How executive pay is taxed in AI infrastructure deals

In short

Publicly held corporations can deduct only $1 million of compensation paid to each covered employee per tax year, no matter whether the pay is cash, stock, or deferred. 26 U.S.C. § 162(m). Recent law changes have widened the group of employees whose pay is covered and the related entities whose pay counts toward the cap. The One Big Beautiful Bill Act (OBBBA), signed July 4, 2025, broadened the controlled group rule to include partnerships and other entities, and removed the employee limit on the 21% excise tax for tax exempt organizations. H.R. 1, OBBBA. The American Rescue Plan Act (ARPA) will add five more employees to the covered group starting in 2027.

At the individual level, an executive’s salary and bonus are taxed at ordinary rates up to 37%, plus a 0.9% Additional Medicare Tax on wages above $200,000 (single) or $250,000 (joint). IRS Topic 560, IRS federal tax rates. Long term capital gains from selling stock are taxed at a top rate of 20% and the 3.8% net investment income tax (NIIT) may also apply to high income taxpayers, for a combined top rate of 23.8%. 26 U.S.C. § 1(h), 26 U.S.C. § 1411, IRS NIIT Q&A. Equity awards, deferred compensation plans, change in control payouts, and carried interest each have their own tax treatment, which the article walks through below.

What is the $1 million deduction cap and who is a covered employee?

The basic rule

Section 162(m) of the tax code says a publicly held corporation cannot deduct more than $1 million of the applicable employee remuneration with respect to any covered employee during a tax year. 26 U.S.C. § 162(m)(1). All forms of compensation count, including salary, annual bonus, stock awards, option exercises, and vested deferred compensation. There is no longer an exception for performance-based pay. That was removed in 2017.

A covered employee is the principal executive officer (usually the CEO), the principal financial officer (CFO), and the three other highest paid executive officers whose compensation is disclosed in the company’s SEC proxy. Once an individual becomes a covered employee for any tax year after 2016, that person stays covered for all future years, even after leaving the company. This is the once covered, always covered rule. Tax alert.

How the OBBBA broadened the controlled group

Before the OBBBA, the deduction limit applied to the corporation and its affiliated group, defined using the corporate-specific standard under section 1504. That left out partnerships and other non-corporate entities that many AI infrastructure companies use.

The OBBBA changed the aggregation rule. For tax years beginning after December 31, 2025, the $1 million cap applies to the publicly held corporation and all members of its controlled group under sections 414(b), (c), (m), and (o). Tax alert, Tax alert, Tax analysis. A controlled group includes partnerships, LLCs taxed as partnerships, and other entities that are under common control. This means compensation paid by an operating partnership or a co investment vehicle must be added together with the public parent’s compensation when figuring out who is a covered employee and whether the $1 million limit has been reached.

The change especially affects companies that use Up-C or UPREIT structures. In those structures, a publicly traded entity holds interests through a partnership. Now pay from the partnership level may count toward the public parent’s 162(m) limit. Compensation Standards, Oct. 7, 2025. The Joint Committee on Taxation estimates the expanded rule will raise $15.7 billion over ten years. Tax alert.

The ARPA expansion to ten employees

A separate change under the American Rescue Plan Act of 2021 will take effect one year after the OBBBA rule, for tax years beginning after December 31, 2026. ARPA added the next five highest compensated employees (besides the CEO, CFO, and the three other named executive officers) as covered employees. Tax alert. That means a publicly held AI data center company will have at least ten covered employees from this list each year, on top of any individuals who are permanently covered by the once covered, always covered rule.

Unlike the original top five, these five additional employees are determined fresh each year based on that year’s compensation. They are not bound by the once covered, always covered rule. But their pay, once they are identified, is subject to the $1 million deduction limit for that year.

So by 2027, a large AI company could easily have a dozen or more employees whose pay is fully or partially nondeductible.

What is still unsettled and what it means for AI infrastructure structures?

The two expansions, OBBBA’s controlled group rule and ARPA’s five additional employees, have different effective dates and different definitions of covered employees. The proposed regulations that the IRS published in January 2025 were written to implement the ARPA change alone. They do not account for the OBBBA controlled group shift, and they will need to be revised. Federal Register, Tax analysis.

Several questions remain open. For example, does an individual working at a partnership under the controlled group become a covered employee of the public parent? The OBBBA says yes in principle, but the exact scope of the controlled group under sections 414(m) and (o), which can pull in service organizations connected through management or ownership, has not been addressed by final guidance. Tax alert. For AI infrastructure joint ventures and co investment vehicles, which often involve multiple partners, this uncertainty makes it hard to model the full deduction limit.

Many AI data center companies are publicly held, so the cap already applies. But the expanded aggregation could bring in entity types that were not previously covered, requiring those companies to gather compensation data from all parts of the structure and to plan how to allocate the $1 million limit across the group.

How are deferred compensation plans taxed and what are the traps?

A nonqualified deferred compensation plan (NQDC) lets an executive postpone receiving part of their pay to a later year. Section 409A sets strict rules for how these plans must work. If the plan breaks the rules, all vested deferred amounts become taxable immediately for the executive. The executive also owes a 20% penalty tax, plus an interest charge at the underpayment rate plus one percentage point. 26 U.S.C. § 409A(a)(1), IRS Notice 2008-115. The penalties hit the individual, not the company, though the company has withholding and reporting obligations.

To comply, the plan must meet several requirements. The decision to defer must be made before the year the services are performed (with exceptions for new hires and certain performance based pay). Treas. Reg. § 1.409A-2(a) . The deferred compensation can only be paid out when one of six events occurs, namely separation from service, disability, death, a fixed date or schedule, a change in control of the company, or an unforeseeable emergency. Acceleration of payments is not allowed. Treas. Reg. § 1.409A-3. For public company executives who are specified employees (top officers), payments triggered by separation from service must be delayed six months. Practitioner guide.

A safe harbor called the short term deferral exemption removes many arrangements from 409A’s scope. If the amount is paid in full within two and a half months after the end of the year when it vests, it is not treated as deferred compensation. Treas. Reg. § 1.409A-1(b)(4). Many annual bonuses and severance packages fit into this window.

Stock options with an exercise price at least equal to fair market value at grant, restricted stock subject to section 83, and certain severance arrangements are also exempt from 409A. NEEBC Guide. But a discounted stock option may be treated as a deferred compensation plan and could trigger the penalties.

AI companies that offer deferred compensation must draft the plan documents carefully. A small mistake, such as a payment made a few days after a fixed date, can cause all benefits under the plan to become taxable and penalized in one year. The IRS describes nonqualified deferred compensation plans broadly under Section 409A, noting that phantom stock plans are NQDC arrangements despite their name and that restricted stock units may also constitute NQDC depending on their terms. IRS Pub. 5528.

How are change in control payments taxed and what is the golden parachute excise tax?

When a company undergoes a change in control (such as a merger or acquisition), executives often receive payments tied to the deal. These can include severance, accelerated vesting of equity, and deal bonuses. Section 280G and 4999 impose a two part penalty on payments that are excessive.

A payment is a parachute payment if it is contingent on a change in control and its present value equals or exceeds three times the executive’s base amount. The base amount is the average annual taxable compensation received over the five tax years before the change in control. Treas. Reg. § 1.280G-1. If the threshold is met, the amount above one times the base amount is called an excess parachute payment. The corporation cannot deduct that excess, and the executive must pay a 20% excise tax on that excess on top of ordinary income tax. 26 U.S.C. § 280G, 26 U.S.C. § 4999.

For example, an executive with a base amount of $2 million receives a change in control payment of $7 million. Three times the base is $6 million. The payment exceeds that, so the excess parachute payment is $7 million minus $2 million, which is $5 million. The company loses a $5 million deduction, and the executive pays $1 million in excise tax (20% of $5 million) on top of income tax.

The definition of disqualified individual (the person subject to these rules) includes officers, shareholders, and highly compensated individuals. Highly compensated individuals are those with annual compensation above $155,000 (2024, adjusted for inflation) who are among the lesser of the highest paid 1% of employees or the highest paid 250 employees. Journal.

Private companies have an important planning tool. If more than 75% of the voting shares (excluding the disqualified individuals) approve the payment with full disclosure before the change in control, the payment can be exempted from the 280G rules entirely. Public companies cannot use this shareholder approval exemption. Treas. Reg. § 1.280G-1, Q&A 6 & 7.

Often, companies negotiate modified cutback provisions in executive contracts. These automatically reduce the parachute payment to just under the 3x threshold (such as 2.99 times the base amount), so the excise tax is avoided entirely. Alternatively, a better after tax clause compares the executive’s after tax position with the full payment (including excise tax) versus the cutback, and delivers whichever gives the executive more money.

How is carried interest taxed for AI infrastructure fund managers?

Managers of private investment funds, including funds that invest in AI data center assets, often receive a profits interest called carried interest. Instead of a salary, they get a share of the fund’s capital gains. Section 1061 requires a three year holding period for that carried interest to qualify for the lower long term capital gains rate. If the asset is held for more than one year but not more than three years, the gain is recharacterized as short term capital gain. 26 U.S.C. § 1061.

The three year rule applies to an applicable partnership interest (API), which is a partnership interest held by someone who performs substantial services for the fund’s business of raising capital and investing in specified assets (like securities, commodities, real estate, or partnership interests). Final Regs. For AI infrastructure funds that hold AI data center properties for more than three years, the carried interest will qualify for long term capital gains treatment, which is 20% plus the 3.8% net investment income tax, giving a combined 23.8%. If the fund flips assets faster, the ordinary rate plus potential NIIT can reach 40.8% (37% + 3.8%).

Certain gains are excluded from the three year recharacterization even if the asset is sold sooner. Section 1231 gains (from the sale of business use property, including goodwill) can still be taxed as capital gains if the underlying transaction qualifies. Regulatory analysis. This is important for infrastructure funds that may sell entire portfolio companies or assets that produce both capital gain and ordinary income.

The capital interest exception is also important. If a fund manager invests actual capital (not just sweat equity) and receives an allocation of gain attributable to that invested capital, that portion is not subject to the three year rule. To qualify, the partnership agreement and the partnership’s contemporaneous books and records must clearly identify the capital interest allocations, and they must be reasonably consistent with how unrelated non-service partners with substantial capital (5% or more) are treated. Regulatory analysis.

The OBBBA did not change section 1061. Proposals to tax carried interest as ordinary income have been introduced in Congress for years but have not been enacted, though the 2017 Tax Cuts and Jobs Act did further extend the holding period from one to three years. Law firm analysis, Tax alert. So the current three year rule remains in effect.

How are stock options, restricted stock, and RSUs taxed for the individual executive?

The most visible part of an AI executive’s pay is often equity. The tax treatment depends on the specific type of award and on whether the executive makes a key tax election.

The ordinary income timing rule

Under Section 83, when an executive receives property (such as shares of stock) in connection with their services, the value is taxed as ordinary income at the time the property becomes substantially vested. A right is substantially vested when it is transferable or no longer subject to a substantial risk of forfeiture (that is, the executive can sell it and will not lose it if they leave). 26 U.S.C. § 83(a), 26 CFR § 1.83-3(b). For restricted stock that vests over time, the ordinary income is measured at the market value on each vesting date, and the company can deduct the same amount.

The 83(b) election and its 30 day deadline

An executive receiving restricted stock can instead elect under section 83(b) to pay ordinary income tax on the grant-date value (if lower) within 30 days of the transfer. This election is available only for property, not for a promise to deliver shares later. Making the election starts the holding period for future capital gains, and if the stock is qualified small business stock (QSBS), it starts the holding period for the QSBS exclusion. Practitioner guide. The election is irrevocable. The 30 day deadline is absolute. Courts have not allowed late elections even for reasonable cause. KPMG, June 2025, Startup Law Blog.

If an executive expects the stock to appreciate sharply, paying tax early on a low value can be a powerful move. For example, an executive who files an 83(b) election on restricted stock worth $50,000 at grant will pay ordinary tax on $50,000. If the stock is later sold for $5 million, the additional gain is capital gain, taxed at 23.8%, not at ordinary rates. Without the election, the entire $5 million would be ordinary income at vesting.

RSUs and nonqualified stock options

Restricted stock units (RSUs) are not a transfer of property. They are a promise to deliver shares in the future. The 83(b) election is not available for RSUs. RSUs are taxed as ordinary income when they vest, measured at the fair market value on that date. The company deducts the same amount. IRS Publication 5992. For tax withholding, the default federal supplemental rate is 22% on amounts up to $1 million and 37% above that, plus FICA taxes.

Nonqualified stock options (NSOs) are taxed at exercise on the spread (the difference between the fair market value at exercise and the exercise price) as ordinary income. Incentive stock options (ISOs) are generally not taxed at exercise, but the spread is an alternative minimum tax (AMT) preference item. If the ISOs are held long enough, the eventual gain upon sale qualifies for capital gains treatment.

QSBS benefits for AI startup equity

The OBBBA increased the exclusion for qualified small business stock under section 1202. For stock issued after July 4, 2025, an executive who files an 83(b) election and holds the stock for five years can exclude up to $15 million of gain (inflation adjusted starting in 2027). There are also tiered benefits, with a 50% exclusion after three years, 75% after four years, and 100% after five years. Practitioner guide. This makes early equity awards at AI startups especially tax-advantaged.

What is the 3.8% net investment income tax and who pays it?

The net investment income tax (NIIT) is a 3.8% surtax on certain investment income for individuals with modified adjusted gross income (MAGI, a figure close to total income minus a few deductions) above $200,000 (single filers), $250,000 (joint filers), or $125,000 (married filing separately). Those thresholds are not indexed for inflation, so they capture more taxpayers each year. 26 U.S.C. § 1411.

Net investment income includes interest, dividends, capital gains, rental and royalty income, and passive income from partnerships and S corporations. It does not apply to salary, wages, self-employment income, or distributions from qualified retirement plans. IRS Q&A on NIIT.

For an AI company executive, the NIIT adds 3.8 percentage points to the tax on capital gains from selling stock, dividends, and carried interest income. That means long term capital gains are taxed at a combined federal rate of 23.8% (20% + 3.8%). Short term capital gains, which are taxed as ordinary income, face the ordinary rate plus the NIIT (37% + 3.8% = 40.8%). Wages are not subject to NIIT. Instead, high wages attract the 0.9% Additional Medicare Tax above the same income thresholds. This gap between ordinary and capital gains rates continues to shape how executives want to be paid.

The table below summarizes the top federal rates for common types of executive income.

What excise tax applies to high executive pay at tax exempt organizations?

Section 4960 imposes a 21% excise tax on applicable tax exempt organizations (ATEOs) for compensation paid to a covered employee in excess of $1 million. It also applies to excess parachute payments. 26 U.S.C. § 4960. Before the OBBBA, the definition of covered employees was limited to the five highest paid employees. The OBBBA changed that.

For tax years beginning after December 31, 2025, the five employee cap is removed. Now every current and former employee of the ATEO is a covered employee. Any employee who receives more than $1 million in total compensation triggers the 21% excise tax on the excess. Tax alert, Tax alert. The OBBBA did not change the tax rate, the $1 million threshold, or how compensation is measured. It only widened the group of people whose pay counts.

Deferred compensation is treated as paid when it vests, not when cash changes hands. A large vesting event can push an employee over the $1 million line and create an unexpected excise tax for the organization. Tax alert. The JCT estimates the OBBBA section 4960 change will raise $3.8 billion over ten years. Tax alert.

AI infrastructure research organizations, university affiliated AI data centers, and other tax exempt entities involved in the AI buildout now face a much broader excise tax exposure. Even a mid level employee with substantial equity or a large year end bonus could push the organization over the threshold.

How do these tax rules shape compensation in AI infrastructure deals?

The AI data center boom is fueling extraordinary executive pay. Microsoft CEO Satya Nadella received $96.5 million in total compensation for fiscal 2025, with more than $84 million of that in stock awards. CNBC, Oct. 21, 2025. Alphabet CEO Sundar Pichai’s pay reached $10.73 million in 2024. CNBC, Apr. 28, 2025. Across the Equilar 100, stock awards made up approximately 73% of median CEO pay in 2024. Equilar 100, May 1, 2025.

Under current law, almost all of that stock compensation is nondeductible for the corporation because it far exceeds the $1 million per-person cap. For large public AI companies spending tens of billions of dollars a year on capital expenditures (Microsoft alone allocated roughly $80 billion to AI data centers in fiscal 2025) the lost deduction is small relative to total expenses but not trivial in absolute dollars. More important is the structural effect. The cap and the other tax rules steer companies toward equity-based pay because it gives executives the chance for long term capital gains taxed at 23.8% rather than ordinary income taxed at 37% plus Medicare tax. And equity compensation aligns executive incentives with shareholder returns, which is especially valued in a high growth sector like AI.

For the many AI infrastructure companies that use partnership structures (such as REITs, UPREITs, and joint ventures), the OBBBA controlled group change means they must now track compensation across a broader set of entities. This can increase the number of individuals whose pay is subject to the deduction limit and make it harder to design efficient plans.

At the same time, the strict 409A rules and the potential for golden parachute excise taxes mean that companies must draft executive agreements carefully. A poorly designed deferred bonus can blow up the executive’s tax year. A change in control deal that triggers a $50 million parachute for a key executive can saddle both sides with extra taxes that good planning could have avoided.

Fund managers in the AI infrastructure space who receive carried interest still benefit from the capital gains rate if they hold assets for more than three years. Given the long term nature of AI data center investments, this is achievable. But they must track holding periods meticulously and maintain the documentation required for the capital interest exception.

Finally, the NIIT looms as a constant 3.8% add-on to nearly all investment income, with thresholds that never adjust for inflation. Executives, fund managers, and startup founders in the AI sector will increasingly face this tax as their incomes rise.

Key takeaways

• For publicly held AI data center companies, only $1 million of compensation per covered employee is deductible each year. There is no exception for performance pay.
• The OBBBA expanded the deduction cap to include pay from all members of the controlled group, including partnerships. This change is effective for 2026 tax years and onward.
• Starting in 2027, ARPA adds five more employees to the covered group, which can double the number of employees subject to the cap.
• Nonqualified deferred compensation plans face severe penalties for violation, including immediate income inclusion, a 20% additional tax, and interest. Compliance with the strict election and payment timing rules is essential.
• Change in control payments that exceed three times an executive’s base amount lose their corporate deduction and trigger a 20% excise tax on the executive. Private companies can use a 75% shareholder vote to avoid the rules.
• Carried interest for AI infrastructure fund managers qualifies for long term capital gains only if the underlying assets are held more than three years. The capital interest portion is exempt.
• Equity awards like RSUs and NSOs are taxed as ordinary income when delivered or exercised. Restricted stock holders can elect under §83(b) to pay tax early at a lower value, but the 30 day filing deadline is absolute.
• The 3.8% net investment income tax applies to capital gains, dividends, and other investment income above fixed income thresholds, adding to the tax on executive stock sales and carried interest.
• Tax exempt organizations pay a 21% excise tax on employee compensation over $1 million. The OBBBA removed the five employee cap, making all employees subject to the tax.
• The combination of these rules strongly favors equity compensation and long term holding for AI executives, while the deduction limits and excise taxes add compliance costs for the companies.

Frequently asked questions

Q:Does the $1 million deduction cap apply to private AI companies?

A:No. Section 162(m) applies only to publicly held corporations. However, if a private company is part of a controlled group with a public company, compensation paid by the private entity may be aggregated with the public company’s compensation for purposes of the cap starting in 2026. Tax alert.

Q:How can an executive avoid the 20% golden parachute excise tax?

A:The most common way is to keep total change in control payments below three times the base amount. Many executive contracts include a cutback provision that automatically reduces payments to 2.99 times the base. For private companies, a vote of more than 75% of disinterested shareholders can exempt the payments entirely. Treas. Reg. § 1.280G-1, Q&A 7.

Q:What is the deadline for filing an 83(b) election?

A:The election must be filed with the IRS within 30 calendar days of the date the property is transferred. There are no exceptions and no extensions. Using the new IRS Form 15620 or the electronic filing portal can help provide proof of timely filing. Tax alert, July 29, 2025, The Startup Law Blog, Apr. 5, 2026.

Q:Does the 3.8% NIIT apply to carried interest?

A:Yes. Carried interest that is treated as long term capital gain is subject to the NIIT, so the effective rate is 23.8%. Short term gain from carried interest held three years or less is taxed as ordinary income plus NIIT, reaching 40.8%. The NIIT does not apply to salary or ordinary income from services.

Q:When do the new §162(m) controlled group rules take effect?

A:They apply to tax years beginning after December 31, 2025. For calendar-year taxpayers, that means 2026. Tax alert.

Q:Does the OBBBA affect carried interest?

A:No. The OBBBA did not amend section 1061. The three year holding period for carried interest to qualify as long term capital gain remains unchanged, despite legislative proposals in prior years.

Q:What happens if a deferred compensation plan fails to meet 409A?

A:All vested deferred compensation becomes includible in the executive’s income in the year of the failure. The executive also owes a 20% additional tax and an interest charge. The employer must report the income, but the penalties are assessed against the individual. 26 U.S.C. § 409A(a)(1), 26 U.S.C. § 3401(a), 26 U.S.C. § 6041(g).

Q:Who is a specified employee under 409A?

A:For public companies, specified employees generally include officers with compensation above a certain level and others holding the top officer positions. A detailed determination is required each year. Payments to a specified employee triggered by separation from service must be delayed six months. Practitioner guide.

Q:Are RSUs subject to the $1 million deduction cap?

A:Yes. The value of RSUs that vest or are settled during a year counts as compensation under section 162(m), and if paid to a covered employee, it is subject to the cap. The company’s deduction is limited to $1 million along with all other compensation.

Q:How is the $1 million limit calculated across a controlled group?

A:The controlled group must aggregate compensation paid to each covered employee from all entities in the group. If an executive receives pay from both the public parent and a partnership subsidiary, the combined amount is measured against the $1 million cap for that individual. Tax alert. The precise allocation rules are subject to future IRS guidance.

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Junde Liu, JD, LL.M. (Taxation) candidate at UF Law. Originally published on Compute Law Blog. This article is general information and does not constitute legal advice. Reading it does not create an attorney client relationship. The reader should not act on the basis of any content here without first consulting a licensed attorney in the relevant state. Last reviewed for accuracy May 23, 2026.