Expanded Section 162(m) ‘Covered Employee’ Definition Takes Effect January 1, 2027

Key Points

• Under the American Rescue Plan Act of 2021 (ARPA), Section 162(m) of the Internal Revenue Code adds a public company’s next five highest compensated employees to its covered employee group for taxable years beginning after December 31, 2026 (January 1, 2027, for calendar-year companies), whether or not they are executives. 
• Because the “once in, always in” rule does not apply to ARPA covered employees, the group is determined anew each year under Section 162(m), although a current or former executive already covered under that rule can count as one of the five. 
• An employee of any member of a public company’s controlled group, generally entities linked by 80% or greater common ownership, including partnerships, can be among the five ARPA covered employees under Section 162(m) as amended by the One Big Beautiful Bill Act, enacted in July 2025. 
• ARPA covered employees are ranked under Section 162(m) by compensation that would otherwise be tax deductible for the year, which for most employees is roughly their W-2 wages, rather than by SEC proxy compensation. 
• A single large payment, such as a lump-sum nonqualified deferred compensation distribution, a multiyear incentive award, an option exercise, or equity vesting, could push an employee who usually earns well under $1 million into the ARPA top five and make compensation above $1 million nondeductible under Section 162(m).

Section 162(m) of the Internal Revenue Code caps a public company’s federal income tax deduction for pay to each “covered employee” at $1 million per year. The American Rescue Plan Act of 2021 (ARPA) amended Section 162(m) to add the company’s next five highest compensated employees to the covered employee group (ARPA covered employees), beginning in 2027. This update explains who those five employees are, how they are identified, and how deferred or “lumpy” pay could, for the first time, cause companies to lose deductions for employees outside the executive ranks.

A Quick Refresher on Section 162(m)

Section 162(m) limits a public company’s federal income tax deduction for compensation paid to each covered employee to $1 million per year. Today, covered employees are the CEO, the CFO, and the three other highest-paid executive officers identified under the SEC’s proxy disclosure rules. Once someone becomes a covered employee, that individual remains a covered employee for every later year, even after leaving the company (often called the “once in, always in” rule).

Changes Beginning in 2027

Under ARPA, for taxable years beginning after December 31, 2026 (January 1, 2027, for calendar-year companies), the covered employee group will also include the company’s next five highest compensated employees for the year — the ARPA covered employees. These five employees do not need to be executives; a top salesperson or a senior engineer could make the list.

Four Key Takeaways

The rules for identifying ARPA covered employees differ from the rules for the executive officer group in four important ways.

1. The “once in, always in” rule does not apply. The ARPA covered employee group is determined anew each year, so someone in the 2027 group is covered only for 2027 unless that person qualifies again. An employee can be an ARPA covered employee even if the individual terminates employment before the end of the applicable tax year. A former employee who performed no services for the public company or its affiliates during a taxable year, however, should not qualify as an ARPA covered employee, even if the former employee received large amounts of post-employment taxable compensation in a year after the year of termination, such as from deferred compensation payments or post-employment stock option exercises. Companies should keep a record of why each person is covered. 
2. A “once in, always in” covered employee can be an ARPA covered employee. A current or former executive who is already covered under the “once in, always in” rule can count as one of the five ARPA covered employees for a year. Two examples illustrate this interplay. Assume for these examples that Public Company X has a single CEO and CFO, and five other executive officers (EOs).

• Example 1 (no ARPA covered employee overlap). Assume in 2027 that EOs 1, 2, and 3 are the three highest-paid executive officers for the year, and EOs 4 and 5 have never been Section 162(m) covered employees in a prior year. Also assume that the five highest-paid employees for 2027 (based on 2027 taxable compensation) other than the CEO, CFO, and EOs 1-3 are EOs 4 and 5 plus the top three paid nonexecutive employees. In this case, EOs 4 and 5 plus those top three paid nonexecutive employees are ARPA covered employees, and if any of those five individuals received taxable compensation for 2027 in excess of $1 million, that compensation over $1 million is not tax deductible. But EOs 4 and 5 and the top three paid nonexecutive employees for 2027 will not necessarily be Section 162(m) covered employees for 2028 or later. The group of ARPA covered employees will be separately determined for 2028 based on 2028 taxable compensation without regard to prior-year determinations.
• Example 2 (ARPA covered employee overlap). Assume the same facts as in Example 1, except that EO 4 was a Section 162(m) covered employee for 2026 by reason of having been one of the top three paid executive officers for 2026. The group of ARPA covered employees for 2027 is the same as described in Example 1 — i.e., EOs 4 and 5 plus the next three top paid nonexecutive employees. However, EO 4 was already required to be a Section 162(m) covered employee for 2027 due to the “once a covered employee, always a covered employee” rule. As a result, for 2027, only four “new” covered employees are added to the deduction limit — i.e., EO 5 and the next three highest-paid nonexecutive employees for the year. The fourth-highest-paid nonexecutive employee is not required to be added to the 2027 ARPA covered employee group.

3. The entire corporate family counts. Under the One Big Beautiful Bill Act, enacted in July 2025, Section 162(m) now applies across the public company’s entire “controlled group.” That generally means entities linked by 80% or greater common ownership, including partnerships. An employee of any group member can be among the five, even if that employee never works for the public company itself. 
4. Pay is measured differently. Executive officers are ranked using SEC proxy compensation, which includes, for example, the grant-date value of equity awards. ARPA covered employees are ranked using compensation that would otherwise be tax deductible for the year, which for most employees is roughly their W-2 wages.

Unexpected ARPA Covered Employees

Because the ARPA covered employee group is based on each year’s otherwise deductible pay, its membership can shift from year to year. The biggest risk involves employees who usually earn well under $1 million but receive one large payment in a single year. Common examples include:

• A lump-sum nonqualified deferred compensation (NQDC) distribution at termination after years of deferrals; 
• A scheduled in-service NQDC payout; 
• A multiyear incentive or retention award that pays out all at once; 
• Equity award vesting or a large stock option exercise; and 
• A sign-on bonus, deferred bonus, or severance payment.

Any of these payments could push an employee into the top five for that year, making all compensation above $1 million nondeductible. For this reason, some companies may consider paying NQDC termination benefits early in the year after termination,¹ an issue worth considering now.

Next Steps

With the effective date approaching, companies may want to take the following steps:

• Review the employee population. Rank employees across the controlled group by otherwise deductible pay, set aside the CEO, CFO, and three other highest-paid executive officers, and form a preliminary view of who may be among the ARPA covered employees for 2027.
• Confirm that tracking systems are up to the task. HR, payroll, tax, and legal teams will need to coordinate, capture pay data from every controlled group member, and document each person’s basis for coverage.
• Consider accelerating 2027 pay into 2026. If compensation is likely to be nondeductible in 2027, paying it in 2026 may make sense. Time is short, however, and because Section 409A generally prohibits accelerating deferred compensation, any proposed acceleration should be reviewed carefully in advance.
• Revisit the timing of NQDC payments. For upcoming NQDC payment elections, consider providing for termination payments to be made in the year after termination rather than in the year of termination.

For questions about the expanded Section 162(m) covered employee definition, contact the attorneys in Troutman Pepper Locke’s Employee Benefits + Executive Compensation Practice Group, who can help companies identify potential ARPA covered employees, evaluate controlled group exposure, and review the timing of compensation and deferred compensation arrangements.

¹ Section 409A of the Internal Revenue Code restricts changes to payment timing, so any such change to an existing NQDC plan generally must apply only to future deferrals.