensation.
Changes coming for 162(m) could impact 2026 quarterly estimates and tax provisions
Several changes to Section 162(m) will go into effect in 2026 and 2027, some of which may influence quarterly tax estimates and tax provision reporting. For tax years that begin after Dec. 31, 2025, certain provisions enacted as part of the One, Big, Beautiful Bill (OBBB) expand the rules that govern how remuneration from different corporations within an affiliated group are aggregated and allocated to determine how much a covered employee is paid, and if the total compensation exceeds the $1 million deductibility limit. As a result, some affiliated groups may become subject to the $1 million compensation limit for the first time, while others may reach the five covered-officer threshold after historically having fewer affected individuals. These changes could alter the amount of deductible compensation for tax purposes, which in turn may impact taxable income — and consequently affect the calculation of quarterly estimated taxes and the related income tax provisions.
The American Rescue Plan Act of 2021 (ARPA) modified the statute for tax years beginning after Dec. 31, 2026, expanding the definition of “covered employee” to include the five highest-paid employees of a corporation as well as the CEO, CFO, and top three executive officers (and any “once covered, always covered” individuals who met the officer criteria after 2016). Unlike the CEO, CFO, and other top executive officers, these five employees won’t be subject to the “once covered, always covered” rule; instead, their status will be retested annually. Importantly, the “once covered, always covered” rule doesn’t exclude an individual from being identified again as one of the five highest-paid officers in a future year. Each period, companies must first identify the CEO, CFO, and the next three highest-paid officers, then identify the five highest-paid employees, and finally include any additional officers who remain covered under the “once covered, always covered” rule but are not otherwise already captured.
In addition to the legislative changes to Section 162(m) scheduled for 2026 and 2027, Treasury has also released proposed regulations intended to clarify the definition of “employee” for purposes of identifying the top five highest-compensated employees and to provide guidance on the treatment of employees in affiliated groups. These new rules expand how remuneration paid across commonly controlled or affiliated entities is aggregated. The proposed guidance was released prior to the summer 2025 enactment of the OBBB, but it expresses Treasury’s concern “that a publicly held corporation may employ many of its highest-compensated employees at subsidiaries, and may even attempt to alter the composition of its five highest-compensated employees” by shifting individuals to subsidiary entities or by adopting a holding company structure. The proposed regulations will apply for tax years beginning after the later of Dec. 31, 2026, or the date of publication of the final regulations.
Tracking differences in tax return and financial statement expenses
Because Section 162(m) applies specifically to publicly held companies, affected taxpayers need to understand how the limitations on compensation impact the tax provision recorded in the financial statements and tax return.
At the basic level, annual remuneration in excess of $1 million paid to the CEO, CFO, the top three highest-paid officers, and any “once covered, always covered” officers, will create a permanent difference with a direct impact on the effective tax rate (ETR). For taxable years beginning after Dec. 31, 2026, annual remuneration in excess of $1 million paid to the five highest-paid employees will also create a permanent difference. Those payments for salary and other forms of compensation will be fully deductible for financial statement purposes, while the tax return deduction for those payments will be capped at $1 million per person, creating book-tax differences.
The complexity of compensation that can generate deferred tax assets
While the annual compensation paid to officers — and after 2026 — the top five employees create relatively straightforward permanent differences, executive compensation is often far more complex.
Timing differences between book and tax recognition of compensation frequently arise and under ASC 740, a deferred tax asset may be recognized only when the underlying item is expected to generate a future tax deduction. However, Section 162(m)’s $1 million limitation can prevent a corporation from realizing those deductions. When compensation that would otherwise be deductible becomes nondeductible due to the 162(m) cap, the related DTA must be reduced or removed since the associated tax benefit is no longer expected to be realized. As a result, Section 162(m) driven adjustments can have cascading effects not only on the DTA itself, but also on the overall valuation allowance evaluation, if applicable, and the income tax provision.
One common timing difference recorded as a DTA arises from stock-based compensation, particularly stock options that include multiple vesting conditions and broad exercise windows. For financial reporting purposes, stock compensation expense is recognized over the vesting period, generating a DTA because the company expects a future tax deduction. At exercise, the employee recognizes ordinary income equal to the difference between the fair market value and the exercise price, and the company claims a corresponding tax deduction. That deduction reduces the DTA, and any windfall or shortfall between the realized deduction and the recorded DTA gives rise to a new permanent difference, when applicable.
The intersection between deferred taxes and Section 162(m) occurs when the exercise of options, and the ability to recognize a deferred tax asset, in the future shifts who is on the top five paid employee list. Because covered-employee status in future years hinges on actual compensation paid in those periods, companies often don’t know in advance which individuals will appear in the top five highest-compensated group at the time options are exercised. Forecasting this requires assumptions about future roles, promotions, turnover, compensation changes, bonus payouts, and equity-award activity — none of which may be known when the related DTA is initially recorded. As a result, taxpayers must estimate covered-employee status based on uncertain information, increasing the risk that DTAs may later need to be significantly adjusted when actual compensation patterns emerge.
Additional conditions placed on the exercise of stock options can further compound the complexity. When an employee receives a restricted stock option that becomes exercisable upon a defined triggering event, the question becomes not only who will be a covered employee at exercise, but also when and how the options will be exercised. If the employee chooses to spread exercises across multiple years, the resulting compensation may stay below the $1 million threshold annually, allowing the company to retain full deductibility. Conversely, a single-year exercise could push an unexpectedly high-earning individual into the covered-employee group, causing compensation to exceed the threshold, and reducing or eliminating the anticipated deduction.
In such cases, a deferred tax asset may have been recorded based on assumptions that the $1 million limit could be triggered in a future period. But as exercise patterns and employee compensation trajectories become clearer, that DTA may need to be reversed or modified. Because DTAs are initially recorded using assumptions about employee behavior, future compensation levels, and option-exercise timing, assumptions that may later prove inaccurate, taxpayers must continuously reassess and adjusted DTAs as actual activity unfolds.
ASC 740 focuses on disclosure requirements
ASC 740 requires transparency for:
- The nature and effect of permanent differences impacting the effective tax rate. In the case of 162(m), that refers to the known amounts of compensation which will not be deductible for tax purposes in each year.
- Changes in deferred tax assets and valuation allowances. From a 162(m) standpoint, that can relate to estimates of future-option exercises and the impact they may have on financial statements and tax returns when exercised.
Planning and forecasting for 162(m) compliance
Publicly held corporations, and those that may be considering initial public offerings in the near future, should begin planning now to manage the full scope of Section 162(m) coverage, including the expansion after Dec. 31, 2026, to cover the five highest-paid employees. Key components of this effort include:
- Expanded compensation tracking for covered employees and those that may become covered employees in the future.
- Coordination across affiliated corporate groups for deduction allocation.
- Preparation for increased complexity starting in 2026 and 2027. Changes to affiliated group rules may impact quarterly tax estimates and quarterly provisions for 2026. The expansion of 162(m) to the five highest-paid employees in 2027 will add an additional level of complexity that taxpayers should begin to address as soon as possible.
Tax teams should be working with their accounting advisors to incorporate Section 162(m) limitations into ETR forecasts and tax provision models. Collaboration with executive compensation teams is critical to anticipate nondeductible amounts and avoid surprises during quarterly or year-end reporting. A first step for many businesses will be evaluating if the communication channels needed to support this coordination currently exist between the tax, accounting, and HR professionals or addressing if it needs to be built.
This checklist may help tax leaders prepare for the expanded coverage of Section 162(m) and its impact on the financial statements as well as the tax return:
- Review executive compensation arrangements to identify amounts subject to Section 162(m) limitations. Be aware of the impact of affiliated group rules. Create communication channels among affiliated group members to make sure teams are aware and sharing information as needed.
- Update tax provision models to reflect permanent differences and adjust DTAs accordingly.
- Assess whether deferred tax assets should be recognized or reduced as compensation deductions become limited under Section 162(m), and evaluate valuation allowance implications where applicable.
- Enhance disclosures to meet ASC 740 requirements for ETR impacts.
- Collaborate with HR and compensation teams to forecast nondeductible amounts and avoid surprises.
It’s somewhat ironic that the fundamental deduction limit for executive compensation has remained unchanged at $1 million, even as the surrounding rules have evolved in ways that make compliance increasingly complex. The expansion of coverage to a new class of employees and the new aggregation rules taking effect in 2026 and 2027 will require careful, and thorough forward-looking preparation by affected taxpayers. Companies should consult with their tax and financial statement advisors to understand how these changes may impact their taxable income and financial statement reporting.
