Introduction

The Internal Revenue Service recently amended the regulations under Internal Revenue Code Section 162(m). Section 162(m) applies to publicly held companies and generally limits the tax deduction that a public company is allowed for certain executive compensation. The recent changes to the 162(m) regulations are likely to have a practical effect only on companies that first became publicly traded in approximately the last four years.

The specific changes to the regulations are:

1. Per Employee Limitation: A stock option or stock appreciation right issued to a covered employee by a public company must be granted under an equity plan that specifies the maximum number of stock options or stock appreciation rights that can be granted to an individual employee during a specified period (for instance, a fiscal year). An aggregate limit for the plan is by itself not sufficient.
   
   Practical Consideration: This change to the regulations is only a clarification. This requirement already was generally well understood even before this IRS amendment to the regulations, and because of this, most companies' plans already are drafted to comply with this rule.
2. Stock-Based Compensation Transition Rule: Restricted stock units (RSUs) granted on or after April 1, 2015, must be paid and included in the employee's income before the end of the transition period for newly public companies to be exempt from Section 162(m) deduction limits. RSUs granted prior to April 1, 2015, and during the transition period will be exempt from the Section 162(m) deduction limits even if paid after the expiration of the transition period.
   
   Practical Considerations:
   • This change to the regulations applies only to companies that first became publicly traded in approximately the last four years.
   • Newly publicly traded companies still within the transition period (see below) should consider granting awards of restricted stock instead of RSUs to avoid the impact of this portion of 162(m).

Background

Section 162(m) limits the annual tax deduction to $1 million for compensation paid to each of a public company's chief executive officer and three highest compensated officers (other than the chief financial officer). This limit, however, does not apply to qualified performance-based compensation, or to certain compensation paid by a company that recently became publicly traded.

Per Employee Limitation

Under Section 162(m), the plan document through which an option or stock appreciation right is granted must state the maximum number of shares with respect to which options or rights may be granted during a specified period to an employee (the "per employee limitation"). There previously was some question about whether companies could rely on the fact that the plan document had a maximum number of shares that could be awarded under the plan in the aggregate, but the IRS made clear that a per employee limitation also is required. Because the IRS considers this a clarification, this requirement applies to grants made on or after June 24, 2011. The requirement that a plan include a per employee limitation does not apply while a newly public company is relying on the transition rule outlined below.

Newly Public Transition Rule

When a company becomes publicly traded, the Section 162(m) deduction limitation does not apply to any compensation paid pursuant to a plan or agreement that existed during the period in which the company was not publicly held.

A company may rely on this transition rule until the earliest of:

1. the expiration of the plan or agreement;
2. a material modification of the plan or agreement;
3. the issuance of all employer stock and other compensation that has been allocated under the plan or agreement; or
4. the first meeting of shareholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which an initial public offering occurs or, in the case of a privately held company that becomes publicly held without an initial public offering (e.g., through a spin-off), the first calendar year following the calendar year in which the company becomes publicly held.

For companies that have recently become publicly traded and are still in the transition period because none of (i) through (iii) has occurred, the shareholder meeting (at which directors are elected) that ends the transition period is specified below:

RSUs granted prior to April 1, 2015, and during the transition period will be exempt from Section 162(m) even if paid and settled after the expiration of the transition period. RSUs granted on or after April 1, 2015, will only be exempt from Section 162(m) to the extent paid and settled prior to the expiration of the transition period.

A company that is in a post-IPO transition period can grant awards of restricted stock instead of RSUs on or after April 1, 2015, and those awards will continue to be exempt from Section 162(m) even if the income from the restricted stock is recognized after the end of the transition period. There are other matters a company should consider before choosing to grant awards of restricted stock instead of RSUs.

Action Items

• Public companies no longer relying on the transition rule should review their equity plans to ensure that stock options and stock appreciation rights intended to constitute qualified performance-based compensation under Section 162(m) are subject to individual employee share limits during a specified performance period. As noted above, we expect that most plans already comply with this requirement.
• Companies either anticipating becoming publicly traded or that have recently become publicly traded should consider either of the following alternatives for senior officers²:
  • structuring new grants of RSUs to senior officers to be settled and paid out prior to the expiration of the transition period; or
  • granting awards of restricted stock instead of RSUs, which will be exempt if granted before the expiration of the transition period even if vesting occurs following the expiration of the transition period.

¹ For a company that becomes publicly traded through an initial public offering, the transition period is only available if the prospectus for that offering (e.g., a Form S-1) describes these plans or agreements.

² The Section 162(m) rules determine covered individuals at the time compensation is paid, not when awards are granted, so it is best to consider the broader universe of potential covered individuals rather than just the few individuals who are covered individuals at the time of grant.