• IRS Clarifies Rules under §162(m) of Internal Revenue Code on Deductibility of Certain Compensation
  • July 22, 2011 | Authors: Michael Jacobster; Melissa K. Ostrower; Bruce H. Schwartz
  • Law Firms: Jackson Lewis LLP - New York Office ; Jackson Lewis LLP - White Plains Office
  • The IRS has proposed Treasury Regulations that clarify the performance-based compensation exception under Section 162(m) of the Internal Revenue Code, which generally precludes a deduction by any publicly held corporation of compensation paid to certain high level employees to the extent the compensation exceeds $1,000,000.  The Treasury Regulations, proposed on June 24, 2011, clarify that in order for stock options and rights to qualify as performance-based compensation, a plan must state the maximum number of shares with respect to which the stock options or rights may be granted during a specified time to any employee.  In addition, the proposed Treasury Regulations clarify that restricted stock units and phantom stock awards granted during the “transition period” (as explained below) will not qualify as performance-based compensation if they are paid after the end of such period.  These clarifications may require changes to, and new shareholder approval of, an employer’s equity plan.

    Clarification of the Maximum Number of Shares Disclosure Requirement
    In order to satisfy the exception for performance-based compensation with respect to stock options and stock appreciation rights, the plan under which the stock options or stock appreciation rights are granted must state the maximum number of shares with respect to which options or rights may be granted during a specified time to any employee.  The proposed Treasury Regulations under Section 162(m) clarify that if a plan states the maximum number of shares that may be granted but does not contain a per-employee limitation on the number of options or rights that may be granted, then any compensation attributable to the stock options or rights under the plan is not performance-based compensation. Although this is a clarification rather than a substantive change, we recommend that clients review their existing equity plans to ensure compliance with this clarification.  If the proposed Treasury Regulations are finalized without change and without a transition rule, as of the effective date of such regulations, any plan that fails to include the per-employee limitation described above will need to be amended and reapproved by shareholders in order for options and rights granted under the plan to qualify as performance-based compensation.

    The text of the proposed Treasury Regulations indicate that this clarification is effective as of June 24, 2011, once the proposed Treasury Regulations are finalized, however, the Preamble to the proposed Treasury Regulations states that they will apply to taxable years ending on or after the date of publication of the rule as final Treasury Regulations.  We anticipate that the final Treasury Regulations will clarify the effective date.

    Section 162(m) Transition Rule Guidance for Private Companies that Become Public
    The proposed Treasury Regulations also provide additional guidance concerning the transition rules under Section 162(m) that apply when a company becomes a publicly held corporation subject to Section 162(m).

    The Treasury Regulations under Section 162(m) provide that in the case of a corporation that was not a publicly held corporation and then becomes a publicly held corporation, the $1,000,000 deduction limit “does not apply to any remuneration paid pursuant to a compensation plan or agreement that existed during the period in which the corporation was not publicly held.” If a corporation becomes publicly held in connection with an initial public offering (“IPO”), then the relief provided in the Treasury Regulations applies only to the extent that the prospectus accompanying the IPO disclosed information concerning the existing compensation plans or agreements and satisfied all applicable securities laws.
     
    Pursuant to the Treasury Regulations under Section 162(m), a corporation may rely on the special Section 162(m) transition rules until the earliest of: (i) the expiration of the plan or agreement; (ii) the material modification of the plan or agreement; (iii) the issuance of all employer stock and other compensation that has been allocated under the plan; or (iv) 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 the IPO occurs or, in the case of a privately held corporation that becomes publicly held without an IPO, the first calendar year following the calendar year in which the corporation becomes publicly held (the “Transition Period”).

    The Treasury Regulations provide that the relief applies to any compensation received pursuant the exercise of a stock option or stock appreciation right, or the substantial vesting of restricted property if the grant occurs on or before the end of the Transition Period.

    Practitioners have asked whether compensation payable under a restricted stock unit arrangement or a phantom stock arrangement is eligible for this special transition rule that applies to stock options, stock appreciation rights and restricted property. (A restricted stock unit is a right to an amount based on the value of the employer's stock, and which is payable in cash, shares of the stock, or other property, following the satisfaction of a specified vesting condition. Compensation payable under a phantom stock arrangement is compensation that is paid at a future date in cash or in property based on the value of the employer's stock.)

    The proposed Treasury Regulations clarify that only compensation attributable to stock options, stock appreciation rights and restricted property is covered under the special transition rule discussed above.  Thus, any company attempting to avail itself of the special transition rules in the Section 162(m) Treasury Regulations should be aware that unless restricted stock units and phantom stock arrangements are paid out prior to the end of the Transition Period, such payments will be subject to the $1,000,000 deduction limit under Section 162(m).  Companies should keep in mind that to the extent restricted stock units and phantom stock arrangements are subject to Section 409A of the Internal Revenue Code, accelerating the payment date of such awards could have adverse tax consequences to participants.

    Prior to publication of these proposed Treasury Regulations, the IRS ruled privately in a number of rulings that where a company that had become publicly traded granted restricted stock units during the Transition Period, payment in respect of the restricted stock units after the close of the Transition Period was not subject to the $1 million deduction limit.  See Priv. Ltr. Ruls. 200449012 and 200406026.

    The text of the proposed Treasury Regulations provides that this new transition rule will apply after the date of the publication of the proposed Treasury Regulations as final Treasury Regulations in the Federal Register, however, the Preamble to the proposed Treasury Regulations state that they will apply to taxable years ending on or after the date of publication of the rule as final Treasury Regulations. We anticipate that the final Treasury Regulations will clarify the effective date.