The Internal Revenue Service has released a proposed rule to clarify what qualifies as performance-based executive compensation deductions under Section 162(m) of the federal tax code.
“As these things go, it's not a significant regulation, but it is important to get it right,” says Ben Wells, a partner with law firm Dinsmore & Shohl. “It's a potential trap for the unwary if you continue to move along and don't at least check to make sure you're in compliance.”
Section 162(m) caps how much executive compensation spending public companies can deduct from their taxable income, limiting them to deducting pay packages of no more than $1 million per year. An exception applies to “performance-based compensation,” which does not count against the $1 million deduction limit.
Stock options and stock appreciation rights are inherently performance-based compensation, but they're exempt from Section 162(m)'s $1 million cap only under certain circumstances:
The grant or award must be made by the compensation committee (made up of at least two independent directors);
Under the terms of the option or right, the amount of compensation the employee may receive is based solely on an increase in the value of the stock after the date of the grant or award; and
The plan under which the option or right is granted must state the maximum number of shares, options, or appreciation rights that can be granted during a specified period.
In regard to the last requirement, the proposed regulations, issued on June 24, clarify that the equity incentive plan must specify the number of shares that may be granted per individual during a specified period. An equity incentive plan which merely states the maximum number of aggregate shares that may be granted doesn't meet the exemption requirements for qualified performance-based compensation.
If 10,000 options are available to be granted during a particular period, for example, some tax compliance experts had taken the stance that those 10,000 options could also be the limit allowed for any individual person, explains Wells. The proposed regulations eliminate this uncertainty.
The proposed rule also requires that preparers have to disclose this limit to shareholders, as well as the methodology used to set the exercise price of any option or appreciation right granted under the plan.
Jennifer Dunsizer, of counsel with law firm Vorys, says that clarification is not anything new, since equity plans must already include an aggregate limit on the number of shares that can be awarded to all participants to comply with the federal securities laws. “If you haven't described how you set the exercise price, you haven't effectively described the compensation somebody is going to get under a grant,” Dunsizer says. “That's a nuance a lot of people had missed in their descriptions historically.”
On a practical level the proposed regulations mean that any company that is public (or that may become public) should review the documentation of its existing performance pay plan, to determine whether any amendments are needed in anticipation of final regulations. “It would be worthwhile to take a look at any option or stock appreciation rights plan that's currently in existence to make sure it contains that necessary [individual] limit, rather than just an aggregate limit,” Wells says.
IPO Deductions
The IRS also revised its stance on what happens to stock-based compensation when a private company goes public. Under current regulations, Section 162(m) states that compensation arrangements that existed during the time the company was private are exempt from the $1 million deduction limit.
“Restricted stock units had been the form of choice in a lot of circumstances, but for private companies that are thinking about going public, there is now a reason to shy away from them.”
—Jennifer Dunsizer,
Of Counsel,
Voryz
This relief is available only during the “reliance period,” which lasts 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 allocated under the plan or agreement; or (4) the first meeting of shareholders to elect directors that occurs after the end of the third calendar year following the year of the initial public offering.
The existing regulations also provide that if an option, stock appreciation right, or a restricted stock award is granted during the transition period under a pre-IPO plan, then compensation received upon the exercise of stock options or stock appreciation rights or the vesting of restricted stock is also exempt, even if the exercise or vesting occurs after the transition period expires.
This rule led many compensation professionals to assume that if the transition rule applies to stock options, SARs, and restricted stock, it also must apply to other equity-based awards, such as restricted stock units and phantom stock arrangements granted during the transition period.
Wrong. The proposed regulation clarifies that this relief is available only for restricted stock, options, and SARs. With respect to any other compensation or award (such as restricted stock units or phantom stock), the rule only applies to compensation recognized during the reliance period.
EXPLANATION OF PROVISIONS
The following excerpt from the SEC's proposed rules examines the, “Maximum number of shares with respect to which options or rights may be granted to each individual employee.”
… The legislative history for section 162(m) provides that ‘‘[i]n the case of stock options, it is intended that the directors may retain discretion as to the exact number of options that are granted to an executive, provided that the maximum number of options that the individual executive may receive during a specified period is predetermined.'' H.R. Conf. Rep. No. 213, 103rd Cong., 1st Sess. 586–87 (1993), reprinted in 1993 U.S.C.C.A.N. 1088, 1275–6.
The preamble to the proposed 1993 Treasury Regulations (58 FR 66310) under section 162(m) explains the reason for requiring an individual limit on the maximum number of shares for which options may be granted:
Some have questioned why it would be necessary for the regulations to require an individual employee limit on the number of the shares for which options or stock appreciation rights may be granted, where shareholder approval of an aggregate limit is obtained for securities law purposes. The regulations follow the legislative history, which suggests that a per-employee limit be required under the terms of the plan. The IRS and the Treasury believe that a limit on the maximum number of shares for which
individual employees may receive options or other rights is appropriate because it is consistent with the broader requirement that a performance goal include an objective formula for determining the maximum amount of compensation that an individual employee could receive if the performance goal were satisfied. A third party attempting to make this determination with respect to a stock option plan would need to know both the exercise price and the number of options that could be granted.
Section 1.162–27(h)(3)(i) of the final regulations provides that, under a transition rule that applies to plans or agreements approved by shareholders before December 20, 1993, a stock option plan was treated as satisfying the requirement to state a maximum
number of shares for which an option could be granted to any employee over a specified period if the plan that was approved by the shareholders provided for an aggregate limit (consistent with SEC Rule 16b–3(b)) on the shares of employer stock for which awards could be made under the plan. This rule was available only during a limited reliance period specified in § 1.162–27(h)(3)(i).
These proposed regulations clarify § 1.162–27(e)(2)(vi) by providing that the plan under which the option or right is granted must specify the maximum number of shares with respect to which options or rights may be granted to any individual employee during a specified period. Accordingly, if a plan states an aggregate maximum number of shares that may be granted but does not contain a specific per-employee limitation on the number of options that may be granted, then any compensation attributable to the stock options or rights granted under the plan is not qualified performance-based compensation under § 1.162–27(e)(2)(vi). A plan satisfies § 1.162–27(e)(2)(vi) where the terms of the plan specify that an individual employee may be granted options or rights to receive the maximum number of shares authorized under the plan during a specified period. Example 9 of § 1.162–27(e)(2)(vii) of the regulations has been modified to illustrate these principles.
These proposed regulations also provide a related clarification of the shareholder approval requirement under § 1.162–27(e)(4). Specifically, § 1.162–27(e)(4)(iv) is clarified to provide that the requirement for description of the compensation in this section is satisfied where 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 is disclosed to the shareholders of the corporation.
Source: IRS Proposed Rule 162(m) Clarification.
The proposed regulations effectively overturn an earlier IRS interpretation in several of its former Private Letter Rulings, in which the IRS said that other equity-based awards, like restricted stock units, can be treated like restricted stock under the regulations. Private-letter rulings, however, only apply to the taxpayer to whom they're directed, so the IRS is allowed to reverse its stance any time, Dunsizer says.
Between the time the Section 162 regulations were proposed and the time they were finalized, the IRS had received several comments on expanding the rule's scope to cover other types of equity, explains Dunsizer. The IRS ultimately decided not to expand the rules.
This clarification is important, since many companies prefer restricted stock units over restricted stock due to their tax-planning flexibility. With restricted stock, the shares of company stock are transferred upfront at the time the award is made, subject to a vesting schedule based on either the stockholder's continued employment, or the attainment of specified performance goals.
Restricted stock units, on the other hand, constitute a promise to transfer shares of a company's stock to the stockholder only after the specified vesting conditions have been met. Since RSUs can vest prior to the stock being delivered and is taxable to the stockholder, they provide companies with more tax planning flexibility than restricted stock. “Restricted stock units had been the form of choice in a lot of circumstances, but for private companies that are thinking about going public, there is now a reason to shy away from them,” says Dunsizer.
“If you are a company that is going public, or just went public, and you're intent on using Section 162(m) transition rule, you will probably want to use options, SARs, or restricted stock, rather than restricted stock units,” agrees Michael Falk, a partner in law firm Winston & Strawn.
“All public companies, or companies thinking about going public, should revisit their equity compensation plans and discuss them with their advisers,” to determine whether they comply with the proposed regulations, says Falk.
Additionally, newly public companies that are subject to Section 162(m) and have granted awards of restricted stock units, phantom stock, or other types of equity-based compensation should consider whether the original grants met the requirements for exclusion from 162(m), says Dunsizer.
Companies need to determine if the original grants were approved by an independent compensation committee and granted under a shareholder-approved plan. If not, the company should consider restructuring the awards to ensure their future deductibility.
Tax planning experts suggest that since these rules constitute a clarification of requirements already in effect companies should not wait until the final regulations have been issued before making changes to their plans, or their practice.
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