Executive Summary: As we start the New Year, publicly traded corporations should begin reviewing their compensation plans/arrangements to ensure that compensation that is intended to qualify as performance-based compensation satisfies the performance-based compensation exception requirements of Section 162(m) of the Internal Revenue Code.

As general rule, Section 162(m) prohibits publicly traded corporations from deducting more than $1 million per year, per person, to its chief executive officer and three other most highly compensated officers (other than its principal/chief financial officer).

Publicly traded corporations, however, are allowed to fully deduct components of executive compensation that qualify as "performance-based" compensation. To qualify for the performance-based compensation exception:

1. The compensation must be paid solely on account of attaining one or more pre-established and objective performance goals;
2. The performance goals related to the compensation must be established by the compensation committee;
3. The material terms of the performance goals and compensation must be disclosed to and approved by shareholders in a separate vote before payment is made; and
4. The compensation committee must certify that the performance goals and any other material terms are satisfied before payment is made.

What this Means for Publicly Traded Corporations

Failure to ensure compliance with Section 162(m)'s requirements could result in compensation that was intended to qualify as performance-based compensation failing to be fully deductible. Further, shareholder derivative lawsuits that have, in part, been based on claims that the corporation failed to qualify compensation as performance-based, have become more prominent. Such lawsuits have alleged that:

1. The corporation failed to disclose the material terms of the performance goals and compensation plan;
2. The corporation failed to comply with an award limit with regard to an incentive award; and
3. The compensation committee increased an incentive award payment even though Section 162(m) prohibits compensation committees from having discretion to increase an amount of compensation payable under a plan.

The Bottom Line

In light of the risks of compensation not qualifying as performance-based, publicly traded corporations should carefully review their compensation plan/arrangements to ensure that:

1. The proxy statement disclosures do not include a promise (or imply a promise) that the compensation will qualify as performance-based compensation under Section 162(m);
2. The performance goals are based on a business criteria;
3. The performance goal is based on an objective formula so that a third party could calculate the award with knowledge of the relevant performance result;
4. The performance goal is established before or soon after the performance period starts; and
5. There is no discretion to increase the amount of compensation payable.