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Section 162(m) of the Internal Revenue Code provides that public companies may not take a tax deduction for certain employee compensation in excess of $1 million during the company’s taxable year. This restriction applies only to compensation paid to “Covered Employees,” and that classification is set to expand for tax years after December 31, 2026.

Currently, the definition of “Covered Employees” generally includes only the company’s named executive officers. However, for tax years beginning on or after January 1, 2027, the definition will expand to include the next five highest-compensated employees. Although this expanded definition does not go into effect for several years, public companies should still begin planning now for this expansion in relation to long-term incentive awards. Specifically, companies may want to consider structuring these awards to vest prior to the application of the expanded definition for individuals who could be covered under the expansion, thus avoiding the lost tax deduction.

If you have questions about who qualifies as a Covered Employee or other executive compensation matters, contact a member of our Employee Benefits and Executive Compensation group.