As we approach the end of the calendar year it is not too early (nor too late) to start discussions about actions that may need to be taken next year relating to Internal Revenue Code (IRC) Section 162(m) (Section 162(m)) performance grants. Fourth quarter Board and Compensation Committee meetings are an ideal time to start the discussions for next year’s proxy season and compensation planning (to the extent such discussions have not already begun).

By way of background, Section 162(m) limits to $1 million the amount of compensation that a publicly held corporation may deduct with respect to compensation paid to its Chief Executive Officer and certain other named executive officers. Compensation that meets the “qualified performance-based compensation” exception under Section 162(m) is not subject to this limit. To meet this exception, compensation must, among other requirements, be payable solely on the account of the achievement of one or more pre-established, objective performance goals. A performance goal is considered objective if an unrelated third party could calculate the amount that is payable. Another requirement is that the corporation’s shareholders approve the material terms of the performance goals to which the compensation is to be paid, which may include a laundry list of various objective performance criteria.

To address the application of Section 162(m) performance grants in the coming year, the following three items may need to be considered:

Impact of GAAP Reporting Adjustments to Section 162(m) Performance Goals – Extraordinary Items. When setting performance goals, it is not uncommon for a Compensation Committee to provide for the automatic exclusion of extraordinary items as defined under GAAP (such as a sale of a division, a major litigation or disaster liability) occurring during the performance period. The reason for the exclusion is that the occurrence of an extraordinary event should not affect a determination as to whether the performance goals for the performance period have been achieved. However, the determination of whether there has been an “extraordinary item” cannot be left to the sole discretion of the Compensation Committee because subjective performance goals or the ability to exercise discretion to increase the payout would cause a performance award to not meet the qualified performance-based compensation exception.

In January of this year, the Financial Accounting Standards Board (FASB) eliminated the reporting of extraordinary items from GAAP for fiscal years that begin after December 15, 2015. This was replaced with a new, more flexible reporting requirement relating to items that are considered to be of “an unusual nature or of a type that indicates infrequency of occurrence or both.”

This change will affect any existing performance grant and bonus that has an adjustment for extraordinary items under GAAP, to the extent such grant and bonus covers a performance period that includes a fiscal year that begins after December 15, 2015 (such as previously granted multi-year performance grants). As a result, the Compensation Committee should carefully consider and discuss how to handle this change in GAAP reporting in order to preserve the continuing deductibility of the grant and bonus under Section 162(m).

With respect to any future grants and bonuses (single or multi-year) for performance periods that include fiscal years beginning on and after December 15, 2015, Compensation Committees will be required to change how performance goals are set to the extent those goals previously included adjustments for extraordinary items as defined in GAAP.

  • Performance Goal Shareholder Re-approvals – Five Year Rule. In order to meet the qualified performance-based compensation exception under Section 162(m), among other requirements, the material terms of the performance goal under which compensation is to be paid must be disclosed to and approved by the corporation’s shareholders. This is accomplished by submitting a cash bonus plan or equity compensation plan to the shareholders for a vote at the corporation’s annual meeting. In submitting a plan for approval, many corporations include a laundry list of objective criteria pursuant to which the performance goals may be measured, without specifying the actual performance goals (i.e., the specific financial or other targets). This provides flexibility for the Compensation Committee to change the performance goals for which performance will be measured each time it sets the performance goals for the performance period, so long as the performance goals are among those that were listed in the plan for which shareholder approval was received. For companies that choose this approach, the material terms of the performance goals must be disclosed to and re-approved by the corporation’s shareholders no later than the first shareholder meeting that occurs after the fifth year following the year in which shareholders previously approved the performance goals.
  • Performance Goals and Plan Limits. If a decision has been made to submit a 162(m) performance plan to shareholders next year, this is a good time to review the laundry list of objective performance criteria for which performance goals may be based in order to make sure that the list includes sufficient criteria for which future performance grants may be based. In addition, this is a good time to determine if the per-person-limits under the plan should be increased to take into account changes in compensation structure, size and stock price, among other considerations. Section 162(m) requires any subsequent changes to add new performance criteria and/or increase the per-person-limits under the plan to be re-submitted to the corporation’s shareholders for a vote.