Practitioners' Forum Discussion: Proposed Regulations under Code Section 162(m)

The following is a summary of an informal discussion of employee benefit practitioners held in Washington, D.C. on July 14, 2011. The topic concerned the proposed regulations under Code §162(m) that were published in the Federal Register on June 24, 2011. Code §162(m) generally provides that a publicly-traded company may not deduct compensation in excess of $1 million for amounts paid to its CEO or any of its three other highest compensated officers (other than its CFO), unless, among other potential exceptions, such compensation is "performance-based" compensation and paid solely on account of the attainment of one or more pre-established performance goals. 

Discussion Participants 

Dan Brandenburg, Saul Ewing LLP 

Adam Cohen, Sutherland Asbill & Brennan LLP 

Keith A. Mong, Buchanan Ingersoll & Rooney P.C.  

Fred Oliphant, Miller & Chevalier Chartered 

Steve Pavlick, McDermott, Will & Emery  

Mr. Mong:At the end of June, the IRS released proposed regulations under Code §162(m) that are intended to "clarify" the performance-based compensation exception in two-respects. The first clarification involves the per-person/per-period limit which provides that a plan must state the maximum number of shares with respect to which options and SARs [stock appreciation rights] may be granted during a specified period to any employee.  The proposed regulations clarify that an aggregate maximum limit on the number of shares that may be granted under the plan is not enough - a plan must contain a specific per-employee limitation on the number of options and SARs that can be granted.

Mr. Cohen: Although the IRS describes the change in the proposed regulations as a clarification, some practitioners are questioning whether the proposed regulations are making a substantive change, and whether the IRS has reached a logical conclusion in requiring an explicit per-employee limit.

Mr. Pavlick: I have always interpreted the regulations to require an individual limit. However, I understand that some companies and practitioners have taken the position in the past that an aggregate limit should satisfy the requirement.

Mr. Oliphant: I have also interpreted the regulations to require an individual limit, but the line between what is the individual limit and what is the aggregate limit may not always be so clear. For example, I understand that the IRS has indicated informally following the issuance of the proposed regulations that a single overall limit on the number of options and SARs that can be granted under a plan may satisfy the requirement if the plan also states that all the shares may be granted to one person. Disqualifying a plan that implies that limit rather than states it explicitly seems a little like form over substance.

Mr. Cohen: Another issue that needs further clarification by the IRS is how the requirement applies to an existing limitation that covers awards in addition to options or SARs. For example, an omnibus-type plan that provides for options, SARs and other equity-related awards such as restricted stock, RSUs [restricted stock units] and phantom shares. Many of these plans currently include an individual limit that applies to all of the awards under the plan and not just to options and SARs. The proposed regulations could be interpreted to require an individual limit for just options and SARs, although an example in the current regulations seems to say that a single individual limit for all types of awards is acceptable.  It would be helpful if this issue is clarified in the final regulations. 

Mr. Mong: I understand that the IRS has indicated informally that an individual limit just for options and SARs is not required and that the IRS will address this issue either in the preamble to the final regulations or the final regulations themselves. The proposed regulations also provide that the clarification to the per-person/per-period limit applies on or after June 24, 2011.  This effective date raises questions about what companies should do if their existing plan language does not include an individual limit.

Mr. Pavlick: With respect to awards that were exercised or paid before June 24th, they should be okay and no corrective action should be required. With respect to awards that are outstanding on or after June 24th, including awards granted after that date, it would appear that the plan may have to be amended to include an individual limit. In addition, it would appear that new shareholder approval of the individual limit may have to be obtained.  The specifics of any required corrective action should be addressed further by the IRS, which should consider providing some type of transition relief or a delayed effective date to address these issues.

Mr. Cohen: This also raises a question of whether any new shareholder approval requirement would require the executive to subject the outstanding awards to forfeiture if the shareholders do not approve the new individual limitation. The Code §280G regulations include a similar requirement for certain post-change-in-control shareholder approvals. It would probably be difficult to get the executives to agree to subject their outstanding awards to a new shareholder approval requirement, particularly when it is only the company's deduction that is at stake and there are no potential adverse tax consequences to the executives of continuing to hold the outstanding awards.

Mr. Mong: The second clarification in the proposed regulations involves the transition rule under the current regulations for private companies that become public. Under this transition rule, certain awards that are paid during a specific transition period following an IPO [initial public offering] are excepted from the requirements of Code §162(m). There is a more generous transition rule for options, SARs and restricted property, which provides that the exception extends to any such awards granted during the transition period, even if they are exercised or the restrictions lapse after the end of the transition period. The proposed regulations "clarify" that the special transition rule does not apply to RSUs or phantom shares.

Mr. Cohen: This change is complicated by the fact that there are two PLRs [private letter rulings] that were issued in 2004 that ruled that the special transition rule does apply to RSUs. Although I recognize that PLRs are not binding and cannot be cited as authority by other taxpayers, generally they do provide insight with respect to the informal position of the IRS on the issues addressed and generally are relied upon by many taxpayers in the absence of contrary guidance. In addition, although the preamble to the final Code §162(m) regulations indicated that the IRS had taken a different position when the regulations were finalized in 1994, the PLRs were issued ten years after the final regulations and suggested that the IRS may have changed its earlier position.

Mr. Pavlick: The IRS essentially acknowledged this contrary guidance by providing a delayed effective date with respect to this portion of the proposed regulations. This proposed modification does not apply until after the regulations are finalized - a prospective effective date.

Mr. Brandendburg: It is not clear what this effective date means. For example, are all RSUs granted during an applicable transition period and before the regulations are finalized grandfathered?

Mr. Cohen: The proposed regulations do not appear to provide for any grandfathering with respect to RSUs that were granted before the regulations are finalized but that become payable after the end of a transition period. For the reasons I mentioned earlier, the IRS may want to consider broader transition relief for RSUs granted before the regulations are finalized.

Mr. Brandenburg: If there is no grandfathering, then presumably all RSUs would have to be paid before the applicable transition period expires to fall within the transition rule. If an RSU is subject to Code §409A it may be difficult, if not impossible, to accelerate the payment of the RSUs in this manner without violating §409A.  The proposed effective dates for both of these clarifications may also raise FIN 48 issues [FASB ASC 740-10] for the affected companies, which should discuss these potential issues with their accounting firms.

This commentary also will appear in the October 2011 issue of the Tax Management Compensation Planning Journal. For more information, in the Tax Management Portfolios, see Moran, 390 T.M., Reasonable Compensation, and in Tax Practice Series, see ¶5420, Reasonable Compensation.