What is Section 162(m) and how does it affect publicly held corporations in 2026?

Section 162(m) of the Internal Revenue Code limits the tax deduction a publicly held corporation can take for compensation paid to certain top executives to $1 million per year per executive. For the 2026 tax year, this limitation continues to apply, but the definition of 'covered employees' has expanded due to the American Rescue Plan Act (ARPA) and the 'controlled group' concept introduced by the One Big Beautiful Bill Act (OBBBA). This means more executives within a corporation and its related entities will likely be subject to the $1 million deduction cap, potentially increasing the amount of non-deductible compensation for the company.

Who is considered a 'covered employee' under Section 162(m) for the 2026 tax year?

For tax years beginning after December 31, 2026 (which includes 2026), the definition of a 'covered employee' is significantly broader. It includes the Principal Executive Officer (PEO) and Principal Financial Officer (PFO) at any time during the year, the three highest compensated executive officers (excluding the PEO/PFO), and the next five highest compensated employees (whether or not they are officers). Additionally, the 'once covered, always covered' rule means that anyone who was a covered employee in any tax year beginning after December 31, 2016, remains a covered employee indefinitely, even if their compensation or role changes.

How do the 'affiliated group' and 'controlled group' rules impact Section 162(m) in 2026?

The OBBBA, effective for tax years beginning after December 31, 2025, replaced the 'affiliated group' concept with a broader 'controlled group' for Section 162(m) purposes. This means that publicly held corporations must now consider compensation paid to employees by all members of their controlled group (as defined under IRC sections 414(b), (c), (m), and (o)) when identifying covered employees and calculating the total compensation subject to the deduction limit. This expansion aims to prevent companies from circumventing the limitation by moving highly compensated employees or their compensation to related entities that were previously not considered part of the affiliated group.

What types of compensation are subject to the $1 million deduction limit?

The $1 million deduction limit applies to all forms of applicable employee remuneration, including salary, bonuses, commissions, and equity awards (such as stock options and restricted stock units). Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, there was an exception for performance-based compensation, but this exception was largely eliminated for tax years beginning after December 31, 2017, subject to certain grandfathering rules for existing contracts.

Are there any exceptions to Section 162(m) for the 2026 tax year?

While the performance-based compensation exception was largely repealed by the TCJA, certain compensation arrangements that were in effect under a written binding contract on November 2, 2017, and not materially modified thereafter, may still be grandfathered and exempt from the $1 million deduction limit. However, corporations must carefully review these arrangements to ensure they meet the strict criteria for grandfathered treatment. There are no other general exceptions to the $1 million limit for applicable employee remuneration.

How does a publicly held corporation report the Section 162(m) limitation on its tax return?

Section 162(m) is a deduction limitation, not a separate deduction that is claimed. Publicly held corporations account for the disallowed amount when preparing their corporate income tax returns, typically Form 1120, U.S. Corporation Income Tax Return. The non-deductible portion of executive compensation is not included in the company's deductible expenses, thereby increasing its taxable income. Corporations must maintain detailed records to support their compensation deductions and the application of Section 162(m) rules.

What are some common mistakes companies make regarding Section 162(m)?

Common mistakes include misidentifying covered employees due to the expanded definitions and the 'once covered, always covered' rule, failing to properly apply the new 'controlled group' rules for aggregating entities and compensation, inadequate tracking of all forms of compensation across related entities, overlooking the specific requirements for grandfathered arrangements, and a lack of proactive planning. These errors can lead to incorrect tax calculations, underpayment of taxes, and potential penalties from the IRS. Consulting with tax professionals is highly recommended to ensure compliance.

Executive Compensation Limitation — Section 162(m)

Overview: Executive Compensation Limitation — Section 162(m)

Section 162(m) of the Internal Revenue Code (IRC) is a critical provision that limits the deductibility of executive compensation for publicly held corporations. Enacted in 1993, its primary aim was to curb excessive executive pay by disallowing a tax deduction for compensation exceeding $1 million paid to certain top executives. Over the years, this section has undergone significant amendments, most notably by the Tax Cuts and Jobs Act (TCJA) of 2017, the American Rescue Plan Act (ARPA) of 2021, and the recent One Big Beautiful Bill Act (OBBBA) of 2025. These legislative changes have progressively expanded the scope of Section 162(m), making it more complex for publicly held corporations to navigate.

For the 2026 tax year, corporations must contend with the cumulative effects of these amendments. The $1 million deduction limit remains a cornerstone, but the definition of “covered employees” has broadened, and the rules for aggregating related entities have shifted from an “affiliated group” to a more expansive “controlled group.” This guide provides a comprehensive overview of Section 162(m) for the 2026 tax year, detailing its purpose, who it affects, how to comply, and common pitfalls to avoid.

What is the Executive Compensation Limitation — Section 162(m)?

IRC Section 162(m) generally disallows a publicly held corporation from deducting compensation paid to a “covered employee” to the extent that the compensation exceeds $1 million for the taxable year. This limitation applies to all forms of compensation, including salary, bonuses, commissions, and equity awards, regardless of whether they are performance-based. Prior to the TCJA, there was an exception for performance-based compensation, but this was largely eliminated for tax years beginning after December 31, 2017, subject to certain grandfathering rules.

The intent behind Section 162(m) is to discourage excessive executive compensation by making it less tax-efficient for corporations. While it doesn't prohibit companies from paying executives more than $1 million, it removes the tax benefit of deducting the amount exceeding the limit. This effectively increases the cost of such compensation for the corporation.

Who Qualifies (Eligibility Criteria)?

The applicability of Section 162(m) hinges on two key definitions: “publicly held corporation” and “covered employee.”

Publicly Held Corporation

For tax years beginning after December 31, 2017, a “publicly held corporation” includes any corporation that is an issuer of securities required to be registered under Section 12 of the Securities Exchange Act of 1934, or that is required to file reports under Section 15(d) of that Act. This definition is broad and encompasses most companies whose stock is publicly traded.

Covered Employee

The definition of a “covered employee” has evolved significantly. For tax years beginning after December 31, 2026, the ARPA amendments expand this definition to include:

The principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year.
The three highest compensated executive officers (other than the PEO or PFO) for the taxable year.
The next five highest compensated employees (whether or not executive officers) for the taxable year.
Anyone who was a covered employee for any preceding taxable year beginning after December 31, 2016 (the “once covered, always covered” rule). This rule means that once an individual is identified as a covered employee, they remain a covered employee for all future years, even if their compensation drops below the $1 million threshold or they change roles within the company or its controlled group.

The OBBBA, effective for tax years beginning after December 31, 2025, further refines the scope by replacing the “affiliated group” concept with a broader “controlled group” for identifying covered employees and aggregating compensation. This means that compensation paid by any member of a corporation’s controlled group (as defined under sections 414(b), (c), (m), and (o)) must be considered when determining covered employees and the total compensation subject to the deduction limit. This expansion aims to prevent companies from circumventing the limitation by shifting highly compensated employees or their compensation to related, but previously unaffiliated, entities [1] [2] [3].

How to Claim It (Form Numbers, Schedule, Process)

The Section 162(m) limitation is not a deduction that companies claim, but rather a limitation on a deduction. Therefore, there isn't a specific IRS form to file to claim 162(m). Instead, publicly held corporations must account for the deduction disallowance when preparing their corporate income tax returns, typically Form 1120, U.S. Corporation Income Tax Return. The disallowed amount is reflected in the calculation of taxable income. While there isn't a dedicated form for 162(m) itself, the impact of the limitation will be evident in the compensation expense reported on the corporate tax return and related schedules. Corporations may need to maintain detailed records to support their compensation deductions and the application of Section 162(m) [4].

2026 Limits, Amounts, or Rates

For the 2026 tax year, the core limitation under Section 162(m) remains a $1 million deduction cap per covered employee. This means that any compensation paid to a covered employee in excess of $1 million is not deductible by the publicly held corporation. It is crucial to understand that this is a per-employee limit, not an aggregate limit for all executives.

The significant changes for 2026 primarily revolve around the expanded definition of “covered employees” due to ARPA and the broader “controlled group” concept introduced by OBBBA. While the $1 million threshold itself has not changed, the number of individuals whose compensation is subject to this limit has increased. This means more executives within a publicly held corporation and its controlled group will fall under the purview of Section 162(m), potentially leading to a larger aggregate amount of non-deductible compensation for the corporation.

There are no specific rates associated with Section 162(m); it is a direct dollar-for-dollar disallowance of the deduction for compensation exceeding the $1 million threshold. The impact on a corporation's tax liability will depend on its marginal tax rate. For example, if a corporation pays a covered employee $5 million, $4 million of that compensation will be non-deductible. At a 21% corporate tax rate, this would result in an additional tax liability of $840,000 ($4 million * 0.21).

Common Mistakes That Cost Taxpayers Money

Navigating Section 162(m) can be complex, and several common mistakes can lead to significant tax liabilities for publicly held corporations:

Misidentifying Covered Employees: With the expanded definition of covered employees for 2026, particularly the inclusion of the next five highest compensated employees and the “once covered, always covered” rule, corporations may fail to accurately identify all individuals subject to the limitation. This can lead to understating non-deductible compensation.
Ignoring the Controlled Group Rules: The shift from an “affiliated group” to a “controlled group” for identifying covered employees and aggregating compensation is a major change. Corporations that do not properly account for all entities within their controlled group risk miscalculating the total compensation subject to the limit and incorrectly determining their covered employees.
Inadequate Tracking of Compensation: Companies must have robust systems in place to track all forms of compensation paid to covered employees, including salary, bonuses, and equity awards, across all entities within their controlled group. Failure to do so can result in inaccurate calculations of the non-deductible amount.
Overlooking Grandfathered Arrangements: While the performance-based compensation exception was largely eliminated, certain grandfathered arrangements from before the TCJA may still be exempt. Corporations need to carefully review existing compensation plans to determine if any qualify for grandfathered treatment.
Lack of Proactive Planning: Waiting until year-end to address Section 162(m) can be costly. Proactive planning, including reviewing compensation structures and forecasting potential non-deductible amounts, allows corporations to make informed decisions and potentially mitigate the impact of the limitation.
Failure to Consult with Experts: Given the evolving nature and complexity of Section 162(m), relying solely on internal resources without expert tax advice can lead to errors. Engaging with tax professionals specializing in executive compensation can help ensure compliance and optimize tax positions.

IRS Code Section Reference

The primary legal authority for the executive compensation limitation is Internal Revenue Code Section 162(m): “Certain employee remuneration in excess of $1,000,000.”

Further guidance and regulations can be found in:

Treasury Regulations § 1.162-27 (for pre-TCJA rules and certain grandfathered arrangements)
Public Law 115-97 (Tax Cuts and Jobs Act of 2017)
Public Law 117-2 (American Rescue Plan Act of 2021)
Public Law 119-1 (One Big Beautiful Bill Act of 2025)
Proposed Regulations REG-118988-22 (January 14, 2025), addressing ARPA amendments to Section 162(m) [5]

Book a Consultation with Uncle Kam

Understanding and complying with the intricacies of Section 162(m) is crucial for publicly held corporations. The evolving landscape of executive compensation regulations demands careful attention and strategic planning. Don't let complex tax rules lead to unexpected liabilities. Our team of experienced tax strategists and CPAs at Uncle Kam is here to help you navigate these challenges, ensure compliance, and optimize your tax position.

Ready to discuss your executive compensation strategy for the 2026 tax year? Book a consultation with us today to ensure your business is prepared and compliant.

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