The IRS has proposed new regulations clarifying two aspects of the Code Section 162(m) performance-based compensation exemption from the $1 million deduction limit for compensation payable to certain executives of public companies. The proposed regulations clarify one of the requirements that must be met for stock options and stock appreciation rights to qualify for the exemption. In addition, they clarify the scope of a transition rule which provides an exemption for certain compensation paid by newly public companies.

Exemption Requirements for Stock Options and Stock Appreciation Rights

Stock options and stock appreciation rights are deemed to be “performance-based” under Code Section 162(m) if the option or right is granted by the compensation committee (consisting of at least two independent directors) and, under the terms of the award, the amount of compensation the employee could receive is based solely on an increase in the value of the stock after the grant or award date. In addition, the plan under which the option or right 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 this last requirement, apparently in response to a lack of awareness by some taxpayers. The proposed regulations now make abundantly clear that the plan under which the option or right 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 individual employee. By example, the proposed regulations indicate that an overall limit within a plan on the number of options or rights that may be granted during a specified period that does not apply on a per participant basis is not sufficient to meet this requirement.

The proposed regulations also address the necessary disclosure for stock options and stock appreciation rights to meet the shareholder approval requirement of the “performance-based” compensation exemption. Under the exemption, the plan under which the options or rights will be granted must be described to shareholders and they must vote to approve the plan. The proposed regulations reiterate the requirement under existing regulations that this disclosure must include (1) a description of the maximum number of shares for which grants may be made to each eligible employee during a specified period (which must also be stated in the plan, as described above) and (2) the exercise price for options (such as fair market value of the company’s stock on the date option is granted).

Transition Relief for Newly Public Companies

The proposed regulations also clarify a transition exemption for equity awards made by newly publicly-traded companies to covered employees. If a company becomes public, the $1 million compensation deduction limit does not apply to compensation paid under a plan or agreement that existed before the company became public. If the company became public through an initial public offering, the company’s offering prospectus had to have disclosed information concerning those plans or agreements. The exemption is only applicable to compensation paid during the period ending on the earliest of:

  • The expiration of the plan or agreement;
  • The material modification of the plan or agreement;
  • The issuance of all employer stock and other compensation allocated under the plan; or
  • The first meeting of shareholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which the initial public offering occurs (shortened to the first calendar year following the calendar year in which the company became public in the case of companies that become public without an initial public offering).

Under current regulations, compensation received in connection with (1) the exercise of a stock option or stock appreciation right, or (2) the substantial vesting of restricted property is exempt so long as the award was granted under a plan or agreement during the transition period described above. The compensation is not required to have been paid during that period. Thus, for example, gain recognized in connection with exercise of a stock option granted during the transition period would be exempt from the deduction limit even if the option was exercised after the transition period ended. The IRS explained when the existing regulations were adopted that this special treatment was available only for options, stock appreciation rights and restricted stock awards, and not for other forms of equity-based compensation.

Apparently in response to taxpayer confusion over the scope of the transition rule, the proposed regulations explicitly state that the special rule for compensation received after the end of the transition period only applies to stock options, stock appreciation rights and restricted stock (if granted during the transition period). Therefore, compensation received in connection with other forms of equity awards, such as restricted stock units or phantom equity, must be paid, rather than merely granted, on or before the end of the transition period in order to be exempt from Code Section 162(m) under the transition rule for newly public companies. Alternatively, such compensation would need to qualify as “performance-based” to be exempt from the deduction limit.

This clarification applies on or after the date of publication of final regulations in the Federal Register. A copy of the proposed regulations can be found here.