In Depth
Section 162(m) of the Internal Revenue Code limits the tax deductibility of compensation paid to certain senior executives at publicly traded companies. Originally enacted in 1993, the rule was designed to discourage excessive executive pay by removing the tax benefit for compensation exceeding $1 million per covered employee per year. When first enacted, Section 162(m) included an important exception for "qualified performance-based compensation" — meaning that stock options, performance-based bonuses, and other pay contingent on meeting objective performance goals were fully deductible regardless of amount. This exception powerfully shaped executive compensation design for nearly 25 years, driving companies to structure pay as "performance-based" to preserve deductibility. The Tax Cuts and Jobs Act of 2017 eliminated the performance-based compensation exception, effective for tax years beginning after December 31, 2017. Under the revised rule, all compensation exceeding $1 million per covered employee is non-deductible, regardless of whether it is performance-based. The covered group was also expanded from the CEO and three other highest-paid officers (excluding the CFO) to include the CEO, CFO, and the three other highest-paid executives. Once an individual becomes a covered employee, they remain a covered employee permanently, even after leaving the company. The elimination of the performance-based exception means companies can no longer avoid the $1 million deduction cap through plan design, which has reduced a key incentive for structuring pay around objective performance metrics. Many companies now explicitly acknowledge in their CD&A that they are willing to forgo tax deductibility when they believe it is necessary to attract, retain, and motivate executives.