When news broke that President Joe Biden had signed the American Rescue Plan Act of 2021 into law on March 11, the headline was that the $1.9 trillion stimulus package would go toward families and businesses, as well as efforts to fight the virus and safely reopen schools.
But tucked into the new legislation was also an update to Internal Revenue Code section 162(m), as a way of raising revenue to offset the cost of the massive financial relief bill. This section of tax code generally prohibits a public company from deducting more than $1 million in compensation paid to a current or former “covered employee.” The update will expand the number of “covered employees” subject to the $1 million deduction limit, effective in 2026.
Under current law, “covered employees” include any principal executive officer (PEO) or principal financial officer (PFO) at any time during the taxable year, plus any employee who is among the three highest compensated officers for that taxable year (other than the PEO or PFO). This means that companies must continue to track former employees in this category — because “once a covered employee, always a covered employee” — so that even payments made by a company post-termination and post-death must be viewed under the $1 million deduction limit.
“The (IRS) is keenly aware that many industries and sectors have non-employee officers earning significant amounts of compensation — often times more than executive officers who are reported and subject to the deduction limit — and that companies have been able to take full deduction for compensation expense for these non-executive officers,” said Deborah Lifshey, managing director at exec comp advisory Pearl Meyer. “Trimming compensation-related deductions was likely an obvious source of revenue to offset to the recent $1.9 trillion stimulus package. It is anticipated to boost revenue by nearly $8 billion from 2026-2031.”
The group will be expanded to include employees who are among the five highest compensated employees for the year, in addition to the existing pool of officers who are “covered employees” under the current 162(m). The law, however, does not apply the “once/always” rule under current 162(m) to this top five group of employees, so they will not automatically be treated as covered employees in a future year. This, Willis Towers Watson noted in its analysis, allows companies some planning opportunities to defer compensation until after separation from service, when that person is certain not to be in the top five. However, they noted in their analysis, because a company always will have a top five group of employees for every year, it’s uncertain whether deferring compensation for that individual will yield any appreciable benefit for the company.
Given the nearly five-year delay of when this new expansion will go into effect, it’s fair to wonder if it will remain in its current form.
“It is quite possible that the rule will be amended and clarified, although with the anticipated new revenue it is hard to imagine a complete repeal,” Lifshey said. “There are many outstanding questions such as how will “compensation” be defined to determine the highest paid? Typically, it is defined with respect to the SEC disclosure rules, but some of those rules may not be as applicable to non-officers whose compensation is structured differently from C-Suite employees. So, we expect a good deal of clarifying guidance before the effective date.”
About the Author
Brett Christie is the managing editor of Workspan Daily.