Section 162(m) Compliance Alert

Section 162(m) generally provides that a publicly traded corporation may not deduct compensation in excess of $1,000,000 for amounts paid to its CEO or any of the three other highest compensated officers, unless such compensation is “performance-based” compensation and paid solely on account of the attainment of one or more pre-established performance goals. The IRS has recently issued proposed regulations under Section 162(m) of the Code (“Proposed Regulations”) to clarify certain requirements contained in the final regulations adopted in 1995 (“Final Regulations”). This compliance alert focuses on certain aspects of the Proposed Regulations that may require changes to existing employer plans and practices.

IRS Proposed Regulations

The Proposed Regulations were issued to clarify uncertainties regarding: (i) the requirement that a stock-based compensation plan must state a maximum number of shares with respect to which stock options and stock appreciation rights (“SARs”) may be granted to any employee; and (ii) the transition rule applicable to corporations that become publicly traded. The IRS has indicated that the Proposed Regulations are not intended to reflect substantive changes to the Final Regulations, but rather are intended to clarify the Final Regulations. Accordingly, employers whose plans and practices are not currently in conformity with these clarifications could risk losing a valuable tax deduction with respect to their covered employees.

Individual Stock Option and SAR Share Limits — Shareholder Approval

Under the Final Regulations, the plan under which stock options and SARs are granted must state the maximum number of shares for which stock options and SARs may be granted to any employee during a specific period. The IRS has continued to receive questions on this requirement as to whether an overall maximum share limitation would satisfy this requirement (e.g., the Corporation may not grant options to purchase more than 900,000 shares over a 3-year period). The Proposed Regulations clarify this issue by providing that the plan must specify the maximum number of shares with respect to which options or SARs may be granted to any individual employee during a specified period (e.g., no individual employee may receive options for more than 100,000 shares over a 3-year period). Additionally, the Proposed Regulations make a corresponding clarification to the shareholder approval requirements by requiring that the description provided to the shareholders must disclose the maximum number of shares for which grants may be made to each individual employee during a specified period and the exercise price of those options (e.g., the fair market value on the date of grant).

IPO Transition Rule

With respect to a corporation that becomes a publicly traded (e.g., through an initial public offering), the Final Regulations contain a special transition rule that provides that the deduction limit does not apply to any compensation paid pursuant to a plan that existed during the period in which the corporation was not publicly traded. This relief may only be relied upon until the earliest of: (i) the expiration or material modification of the plan; (ii) the issuance of all employer stock and other compensation that has been allocated under the plan; or (iii) the first meeting of the shareholders at which directors are to be elected that occurs after the close of the third calendar year in which the initial public offering occurs. The Final Regulations also provide that, with respect to stock-based compensation, the transition rule will apply to any compensation received pursuant to the exercise of a stock option or stock appreciation right, or the substantial vesting of restricted property, that was granted under any such plan or agreement, provided that the grant occurs on or before the expiration of the transition period.

In 2004, the IRS issued several private letter rulings which held that the compensation payable under a restricted stock unit (“RSU”) would be deductible under the transition rule if the RSU was granted prior to the expiration of the transition period. See e.g., PLR 200449012 and 200406062. In these private letter rulings, the IRS reasoned that a grant of an RSU is stock-based compensation that is the economic equivalent of a grant of a restricted share of common stock. After reconsidering this issue, the IRS has decided to not follow these earlier private letter rulings and has clarified this issue in the Proposed Regulations. Accordingly, phantom stock, RSUs and other forms of unit awards (e.g., performance share units) must be actually paid, and not merely granted, prior to the expiration of the transition period.

Effective Date

The Proposed Regulations are tentatively scheduled to apply on or after the date of publication of the final provisions in the Federal Register. The IRS, however, will consider timely-submitted public comments on the Proposed Regulations.

What Should Employers Do Now?

In light of the fact that the IRS views the Proposed Regulations as a clarification of the Final Regulations (and not substantive changes), employers should review their existing equity plans to determine whether any amendments or changes in grant practices are warranted. To the extent an amendment is necessary to incorporate an individual award limit, the revised plan will also need to be approved by shareholders. In all instances, however, employers should review their shareholder approval process to make certain that the disclosures to their shareholders are consistent with the requirements of the Proposed Regulations.

With respect to corporations that have recently become publicly traded, the deductibility of compensation paid pursuant to the grant of RSUs, performance share units and phantom stock could be in jeopardy to the extent the corporation relied on unofficial guidance contained in prior IRS private letter rulings. Accordingly, any such awards should be reviewed to determine whether the timing of the payment of such compensation can be modified (e.g., accelerated) to limit the impact of the Proposed Regulations. Additionally, affected employers should consider submitting comments to the IRS to request that the Proposed Regulations be applied prospectively in order to mitigate the potential loss of a tax deduction with respect to outstanding awards.