Section 162(m) and the $1 Million Cap: Why Your Covered Employee List Is About to Get a Lot Longer in 2026

Imagine your finance team just finalized executive pay for the year. The CEO, CFO, and three top executive officers are all flagged for Section 162(m) tracking, as expected. Then a tax partner walks in and asks: Are you also tracking the five highest-paid non-officer employees? And the partnership down the org chart that's paying half of your CEO's bonus through a profits interest? And the LLC that issued restricted units to your principal engineering lead?

Most public companies aren't ready for those questions. They're about to be required to answer them.

Section 162(m) of the Internal Revenue Code is the rule that caps a publicly held corporation's federal tax deduction for compensation paid to certain employees at $1 million per person per year. It has been on the books since 1993, but the version arriving for tax years beginning in 2026 is materially broader than anything that came before. Between the One Big Beautiful Bill Act (OBBBA) and the still-pending expansion enacted by the American Rescue Plan Act (ARPA), the universe of "covered employees" is growing, the universe of paying entities is growing, and the tracking burden is moving from the tax department into a cross-functional compliance exercise.

This guide walks through what the rule does today, what changes in 2026 and 2027, and what public companies should be building this year to keep the deduction.

What Section 162(m) Actually Does

Section 162(m) is a deduction-cap rule, not a pay-cap rule. A board can pay an executive $30 million. The company simply cannot deduct anything above $1 million when calculating federal taxable income.

In rough numbers, every $1 million of non-deductible compensation costs a 21%-rate corporation $210,000 in additional federal tax. For a company with five $10 million executives, the lost deduction can run to about $9.45 million per year. Multiply that across multiple years and equity vesting tranches, and the planning stakes climb quickly.

A few baseline rules that everyone working in this area should know:

• Who it applies to: publicly held corporations (those required to register securities under Section 12 of the Exchange Act, or that file reports under Section 15(d)). Privately held companies are outside the rule.
• What counts as compensation: cash salary, bonuses, stock options, restricted stock units, performance shares, severance, and most other forms of pay. Stock options and restricted shares are generally measured when they vest or are exercised, not when granted.
• Once covered, always covered: an employee who becomes a "covered employee" in any year after 2016 stays covered for life — including after retirement and even after death (post-termination payments to a deceased executive's estate remain subject to the cap).
• No performance-based exception: the Tax Cuts and Jobs Act of 2017 removed the old carve-out for performance-based compensation. There is no longer a way to "earn" your way out of the cap with rigorous performance criteria.

Who Is a Covered Employee Today

Under the current rules, a covered employee at a public company is anyone who falls into one of three buckets:

1. The principal executive officer (PEO, typically the CEO) or principal financial officer (PFO, typically the CFO) at any time during the year.
2. The three highest-compensated executive officers (other than the PEO and PFO) for the year.
3. Anyone who was a covered employee in any prior taxable year beginning after December 31, 2016 — the "once-covered, always-covered" rule.

That third bucket is the one that quietly grows every year. A company that has been public since 2017 likely has between 25 and 50 individuals on its covered list today, even if only five are currently active executives. Retired CEOs, departed CFOs, sold-business-unit presidents — they all stay on the list as long as the company is still paying them anything.

What Changes in 2026: The OBBBA Controlled Group Rule

OBBBA added a new subsection — IRC § 162(m)(7) — that introduces an aggregation rule for taxable years beginning after December 31, 2025. The change addresses a structural gap in the prior law.

Before OBBBA, the $1 million cap applied to the publicly held corporation and its corporate affiliates as defined in IRC § 1504. That definition reaches first-tier and lower-tier corporate subsidiaries, but it does not reach partnerships, LLCs taxed as partnerships, or other non-corporate trades or businesses. Many real-world public companies pay their executives through, or partly through, those non-corporate entities — particularly in structures known as "Up-Cs" and "UPREITs," where the operating business sits in a partnership underneath the publicly traded corporation.

Starting in 2026, § 162(m)(7) sweeps those entities in. The cap now applies across the public corporation's full "controlled group" as defined in IRC § 414(b), (c), (m), and (o). That definition is much broader than § 1504 and captures unincorporated entities under common control.

In practice, that means three things:

• Aggregation of payments: compensation paid to a covered employee is added together across every member of the controlled group, including partnerships and LLCs. If the operating partnership pays the CEO $8 million and the public corporation pays $4 million, the relevant number for the cap is $12 million.
• Allocation of the cap: the $1 million deduction allowance is allocated among the paying entities in proportion to the compensation each one paid. So if the partnership paid two-thirds of the total, it gets two-thirds of the deduction.
• New paying parties get pulled into compliance: partnerships and LLCs that never had a 162(m) tracking obligation now need to coordinate with the parent corporation's tax department on each material executive payment.

This change is particularly painful for Up-Cs, UPREITs, and tracking-stock structures where compensation is intentionally pushed down to operating partnerships for partnership tax or capital-allocation reasons. The result is the same dollar of comp, but now non-deductible for the corporate-tax piece.

What Changes in 2027: The ARPA Top-Five Expansion

The second wave is the ARPA expansion, originally enacted in 2021 but with a delayed effective date for tax years beginning after December 31, 2026.

The IRS issued proposed regulations on the ARPA changes in early 2025. Once in effect, the covered-employee list adds a fourth bucket: the five highest-compensated employees for the year, whether or not they are executive officers.

A few critical wrinkles in the new bucket:

• Not subject to once-covered-always-covered: the original three categories include the lifetime rule, but the new "next five" group is re-tested every year. An employee can be in the top five one year and out the next, with no permanent designation.
• No officer requirement: the new bucket reaches anyone, including engineers, traders, salespeople, sales-bonus earners, and partner-track professionals at investment banks, asset managers, and tech companies. A star quant who isn't a Section 16 officer can absolutely land on this list.
• Determined by total compensation, not SEC proxy disclosure: the test uses Code-defined compensation rather than the Summary Compensation Table values. A high commissions earner whose pay is realized through deferred plans can be ranked differently than the proxy would suggest.

That last point is the one most likely to surprise companies. The proxy table identifies the named executive officers based on SEC rules. The 162(m) "top five" test runs on tax-based comp definitions, including the year of inclusion for equity awards. Reconciling those two universes will require a written methodology, not a back-of-the-envelope review.

The Compliance Workload No One Sees Coming

For a typical public company, the operational implications fall into four areas:

Master Tracking List

Maintain a single, durable list of every individual who has ever been a covered employee, with the year of first inclusion and the basis for inclusion (PEO/PFO, top-three executive, ARPA top-five, or prior-year carryforward). The "once-covered-always-covered" rule means this list only ever grows, and individuals from acquired companies join the list at the date of acquisition.

Compensation Aggregation Across the Controlled Group

For each covered employee, capture every dollar of compensation paid by every entity in the IRC § 414 controlled group. That requires a pull from each subsidiary's payroll, plus equity admin, plus deferred compensation plans, plus any payments routed through partnership entities. The cleanest approach is a single annual data request with standardized fields and timing.

Mid-Year Status Tracking

Because the ARPA top-five test runs every year, companies need a process for projecting compensation ranks during the year, not just at year-end. A common pattern is a quarterly compensation reconciliation, with a final true-up in January or February once equity vesting and bonus accruals are settled.

Deduction Allocation Mechanics

Under the OBBBA aggregation rule, the deduction must be allocated among paying entities in proportion to the compensation each one paid. That allocation has to be documented and reflected in each entity's tax filing — including partnership returns where the allocation flows through to partners' K-1s. For Up-C structures, the public-corporation partner's share of the partnership's lost deduction directly reduces its own taxable income; for UPREITs, REIT-level taxable income is similarly affected.

Practical Examples

A few stylized examples make the mechanics easier to see.

Example 1: Up-C operating partnership PublicCo, a Delaware C corp, owns 35% of OperatingLP, which is the historic operating business. The CEO is paid $2 million in cash by PublicCo and $10 million in LP unit awards by OperatingLP. Pre-OBBBA, only PublicCo's $2 million payment was subject to 162(m), and $1 million of that was non-deductible. Post-OBBBA, the full $12 million is aggregated. The $1 million deduction allowance is allocated 1/6 to PublicCo and 5/6 to OperatingLP, leaving $11 million collectively non-deductible across the controlled group.

Example 2: Top-five rank shift In 2027, a public tech company's three highest-paid executive officers are the CEO, CFO, and Chief Product Officer. The next five highest-paid employees include a VP of Engineering whose equity vested heavily that year and a managing director in a quant trading group with a $4 million performance bonus. Both are covered employees for 2027, even though neither files a Section 16 form. If the trader's bonus is back to normal in 2028 and the VP's equity vests lower, both fall off the new-bucket list — but if either was promoted into an executive officer role during 2027, they stay covered permanently.

Example 3: Acquired-CFO carryforward PublicCo acquires PrivateCo in 2029. PrivateCo had been public from 2015 through 2022. PrivateCo's pre-acquisition covered employees join PublicCo's covered list at closing under the regulations that govern merger transitions, so PublicCo inherits a roster of legacy executives whose compensation it must continue to track.

Why Bookkeeping Discipline Matters Here

Section 162(m) compliance is, at its core, a data problem. The substantive rule is short. The hard part is producing, for any covered individual, a clean ledger of every dollar of compensation paid by every entity in the controlled group, separated by year and by type. That requires a chart of accounts that distinguishes salary, bonus, stock-based compensation, deferred compensation, and severance; entity-level postings that allow consolidation; and a documented method for matching equity vesting to the tax year of inclusion.

Public companies that already maintain plain-text or version-controlled accounting records tend to have an easier time producing that ledger on demand — the underlying data is auditable, queryable, and reproducible. Companies that rely on rolled-up spreadsheets or vendor reports often discover, only during a deduction review, that they cannot reconstruct who got paid what by which entity in a prior year.

Five Questions to Bring to Your Next Compensation Committee

1. Do we have a single covered-employee master list, and who owns it?
2. Have we identified every IRC § 414 controlled-group member that pays compensation to current or former covered employees?
3. What is our methodology for projecting the ARPA top-five list during the year?
4. How will we allocate the $1 million deduction across paying entities, and is that methodology consistent with how we file partnership returns and REIT income calculations?
5. What documentation will we retain to support our allocations under audit?

If the answers to any of those are "we'll figure it out at year-end," the time to start is well before the 2026 tax year closes.

Don't Forget Section 4960

A close cousin of 162(m) — Section 4960 — imposes a 21% excise tax on compensation above $1 million paid by an "applicable tax-exempt organization" (ATEO) to certain covered employees, and on excess parachute payments. OBBBA also expanded the 4960 covered-employee definition to mirror the new 162(m) rules. Tax-exempt organizations and their related entities should be running a parallel compliance project; the same data infrastructure works for both regimes.

Keep Your Compensation Records Clean from Day One

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