Section 162(m) Covered Employee Expansion: What to Know

Starting in 2027, public companies must account for an expanded definition of "covered employee" under Section 162(m) of the Internal Revenue Code, as detailed in recent updates from Davis Polk. Managing the Section 162(m) covered employee expansion requires a rigorous approach to tracking total compensation across your entire controlled group to ensure tax deduction compliance.

Key Takeaways

• Effective for taxable years starting after December 31, 2026, the five highest-compensated employees will be classified as "covered employees."

• The scope has shifted from "affiliated group" to "controlled group," pulling in more entities and employees into the calculation.

• Compensation for these five individuals must be tracked using a W-2-style deductible definition rather than SEC proxy disclosure standards.

• Controlled groups must coordinate data across all subsidiaries to accurately identify the top five earners.

What Is the Section 162(m) Covered Employee Expansion?

For decades, Section 162(m) functioned as a relatively straightforward limit on the deductibility of executive pay. It capped the federal income tax deduction at $1 million per year for the CEO, CFO, and the three next highest-compensated executive officers. The landscape shifted with the Tax Cuts and Jobs Act (TCJA) and again with the American Rescue Plan Act (ARPA).

The upcoming change expands this scope further. Starting in 2027, you are not only looking at your named executive officers. You must also include the five highest-compensated employees in the entire organization—or more accurately, the entire "controlled group." These individuals do not need to be officers or hold any specific title. If they are among the top five earners in the group, they fall under the $1 million deduction ceiling.

How Does the Controlled Group Shift Impact Your Payroll Strategy?

The shift from "affiliated group" to "controlled group" is a significant technical change. In an affiliated group, connections were often limited to direct parent-subsidiary stock ownership. A controlled group, however, is a much wider net that includes related entities treated as a single employer for benefit plan purposes. This could include partnerships or even affiliated service groups.

For HR and finance leaders, this means your data collection can no longer be siloed. You must aggregate compensation data across every entity that shares a controlled group status with the public company. If you operate decentralized payroll systems across different subsidiaries, the process of identifying the top five highest-compensated employees requires a centralized view of all W-2 reportable income.

Identifying the Top Five Compensated Employees

One of the most frequent questions we see regarding this update involves the distinction between SEC proxy rules and the IRS definition of compensation. Traditional executive officers are identified based on SEC disclosure standards. However, the five additional "covered employees" are identified based on total compensation that would otherwise be tax-deductible.

In practice, this means you are looking at W-2 compensation as the primary baseline. Because the IRS has not yet issued final rules—relying instead on the proposed regulations—companies should prioritize building a robust data integration process now. You cannot wait until the end of the 2027 taxable year to identify these individuals, as you need to plan your tax strategy and potential compensation adjustments well before year-end closes.

Category SEC-Based Executives Top 5 Highest-Compensated Identification Standard SEC Proxy Disclosure Rules Total Deductible Compensation (W-2) Role Requirement Must be an Executive Officer No specific title required Status Persistence "Once covered, always covered" Annual determination only

Operational Realities for Finance and HR Leaders

As you prepare for these changes, consider the administrative burden of cross-entity reporting. If your organization has acquired smaller firms or maintains distinct payroll platforms for different business units, the risk of misidentifying the top five earners is high. Failure to aggregate compensation correctly could result in improper tax deductions.

We often see that the biggest challenge is not the legal definition, but the visibility of data. If your technology stack is fragmented, manually reconciling W-2 data across a controlled group is prone to error. You need a unified view that pulls data from every subsidiary entity. This is an ideal time to review your internal reporting structures and hcm workforce management advisory processes to ensure you are ready for the 2027 deadline.

Avoiding Common Compliance Pitfalls

Many organizations make the mistake of assuming the "once a covered employee, always a covered employee" rule applies to everyone. Under the proposed rule, this does not apply to the five highest-compensated employees who fall into the category solely because of their pay. If an individual is not an executive officer and happens to be one of the top five earners one year but not the next, they are not permanently "covered."

This creates a fluctuating pool of employees that requires annual assessment. Don't fall into the trap of over-reporting or over-restricting pay for individuals who may only trigger the limit for a single year. Maintain a clear, audit-ready log that tracks why specific employees were identified each year, keeping documentation that aligns with compliance requirements.

Frequently Asked Questions

What is the primary change to Section 162(m) in 2027?

The main change is the inclusion of the company's five highest-compensated employees in the "covered employee" definition, regardless of their role as executive officers. This is in addition to the existing requirements for the CEO, CFO, and other top-paid executives.

How does the 'controlled group' definition affect tax deductions?

Section 162(m) now applies to the entire 'controlled group' rather than just an 'affiliated group.' This means an employee working for any member of the controlled group could count toward the public company's limit, potentially impacting your overall tax deduction planning.

Does an employee automatically remain a covered employee under the new rule?

No. Unlike the 'once a covered employee, always a covered employee' rule for executives, an employee who qualifies only because they are among the five highest-compensated for a single year does not automatically remain a covered employee in future years.

How should companies identify their five highest-compensated employees?

Under the proposed rules, identification is based on total compensation for the taxable year. Companies should focus on tracking deductible compensation, as this definition is broader than the SEC proxy disclosure requirements used for traditional executive officers.

Ready to Review Your Compliance Strategy?

Managing the complexities of executive compensation and shifting tax regulations requires precise data and clear visibility into your workforce operations. If you are concerned about how these changes affect your organization's tax strategy or need help auditing your current data aggregation process, we invite you to contact our advisory team. We provide objective, advisor-led support to help you evaluate your workforce systems and ensure you are prepared for upcoming regulatory shifts.

This article is general operational guidance, not legal advice. Requirements change, so confirm current rules with qualified counsel before acting.