U.S. Internal Revenue Service Releases Final Section 162(m) Regulations; Primary Impact Is on Equity Awards Granted by Newly Public Corporations

March 31, 2015

Earlier today, the Internal Revenue Service published in the Federal Register final regulations under Section 162(m) of the Internal Revenue Code (the "Code").  Code Section 162(m) limits the ability of public corporations to deduct compensation paid to any covered employee to the extent that such compensation exceeds $1,000,000 in any taxable year.  For purposes of this rule, a public company’s "covered employees" generally include the company’s named executive officers (other than the company’s chief financial officer) as reported to the company’s shareholders under the Securities Exchange Act of 1934.

Code Section 162(m)(4)(C) provides an exception from the $1,000,000 deduction limit for "performance-based" compensation that meets the requirements specified in that section.  Generally, to qualify as performance-based compensation:

• the compensation must be payable solely on account of the attainment of one or more performance goals;
• the performance goals must be determined by a compensation committee of the corporation’s board of directors comprised solely of two or more outside directors;
• the material terms under which the compensation is to be paid, including the performance goals, must be disclosed to shareholders and approved by a majority vote of the shareholders; and
• before the payment of any such compensation, the compensation committee must certify that the performance goals were in fact satisfied.

Individual Award Limitations

The final regulations confirm that, in order to satisfy these requirements, a stock-based compensation plan must specify the maximum aggregate number of shares with respect to which stock options, stock appreciation rights, restricted stock, restricted stock units and other equity-based awards may be granted to any individual employee during a specified period (most typically, one year, although that is not mandatory).  The final regulations clarify that this limitation may apply to all equity-based awards under the plan (as opposed to only stock options and stock appreciation rights, as per the proposed regulations), must be specified on an individual, per employee basis (as opposed to an aggregate share limit), and must be separately disclosed to shareholders of the corporation in connection with the approval process in order to satisfy the shareholder approval requirements.

We expect that most plans already satisfy this rule, because plans typically are drafted in this manner.  However, public companies should review their equity compensation plans for compliance with this individual award limitation requirement.

IPO Transition Rule

In addition, the final regulations clarify certain transition rules that apply to newly public corporations.  Treasury Regulation Sections 1.162-27(f)(1-3) provide that, when a corporation first becomes publicly held, the $1,000,000 deduction limitation does not apply to any compensation received pursuant to the exercise of a stock option or stock appreciation right, or the substantial vesting of restricted property, or otherwise that is paid pursuant to a compensation plan or agreement that existed when the corporation was not publicly held.  A corporation may rely on this transition rule until the earliest of:

• the expiration of the relevant plan or agreement;
• a material modification of the relevant plan or agreement;
• the issuance of all stock or other compensation that has been allocated under the plan or agreement; or
• the first shareholder meeting at which directors are to be elected that occurs after the close of the third calendar year following the year in which an IPO occurs (or for corporations that become public without an IPO, the first calendar year following the year in which the corporation becomes publicly held).

For these purposes, restricted stock and stock options that are granted before the expiration of the transition period remain "grandfathered" even if the compensation is not "paid" (i.e., restricted stock does not vest or stock options are not exercised) until after the transition period, as long as the grant was made before the end of the transition period.  Historically, most companies have taken the position that the same rule applies to restricted stock units (RSUs), since they are economically identical to restricted stock.  However, proposed regulations issued in 2011 did not extend this rule to RSUs.

Commentators had requested an extension of this transition relief to RSUs or phantom stock arrangements granted (rather than paid) before the earliest of the above-enumerated events.  However, the Service rejected these requests and retained the language in its 2011 proposed Section 162(m) regulations.  Thus, RSUs and phantom stock will not qualify for transition relief unless payment is made (i.e., the awards are actually settled) before the end of the transition period.  However, the final regulations provide that this clarification with respect to RSUs and phantom stock arrangements only applies with respect to grants made after March 31, 2015.  Thus, reliance on the transition rule for RSUs and phantom stock granted before that date presumably is permissible even if the RSUs and/or restricted stock do not settle until after the applicable transition period ends.

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