The IRS issued proposed regulations clarifying the performance-based compensation exception under Section 162(m) of the Internal Revenue Code. Code Section 162(m) limits the amount of compensation that may be deducted annually by a publicly held company for each of its “covered employees” to $1,000,000. This $1,000,000 limitation does not apply to compensation that qualifies as “performance based compensation”.

The proposed regulations address (i) the requirement that the plan state the maximum number of shares to which stock options and stock appreciation rights may be granted to each individual employee and (ii) the application of the transition rule for stock-based compensation for newly public companies.

Per-Employee Limitation Required

Stock options and stock appreciation rights (SARs) may constitute performance-based compensation if certain requirements are met. Among these requirements is that the plan under which the option or SAR is granted must state the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee. The proposed regulations clarify that a plan must contain a specific per-employee limitation on the number of options or SARs that may be granted in order for options and SARs to constitute “qualified performance-based compensation”. Merely stating an aggregate maximum number of shares that may be granted to all employees under the plan is not sufficient; however, a plan can satisfy the per-employee limit by specifying that an individual employee may be granted options or SARs to receive the maximum number of shares authorized under the plan during a specified period.

The proposed regulations also clarify that the request for shareholder approval of the plan must disclose this limit and how the exercise price is determined (for example, fair market value on the date of grant).

Newly Public Companies

For newly public companies, the $1,000,000 deduction limitation does not apply to compensation paid under a plan or agreement that was in effect while the company was private. In the case of an initial public offering (IPO), this relief is available only to the extent the prospectus accompanying the IPO provides adequate disclosure of the compensation plan or agreements. This relief is available only during a reliance period, which ends at the earliest of (i) the expiration of the plan or agreement; (ii) a material modification of the plan or agreement; (iii) the issuance of all shares available under the plan or agreement; or (iv) the first shareholder meeting at which directors are elected that occurs after the third year after the year of the IPO (or if no IPO, after the first year following the year the company becomes public).

For stock-based compensation, the current regulations provide a special rule that if an option, SAR or restricted stock award is granted during the reliance period under a pre-IPO plan, and the plan has not been materially modified, any compensation received pursuant to the exercise of stock options or SARs or the vesting of restricted stock is also exempt, regardless of when exercise or vesting occurs. The proposed regulations clarify that this special rule is not available to other equity-based awards, such as restricted stock units or phantom stock arrangements notwithstanding earlier indications from the IRS in private letter rulings that restricted stock units were the economic equivalent of restricted stock and therefore entitled to the same transitional relief. Accordingly, restricted stock units and phantom stock must be paid, not merely granted, on or before the end of the reliance period to be exempt from the $1,000,000 deduction limitation.

Next Steps

Public companies and private companies that are contemplating an IPO should review their equity plans to determine whether any amendments are required to comply with the proposed regulations.