[author: Mark Kelly]
Section 162(m) of the Internal Revenue Code ("Section 162(m)") limits the tax deduction that a publicly held corporation may take with respect to compensation paid to each of the corporation's chief executive officer and its three other highest paid officers (excluding the chief financial officer) to $1 million per year.1 Two exceptions to the $1 million deduction limit involve "qualified performance-based compensation" and compensation awarded under a plan that existed before a company becomes publicly-held. The final regulations issued by the IRS clarify both of these exceptions, but do not substantively change the existing requirements of Section 162(m).
Qualified Performance-Based Compensation. "Qualified performance-based compensation" is exempt from the $1 million deduction limit under Section 162(m). Stock options and stock appreciation rights (SARs) automatically qualify as performance-based compensation without being subject to separate performance goals as long as the shareholder-approved equity plan includes a per-employee limit on the number of options or SARs that may be granted to an employee during a specified period. The final regulations reject the position taken by some practitioners that the plan's aggregate limit of shares reserved for issuance under the plan also served to satisfy the per-employee limit. This position was based on the theory that an employee could never receive a number of options/SARs that exceeded the aggregate maximum number of reserved shares.
The final regulations also clarify that the per-employee limit will be satisfied if the plan specifies an aggregate maximum number of shares underlying all equity-based awards that may be granted during a specified period to any individual employee. However, companies should consider specifying per-employee limits for stock options/SARs separately from per-employee limits for other awards (such as restricted stock, restricted stock units and other equity-based awards) in order to maximize flexibility.
The clarifications regarding the per-employee maximum share limitation are not intended to reflect substantive changes. Accordingly, the clarifications will apply to compensation attributable to options and SARs granted on or after June 24, 2011, which was the date of the original proposed regulations.
IPO Exception. Section 162(m) also provides an exception for newly public companies (the "IPO Exception"). Under the IPO Exception, the $1 million tax deduction limit does not apply to compensation that is "paid" under a plan which existed before a company becomes publicly-held. However, this exception is available only during a transition period which expires upon the earliest of: (i) the expiration of the plan; (ii) a material modification of the plan; (iii) the issuance of all the stock or other compensation reserved under the plan; and (iv) the first annual shareholders meeting to elect directors that occurs after the close of the third calendar year following the calendar year in which the IPO occurs (or if the company did not have an IPO, the first calendar year after the calendar year in which the company became public).
For purposes of the IPO Exception, the regulations provide that amounts attributable to stock options, SARs and/or restricted stock will be treated as "paid" upon the grant date. This means that as long as an award of stock options, SARs and/or restricted stock is granted during the transition period, any compensation recognized upon the exercise of a stock option or SAR, or upon the vesting of restricted stock, will qualify for the IPO Exception--even if such compensation is recognized after the end of the transition period.
The final regulations concluded that restricted stock units (RSUs) or phantom stock arrangements should not be treated like stock options, SARs and restricted stock for purposes of the IPO Exception. The final regulations provide that RSUs and phantom stock arrangements qualify under the IPO Exception only if such awards are actually settled or paid during the transition period. In other words, these types of awards will not be treated as "paid" upon the date of grant. Fortunately, the final regulations provide some relief-- this clarification will only apply prospectively to RSU and phantom stock arrangements that are issued on or after April 1, 2015.
Take Away: Companies should take this opportunity to confirm that their stock plans satisfy the required individual per-employee maximum share limitation, and consider whether it is desirable to establish multiple limits for different types of awards. Newly public companies that intend to rely on the IPO Exception should consider whether to continue granting RSUs or phantom stock if such awards could be settled after the end of the transition period. However, companies can take comfort that a tax deduction is still available with respect to awards of RSUs and phantom stock granted prior to April 1, 2015, even if such awards are settled after the end of the transition period.
1Section 162(m) also mandates a $500,000 per year deduction limit applicable to "covered health insurance providers", a discussion of which is beyond the scope of this article.