The Internal Revenue Service (IRS) recently issued final regulations under Section 162(m) of the Internal Revenue Code (Code). The final regulations are substantially similar to the proposed regulations issued by the IRS in 2011, discussed here. The final regulations make two important clarifications to the Section 162 (m) limit, as discussed below.

Section 162(m) generally limits the deduction that public companies may take for the annual compensation paid to their CEOs and three other most highly compensated officers (excluding the CFO) to $1 million each. There are several important exemptions to the deduction limit, including an exemption for both (i) “performance-based compensation” awards, which include stock options and stock appreciation rights (SARs), provided the shareholder-approved arrangement authorizing such awards states the maximum number of shares as to which options or SARs may be granted during a specified period to any employee; and (ii) compensation (whether or not performance-based) that is payable during a transition period for newly public companies under an arrangement that was in effect before the company became public. The transition period for newly public companies generally lasts until the earliest of (i) the date the arrangement expires or is materially modified; (ii) the date all the shares or other compensation allocated to the arrangement have been issued; or (iii) for companies that became public pursuant to an initial public offering (IPO), the first annual meeting following the end of the third calendar year after the year in which the IPO occurred.

The final regulations make two clarifications to the performance-based compensation exemption to the Section 162(m) limit:

  • For options and SARs to be exempt, the shareholder-approved arrangement must state the maximum number of shares as to which options or SARs may be granted during a specified period to anyindividual employee, as opposed to relying on the maximum number of shares authorized under a share reserve to satisfy this requirement. As a practical matter, virtually all companies have already been observing this requirement; however, the IRS had granted relief for options and SARs granted prior to the proposed regulations’ publication date (June 24, 2011).
  • Under a transition rule for newly public companies, restricted stock, options and SARs qualify for exemption if granted before the end of the applicable transition period, even if they vest or are exercised after the end of such period. Because restricted stock units are economically similar to restricted stock, there was a question whether such units granted before the end of the transition period might be exempt as well, even if paid after the end of such period. The IRS has now clarified that restricted stock units and other similar awards, such as performance shares and phantom stock (collectively, RSUs), granted before the end of the transition period will be exempt only if they are also paid out before the end of such period.

The clarification as to RSUs was a disappointing but not unexpected result. What was surprising, however, is that the final regulations depart from the proposed regulations by stating that the clarification applies only to RSUs granted on or after April 1, 2015. Thus, RSUs granted before April 1, 2015, will still be exempt even if they are paid out after the end of the transition period. The proposed regulations had stated that the clarification would apply to RSUs paid out after the effective date of the regulations, even if granted before then. The new exception for RSUs granted before April 1, 2015, is therefore a welcome change.