IRS Issues Helpful Guidance Excluding Principal Financial Officers from Coverage Under Section 162(m) of the Internal Revenue Code

June 8, 2007

On June 4, the IRS issued guidance clarifying which executive officers are "covered employees" for purposes of the $1 million deduction limitation under section 162(m) of the Internal Revenue Code. Under IRS Notice 2007-49, covered employees include the principal executive officer (PEO) and the three other most highly compensated executive officers other than the principal financial officer (PFO). Thus, unlike the prior rule, generally only four executive officers will be subject to the section 162(m) limitation each year.

Code section 162(m) limits to $1 million the annual deduction for compensation paid to covered employees of publicly traded companies, subject to an exception for "performance-based compensation" (e.g., stock options issued pursuant to a shareholder-approved plan that are not in the money when issued and satisfy certain other requirements). Pursuant to section 162(m), the group of covered employees includes the chief executive officer and the other executive officers whose compensation is required to be disclosed in SEC filings "by reason of" being among the four other most highly compensated officers of the corporation.

Under prior rules, there generally were five covered employees. At the time of section 162(m)’s enactment, the covered employees corresponded to the officers whose compensation was subject to disclosure under the SEC’s executive compensation disclosure rules. However, generally effective for fiscal years ending after December 15, 2006, the SEC changed its executive compensation disclosure rules to cover the PEO, the PFO and the three most highly compensated executive officers other than the PEO and the PFO. Because the PFO’s compensation is no longer reported in SEC filings "by reason of" his or her compensation, but rather due to his or her position, the PFO will no longer be a covered employee for purposes of Code section 162(m). Rather, the covered employee group consists of the PEO and the next three most highly compensated executive officers other than the PFO. (Of course, in the unlikely event that the PFO is also the PEO (usually when this occurs it is only on an interim acting basis), then the PFO presumably will be a covered employee as a result of that status.)

This guidance applies to corporations with taxable years ending after December 15, 2006, so it includes calendar year 2006 for corporations that use the calendar year as their tax year. In addition, the new rule applies in future years. However, it should be noted that Congress is considering changes to expand the reach of Code section 162(m) (see our client alert from January 18, 2007), and we would not be surprised if Congress closes this new "loophole" in section 162(m). In addition, covered employee status is measured as of each year-end, not as of the date an award is granted, so it is important to ensure that compensation grants to any person who could be a covered employee at the time compensation otherwise is deductible (e.g., upon option exercise for nonqualified stock options) qualifies for the performance-based compensation exception even if the person is not a covered employee as of the date of grant. Nevertheless, at least in the short-term, Notice 2007-49 is one of the few pieces of good news on executive compensation for public corporations in recent years.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or

Stephen W. Fackler (650-849-5385, [email protected]),
Charles F. Feldman (212-351-3908, [email protected]),
David West (213-229-7654, [email protected]),
David I. Schiller (214-698-3205, [email protected]),
Michael J. Collins (202-887-3551, [email protected]),
Sean Feller (213-229-7579, [email protected]),
Amber Busuttil Mullen (213-229-7023, [email protected]),
Jennifer Patel (202-887-3564, [email protected]), 
Chad Mead (214-698-3134, [email protected]), 
Kimberly Woolley (415-393-8225, [email protected]), or
Jonathan Rosenblatt (650-849-5317, [email protected]).

© 2007 Gibson, Dunn & Crutcher LLP

The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.