Section 162(m) generally limits to $1 million the amount that a public company can annually deduct with respect to remuneration paid to certain covered employees. This deduction limitation, however, does not apply to remuneration that qualifies as “performance-based compensation” or that is paid in accordance with a transition rule that is available to new public companies. The performance-based compensation exemption is commonly used to ensure that all gains resulting from exercising stock options or stock appreciation rights (SARs) will be deductible. The transition rule for new public companies, often referred to as the initial public offering (IPO) transition rule, allows for compensation to be exempt from the $1 million deduction for a limited period of time even though it does not qualify as performance-based compensation.
On March 31, 2015, the Internal Revenue Service (IRS) issued final regulations clarifying that stock options and SARs will only qualify as performance-based compensation if granted under a stockholder-approved plan that includes an individual limit on the number of such awards that a covered employee may receive during a specified period. In addition, only certain types of stock-based compensation are eligible to be treated as “paid” when granted for purposes of qualifying for the exemption under the IPO transition rule. The final regulations largely follow the rules set forth in the proposed regulations issued in 2011, except for the following changes:
- The change to the IPO transition rule described above applies only to stock-based awards granted on or after April 1, 2015.
- The individual limit described above can be structured to also include types of equity awards other than stock options and SARs.
The final regulations did not change the effective date for the requirement to have a shareholder-approved individual per-employee limit for stock options (and, if applicable, SARs). As a result, stock options and SARs granted under a plan without an individual per-employee limit on or after June 24, 2011, will not qualify as performance-based compensation under Section 162(m). Following is a more detailed description of the clarifications made under the final regulations.
Individual Per-Employee Limit
One of the requirements for “performance-based compensation” is that a stockholder-approved plan must set forth the maximum amount of compensation that may be earned by a covered employee. With respect to stock-based compensation, some public companies took the position that this requirement was met by virtue of stockholders approving a share reserve under a plan with a stated term. The idea was that no employee could receive a combination of stock options and SARs that exceeded the maximum number of shares subject to the share reserve. The proposed regulations stated that an aggregate limit on the number of shares that could be granted under a stockholder-approved plan would not meet the requirement for establishing the maximum amount of compensation that may be received by an individual covered employee. The final regulations, citing to the legislative history under Section 162(m), retain this approach and describe the change as not being “substantive.” However, the clarification in the final regulations does not apply to stock options and SARs granted prior to the issuance of the proposed regulations.
Various alternatives exist when structuring an individual per-employee limit for stock options and SARs to comply with Section 162(m) requirements. This limit can apply to these types of awards only or to all types of stock-based awards, whether or not they are intended to qualify as performance-based compensation under Section 162(m). A public company that wants to maximize flexibility for equity grants can have separate limits for stock options/SARs and for full-value awards (e.g., performance shares, performance-based restricted stock and restricted stock units) that are intended to qualify as performance-based compensation. There is no requirement to have an individual per-employee limit for time-based restricted stock or restricted stock units. For public companies that want to have a stockholder-approved restriction on the number of equity awards that are granted to non-employee directors, it is possible (and appropriate) to impose this limit separate from the individual per-employee limit that is used for Section 162(m) compliance.
IPO Transition Rule
The $1 million compensation deduction limitation does not apply to any compensation “paid” pursuant to a plan that existed before the company becomes publicly held, and the company may rely on this transition relief until the earlier of (1) the expiration of the plan, (2) a material modification of the plan, (3) the issuance of all stock that had been reserved under the plan and (4) the first meeting of the stockholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which the IPO occurs (or, in the case of a company that did not have an IPO, the first calendar year after the calendar year in which the company becomes publicly held). For purposes of demonstrating when stock-based compensation has been “paid” for purposes of this special transition rule, Treas. Reg. Section 1.162-27(f)(3) provided that amounts attributable to stock options, SARs and restricted stock would be treated as “paid” upon the grant date. This means that the Section 162(m) deduction limitation would not apply to gains, irrespective of when deductible to the company, as long as the grant occurred during the transition period. The IRS, in private letter rulings, had also ruled that restricted stock units would be treated as “paid” upon grant irrespective of when shares were actually distributed to the participant (click here for additional details).
The final regulations, similar to the proposed regulations, reverse the favorable result in the private letter rulings. Shares issued upon settlement of restricted stock units, performance shares or other similar stock-based deferred arrangements will not qualify for relief under the IPO transition rule unless the share issuance occurs during the transition period—i.e., these types of awards will not be treated as “paid” upon the date of grant. Fortunately, this change will only apply to restricted stock units, performance shares or other similar stock-based deferred arrangements that are issued on or after April 1, 2015. A less generous transition rule had been provided under the proposed regulations.
Public companies with stock-based plans that are intended to comply with the requirements for performance-based compensation should confirm that their plan document sets forth the required individual per-employee limit. If a plan will be submitted to stockholders, companies should consider whether the structure of the limit set forth in the plan meets the company’s needs, both in terms of who is covered by the limit and whether there should be multiple limits.
Public companies that intend to rely on the IPO transition rule should evaluate whether it remains appropriate to grant performance-based restricted stock units or performance shares. In many cases, these awards will result in shares being issued after the end of the IPO transition period. If these awards are settled in stock after the end of this period, valuable tax deductions may be lost. In many cases, use of restricted stock, in lieu of restricted stock units and performance shares, will ensure an exemption from the $1 million deduction limitation as long as the grant occurs before the end of the IPO transition period.