The IRS and Treasury Department recently issued final regulations under Code Section 162(m) that, as the IRS describes it, “clarifies” stock and equity-based compensation plan drafting issues. Of course, whether something represents a clarification or a substantive change lies in the eye of the beholder (particularly if that beholder is a politician or regulator in need of political cover). In this case, however, the IRS generally is correct to describe the final regulations as clarifications. With respect to stock options and SARs, the new regulations reflect what were widely held opinions in the executive compensation community. With respect to restricted stock units (“RSUs”) and phantom stock granted by privately held companies that become publicly traded, the new regulations could be considered a more substantive change, but the IRS in effect has provided nearly four years’ worth of advanced notice of this change. The good news is that the new regulations should not affect most employers’ stock plans. Still, it would be wise for public companies to perform a review of these plans to confirm whether they qualify for the performance-based exception to the $1 million deduction limit under Code Section 162(m).

Code Section 162(m), generally

As background, Code Section 162(m) limits the deduction that a publicly traded company can take with respect to remuneration paid to its “covered employees”—its CEO and three most highly paid named executive officers (other than the CEO and CFO)—to the extent that such compensation exceeds $1 million. The deduction limit does not apply, however, to qualified performance-based compensation. Publicly traded companies often structure their equity based compensation plans in a manner to qualify the awards under those plans (options, SARs, RSUs, restricted stock, etc.) as performance-based compensation.

Options and SARs

In 2011, the IRS issued proposed regulations that “clarified” that the plan under which options and SARs were granted must specify the maximum number of shares relating to those awards that may be granted to any individual during a specified period. Most practitioners had long counseled their public company clients to put these individual limits in their plans to make sure these awards qualified as performance-based compensation under Code Section 162(m). Some commentators, however, argued that stating an aggregate share limit for all awards should be enough. The IRS rejected this view in the proposed regulations, stating that a per employee limit was necessary to assist a third party in determining the maximum amount of compensation that could be payable to any individual employee during a specified period.

The final regulations formally adopt this view. The one modification is that a plan may specify a maximum number of shares with respect to all types of awards (options, SARs, RSUs, restricted stock, performance shares) that may be granted to an employee during a specified period.

RSUs and phantom stock of private companies that become public

Additionally, the proposed regulations clarified that an existing limited transition period does not apply to grants of RSUs or phantom stock by a company that, at the time the grants are made, is not a publicly traded company in the event that the company later becomes a publicly traded company when the grants are still outstanding. This interpretation reversed a position taken by the IRS in previously issued private letter rulings. The transition period rule generally provides that compensation related to the exercise of stock options or SARs, or the substantial vesting of restricted stock, under a pre-existing plan will not be subject to the $1 million deduction limit for a limited grace period after the company becomes publicly traded. Many practitioners believed that this grace period would apply to phantom stock and RSUs as well, but the proposed regulations said that would not be the case. The final regulations adopt the interpretation of the proposed regulations. Commenters had requested that the relief extend to RSUs and phantom stock, but the IRS did not adopt these recommendations.

Effective dates

The per employee share limits portion of the proposed regulations were effective with respect to options and SARs granted on or after June 24, 2011. The final regulations state that this rule remains effective as of that date. The preamble explains that a transition period for that rule is not necessary because this interpretation did not represent a substantive change in the rules. On the other hand, the interpretation regarding RSUs and phantom stock awarded previously by privately held companies that become public companies will become effective on the date the final regulations are published in the Federal Register.

Again, because the final regulations confirm what the IRS has long been telling us about equity-based compensation awards, most publicly traded companies probably will not see much, if any, impact on their plans. Nevertheless, the publication of the final regulations represents a good opportunity to review these companies to make sure that the awards under their plans still qualify for the performance-based compensation exception to the $1 million deduction limit.