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04.17.2015 | Legal Advisory

Brief Summary

On March 31, 2015, the Internal Revenue Service issued final regulations under Section 162(m) of the Internal Revenue Code. Section 162(m) precludes publicly-held companies from deducting compensation paid to covered employees in excess of $1 million unless certain requirements regarding performance-based compensation are met. The final regulations (1) clarify that, in order to meet those requirements, equity compensation plans must include individual plan limits with respect to stock options and share appreciation rights and (2) include a more restrictive interpretation of the transition rule for newly-public companies as it applies to restricted stock units and phantom stock arrangements.

General Requirements of Section 162(m)

Section 162(m) generally disallows a deduction to any publicly-held company for taxable compensation paid to any “covered employee” in any one taxable year that exceeds $1 million. For this purpose, covered employees include a company’s chief executive officer and its three other most highly compensated employees (other than the chief financial officer). There is an exception, however, for “qualified performance-based compensation,” which would not count against the $1 million limit provided certain requirements are met. To qualify as performance-based compensation: 

• The compensation must be paid solely on account of the attainment of one or more preestablished, objective performance goals; 
• The performance goal(s) under which such compensation is to be paid must be established by a compensation committee comprised solely of two or more outside directors; 
• The material terms of the performance goal(s) pursuant to which such compensation is to be paid must be disclosed to, and approved by a majority of, the company’s shareholders prior to payment; and 
• The company’s compensation committee must certify in writing prior to the payment of any compensation that the performance goals and any other material terms were satisfied.

Section 162(m) includes transition relief for newly-public companies meeting certain disclosure requirements which provides generally that the deduction limitation will not apply to any compensation paid under any plan or arrangement that existed prior to the company becoming publicly-held. This transition relief is available to newly-public companies until the first to occur of: (i) the expiration of the plan or agreement; (ii) any material modification of the plan or agreement; (iii) the issuance of all stock and other compensation that has been allocated under the plan; and (iv) the first meeting of the shareholders after either the close of the third calendar year following the calendar year the company became publicly held through an IPO (or the close of the first calendar year following the calendar year in which the company became publicly-held other than through an IPO).

Impact of Final Regulations

Individual Per Plan Limits

The final regulations clarify that compensation attributable to stock options and stock appreciation rights will meet the qualified performance-based compensation requirements of Section 162(m) only if a shareholder-approved plan or agreement under which such equity awards are granted includes specific limits on the maximum number of shares with respect to which options or stock appreciation rights may be granted to any individual employee during a specified period. The shareholder-approved plan or agreement also may satisfy this requirement by including an aggregate maximum number of shares with respect to which any equity-based award may be granted to any individual employee during a specified period. This clarification applies to any stock options or stock appreciation rights granted on or after June 24, 2011.

Treatment of Restricted Stock Units and Phantom Stock

As described above, Section 162(m) includes transition relief for newly-public companies for compensation paid during the transition relief period. This relief previously applied to any compensation paid pursuant to the exercise of a stock option or stock appreciation rights, or the substantial vesting of restricted property, if the grant of the equity-based compensation occurred during the applicable transition relief period. The final regulations clarify that such relief is available for a restricted stock unit or phantom stock arrangement only if the arrangement is not only granted, but also paid, during the applicable transition relief period. The final regulations regarding the treatment of restricted stock unit and phantom stock arrangements apply to any grants occurring on or after April 1, 2015.

Newly-public companies intending to take advantage of the Section 162(m) transition relief should review their current grant practices to ensure that they do not run afoul of the final regulations.

This advisory was prepared by the Tax Department at Nutter McClennen & Fish LLP. For more information, please contact your Nutter attorney at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.