What's Happening?
Effective January 1, 2027, the American Rescue Plan Act of 2021 (ARPA) will expand the definition of 'covered employee' under Section 162(m) of the Internal Revenue Code. This change will add a public company’s next five highest-compensated employees
to the existing group of covered employees, which currently includes the CEO, CFO, and the three other highest-paid executive officers. Unlike the 'once in, always in' rule for current executives, the ARPA covered employee group will be determined annually. These five additional employees do not need to be executives; they could be top salespeople or senior engineers. The compensation used for ranking these employees will be their otherwise tax-deductible pay, generally equivalent to W-2 wages, rather than SEC proxy compensation. The 'One Big Beautiful Bill Act,' enacted in July 2025, further specifies that Section 162(m) will apply across a public company’s entire 'controlled group,' meaning entities linked by 80% or greater common ownership, including partnerships. This means an employee of any group member could be among the five, even if they do not directly work for the public company itself.
Why It's Important?
This expansion of Section 162(m) has significant implications for public companies in the U.S., as it caps the federal income tax deduction for compensation paid to each covered employee at $1 million per year. The inclusion of an additional five highly compensated employees, who may not be traditional executives, means more companies will face limitations on their ability to deduct compensation expenses. This could lead to increased tax liabilities for companies, particularly those with employees receiving large, one-time payments such as lump-sum nonqualified deferred compensation distributions, multiyear incentive awards, or significant equity vesting. Companies will need to meticulously track compensation across their entire controlled group to identify these newly covered employees. The change could also influence how companies structure compensation packages, potentially leading to adjustments in the timing of deferred compensation payments to mitigate the impact of the deduction limit. The shift in how compensation is measured for ranking (W-2 wages vs. SEC proxy compensation) also adds a layer of complexity for compliance.
What's Next?
Public companies are advised to take immediate steps to prepare for these changes. This includes reviewing their employee populations to identify potential ARPA covered employees by ranking them based on otherwise deductible pay, excluding the CEO, CFO, and the three other highest-paid executive officers. Companies must also ensure their HR, payroll, tax, and legal teams coordinate to update tracking systems to capture pay data from all controlled group members and document the basis for each person's coverage. Some companies may consider accelerating 2027 compensation into 2026, though this requires careful review due to Section 409A restrictions on accelerating deferred compensation. Additionally, companies should revisit the timing of nonqualified deferred compensation (NQDC) payments, potentially structuring termination payments to occur in the year after termination rather than in the year of termination to avoid pushing employees into the top five for a given year. Legal and benefits experts can assist companies in navigating these complex changes.
Beyond the Headlines
The expanded Section 162(m) reflects a broader legislative trend towards scrutinizing and potentially limiting corporate tax deductions for executive and high-level employee compensation. While the immediate impact is financial for companies, it also raises questions about corporate governance and compensation strategies. Companies might explore alternative compensation structures that are less susceptible to the $1 million deduction cap, potentially shifting towards performance-based incentives that are not immediately taxable or re-evaluating the balance between base salary, bonuses, and equity awards. This legislative move could also subtly influence the perceived value of certain roles within a company, as the tax deductibility of their compensation becomes a more prominent factor. The inclusion of non-executive employees in this cap highlights a legislative intent to broaden the scope of compensation subject to these limitations, moving beyond just the C-suite to a wider array of highly compensated individuals within an organization and its affiliates.
