Publicly traded companies may need to act quickly to review, and, if necessary, amend their stock option and stock appreciation right (“SAR”) plans in order to preserve tax deductions for compensation in excess of $1 million paid to certain executives. The reason for this review is that the Internal Revenue Service (the “IRS”) and the United States Treasury Department recently issued proposed regulations that clarify a few items with respect to the application of Section 162(m) of the Internal Revenue Code (the “Code”) to such plans. One item relates to requirements that stock options and SARs must meet to qualify as performance-based compensation. Another item relates to a transition rule for companies that initially are privately held but that later become publicly traded companies.

As background, Code Section 162(m) limits the deduction a publicly traded company may take with respect to remuneration paid to its “covered employees”– its CEO and three most highly paid 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 stock options and SARs in a manner to qualify as performance-based compensation.

The proposed regulations clarify that in order for stock options and SARs to qualify as performance-based compensation, the plan under which such awards are granted must specify the maximum number of shares relating to those awards that may be granted to any individual employee during a specified period. Previously, some commentators had argued that stating an aggregate share limit for all awards granted under the plan should satisfy the performance-based compensation exception requirements. The preamble to the proposed regulations, however, states that this aggregate approach is inconsistent with the purpose of Code Section 162(m), and that an individual employee limit is 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. Additionally, the proposed regulations require that publicly traded companies disclose to their shareholders these individual employee share limits in order for the options and SARs to qualify as performance-based compensation.

Finally, the proposed regulations clarify that an existing limited transition period will not apply to grants of restricted stock units (“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 still are outstanding. This position is a reversal of 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 make clear that this is not the case.

The proposed regulations are somewhat ambiguous as to when these clarifications would become effective if they become final. The preamble states that all of the clarifications would first become effective in the taxable year ending on or after the date of publication of the final regulations, but in essence two different effective dates seem to have been established (pending resolution in the final regulations) for the two clarifications. The proposed regulations state that the individual employee share limit requirements for options and SARs would become effective starting June 24, 2011 (i.e., the date the proposed regulations were published) and apparently would apply to all grants on and after that date. However, the limitation of the transition period for RSUs and phantom stock awarded by newly publicly traded companies would become effective on the date final regulations are published.

Given these effective date provisions, publicly traded companies should review their stock option and SAR arrangements now and determine with counsel whether they need to be amended to provide a per-employee share limit. Failure to do so could mean that these companies may not deduct any compensation in excess of $1 million to “covered employees” related to grants of stock options or SARs. Privately held companies that may soon become publicly traded may want to consider the payment features of any RSU or phantom stock awards they grant, and even may want to consider granting restricted stock awards, stock options, or SARs instead of RSUs or phantom stock in light of these new clarifications.