IRS Issues Proposed Regulations Under Code Section 162(m)

Code Section 162(m) of the Internal Revenue Code of 1986, as amended (the "Code") precludes a tax deduction for remuneration paid to certain employees of publicly held companies in excess of $1,000,000.  On June 23, 2011 the IRS issued proposed regulations under Code Section 162(m) to clarify two provisions of existing treasury regulations.

Performance-Based Compensation.  The Code Section 162(m) deduction limitation does not apply to compensation paid on attainment of pre-established performance goals that qualifies as performance-based compensation.  Under existing regulations, compensation attributable to a stock option or stock appreciation right is deemed paid on attainment of pre-established performance goals if (i) the grant or award is made by the compensation committee; (ii) the plan under which the option or right is granted states the maximum number of shares or rights that may be granted during a specified period to any employee; and (iii) under the terms of the option or right, the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the date of the grant or award (such as a stock option with an exercise price at fair market value on the date of grant).

The proposed regulations clarify the maximum number of shares requirement in (ii) above by requiring that a plan must state the maximum number of shares or rights that may be granted to any individual employee during a specified period to qualify as performance-based compensation.  Accordingly, options or rights granted under a plan that states an aggregate maximum number of shares that may be granted but does not contain a per-employee limitation for a specified period will not be considered performance-based compensation.  The proposed regulations also clarify that the shareholder approval requirement in the current regulations is satisfied if the maximum number of shares for which grants may be made to each individual employee during the specified period and the exercise price of those options are disclosed to the shareholders of the corporation.

Public Company Transition Rules.  Existing treasury regulations include a transition rule for corporations that become publicly held.  Regulations currently provide that the $1,000,000 limitation under Code Section 162(m) does not apply to remuneration paid pursuant to a compensation plan or agreement that existed prior to the corporation becoming publicly held.  A corporation may rely on this exception to Code Section 162(m) until the earliest occurrence of certain events specified in the regulations.  This transition period relief from Code Section 162(m) applies to any compensation received pursuant to a stock option, stock appreciation right, or vesting of restricted property granted under such a plan or agreement so long as the grant occurs before the earliest of the specified events.

The proposed regulations specify that the transition relief provided to compensation received pursuant to a stock option, stock appreciation right or restricted property does not apply to any other form of stock-based compensation.  Accordingly, compensation payable under a restricted stock unit arrangement or a phantom stock arrangement, for example, must be paid rather than merely granted prior to the occurrence of the earliest of the specified events in order for the transition rule to apply.

These proposed regulations will apply to taxable years ending on or after the publication of final regulations in the Federal Register.  Public companies should review their Code Section 162(m) plan documents to determine whether any amendments are necessary to conform to these proposed regulations.