Reminder: Expanded “covered employee” definition under Section 162(m) to take effect in 2027 

This client update reviews how the definition of covered employee was expanded and how they should be identified. For our prior client updates on these developments, see Administering Compensation Programs in the Wake of TCJA – New Section 162(m), The American Rescue Plan Act expands covered employees under section 162(m), and IRS releases proposed regulations for Section 162(m)’s expanded covered employees.

Some history

For much of the period between 1994, when Section 162(m) first took effect, and 2017, when “new” Section 162(m) was amended by the Tax Cuts and Jobs Act (TCJA), public companies typically had four covered employees – the chief executive officer and the three most highest compensated executive officers (other than its CEO and chief financial officer), as disclosed in the company’s Summary Compensation Table relating to the relevant year under the proxy disclosure rules of the Securities and Exchange Commission (SEC). 

In 2017, the TCJA amended Section 162(m) by providing that, effective for taxable years beginning after December 31, 2017, the covered employees included at least five individuals – the CEO, the CFO and the three highest compensated executive officers, as determined under the SEC disclosure rules. The TCJA also provided that an individual will be considered a covered employee for that year and all subsequent years, even after the individual terminates employment (often referred to as the “once a covered employee, always a covered employee” rule).

In 2021, Congress enacted the American Rescue Plan Act of 2021 (ARPA), a stimulus bill in response to the economic fallout from the COVID-19 pandemic. As one offset to ARPA’s spending provisions, ARPA expanded the definition of covered employee to include, in addition to the individuals described above, the company’s next five highest compensated employees, regardless of whether or not they are current or former executive officers of the company. This expanded definition will be effective with taxable years beginning after December 31, 2026 – i.e., starting as early as this coming January 2027.

On January 16, 2025, the Federal Register published the IRS’s proposed rule that sets forth how these five extra covered employees will be identified. The IRS has not yet issued the final rule, so companies will be referring to this proposed rule for guidance.

On July 4, 2025, the One Big Beautiful Bill Act (OBBBA) introduced further changes to Section 162(m). Section 162(m) previously applied the deduction limit to compensation paid by a corporation and any member of its “affiliated group.” OBBA slightly broadens the scope of 162(m), applying the deduction limit to compensation paid by a corporation or members of its “controlled group.”

Key questions under the proposed rule

Q: Who will be a “covered employee” for taxable years beginning on or after January 1, 2027?

In addition to the executive officers who are determined under the SEC disclosure rules, plus the executive officers who are picked up by the “once a covered employee, always a covered employee” rule, Section 162(m) will include any employee who is among the five highest compensated employees for the taxable year. The term “employee” has the meaning given in Section 3401(c) of the Code, which includes both common law employees and executive officers; thus, these five employees can include executive officers. 

The proposed rule provides that the five highest compensated employees are identified based on compensation for the taxable year, regardless of whether they are still in service to the company at the end of that year.

Q: How is compensation measured to identify the five highest compensated employees?

For purposes of identifying the five highest compensated employees, compensation is defined as that which, but for Section 162(m), would be allowable as a deduction – for many employees, this will be the compensation that is reported on their W-2. This differs from the test used to identify the three highest compensated executive officers, which relies on the compensation disclosed under the SEC’s rules. 

The IRS took this approach in part because the statute does not refer to compensation disclosure, and in part because the five highest compensated employees are not limited to executive officers. The approach is also intended to make the determination simpler, because companies already track deductible compensation for tax purposes.

Q: Will the five highest compensated employees for 2027 be identified based on 2026 or 2027 compensation?

This question has not been expressly addressed. Using 2026 compensation would allow companies to identify their five highest compensated employees at the start of 2027. However, because ARPA states, “in the case of taxable years beginning after December 31, 2026, such employee is among the 5 highest compensated employees for the taxable year” (emphasis added), the determination will likely be based on 2027 compensation. If so, companies may not be able to identify these employees until after the end of their 2027 taxable year.

Q: Does the “once a covered employee, always a covered employee” rule apply to the five highest compensated employees?

No. Under the proposed rule, an individual who is a covered employee solely because he or she is one of the five highest compensated employees for a year does not automatically remain a covered employee in the future. 

Note that, if an individual who is already a covered employee due to the “once a covered employee, always a covered employee” rule happens to be one of the five highest compensated employees for a given taxable year, then that individual may be counted as one of the five highest compensated employees for such year. Previous covered employees do not need to be counted separately from the newly required five highest compensated employees. This could potentially reduce the total number of individuals treated as covered employees.

Q: How do controlled groups identify their five highest compensated employees?

After the passage of OBBBA, the deduction limit now applies to a “controlled group,” not an “affiliated group.” A controlled group is a broader concept than an affiliated group. An “affiliated group” is a chain of includible corporations connected through stock ownership by a parent corporation. In contrast, a “controlled group” is a group of related entities that is treated as a single employer for employee benefit plan purposes. Ownership under a controlled group is measured by whether the parent owns, by vote or value, 80% or more of a subsidiary, even if it is not direct ownership. This can apply not only to groups of corporations, but also partnerships, proprietorships and “affiliated service groups.” 

Under existing Section 162(m), a “publicly held corporation” includes a controlled group of companies that contains at least one public company.  As a result, an employee of any member of the controlled group may be counted among the public company’s five highest compensated employees, even if he or she is not employed by, and does not perform services for, the public company itself.

If a controlled group contains more than one public company, each public company must identify its own five highest compensated employees. To do so, the group is divided into smaller subgroups, each consisting of one public company and certain of its affiliates. An individual who works for more than one member of the controlled group may be counted among the five highest compensated employees of only one public company.

If an employee is paid by more than one member of a controlled group, that compensation is generally aggregated to determine whether the employee is one of the five highest compensated employees. However, compensation paid by different public companies is considered separately rather than combined. 

Q: Does compensation that is paid by a foreign corporation within the controlled group count?

Maybe. Generally, if compensation paid by non-U.S. members of the affiliated group is allowed as a deduction for U.S. federal income tax purposes, then it will count toward this determination. The proposed rule clarifies the rules for how this compensation should be included, but the preamble makes clear that this clarification is “not a substantive change to the 1995 regulations and the current regulations.”

Q: Does compensation that is paid by a third party, such as a professional employer organization, count?

Yes. An “employee” includes an individual who, under Section 3401(c), is an employee of an entity other than the public company itself (such as a related but unaffiliated organization or certified professional employer organization) but nevertheless functions as an employee of the company. Given this, the proposed rule clarifies that, in such circumstances, to the extent otherwise allowable as a deduction to the company, amounts paid to the individual or to a third party to obtain the services performed by the individual are considered “compensation.”

Next steps

To prepare for the expanded definition of covered employees under Section 162(m), companies may want to: 

• Review their employee populations to make a preliminary assessment as to who may be their covered employees beginning in 2027, 
• Confirm that their systems for tracking compensation are sufficient for this purpose, and
• Consider whether to accelerate any compensation that would otherwise be paid in 2027 into 2026, if it is likely to be disallowed as a tax deduction for 2027.