Top officers of public companies often receive compensation that is intended to be exempt from the $1 million limit on tax-deductible compensation. In many cases, the plans under which the compensation is granted must be reapproved by shareholders not less frequently than every five years in order to continue to satisfy the requirements for the exemption. Companies maintaining such plans should confirm whether such reapproval is required and, if so, the applicable deadline for such reapproval.
US Internal Revenue Code section 162(m) generally provides that a publicly held corporation is not entitled to a tax deduction for annual compensation in excess of $1 million paid to the company’s chief executive officer and no more than four of the company’s other highest paid executive officers. Section 162(m) provides that certain compensation will be exempt from this limit, with the most common exemption being for “performance-based compensation.”
Stock options and stock appreciation rights (SARs) under a shareholder-approved plan will generally satisfy the performance-based compensation exemption to the $1 million limit. In most cases, it will not be necessary to resubmit the plan to shareholders to maintain the exemption for such awards (although the plan may need to be reapproved by shareholders from time-to-time to satisfy other requirements).
Compensation arrangements (other than options and SARs) can also be structured to satisfy the performance-based compensation exemption from the $1 million limit. Such arrangements will satisfy these requirements only if, among other things, payment of the compensation is contingent on the achievement of performance goals established by the company’s compensation committee, but only if the performance goals are based on one or more business criteria that have been disclosed to and approved by the company’s shareholders.
In many cases, the plan will include a menu of business criteria from which the compensation committee may choose. If a plan provides for a menu of two or more alternative business criteria, however, the material terms, including the business criteria, must be reapproved by the shareholders no later than the first shareholder meeting that occurs in the fifth year following the year in which the material terms were previously approved by the shareholders.
Many companies maintain a single plan (sometimes called an “omnibus plan”) under which all performance-based compensation (including options, SARs, other stock-based awards and certain cash awards) are granted. An omnibus plan will typically be resubmitted to shareholders more frequently than every five years for reasons unrelated to approval of the business criteria (for example, to increase the number of shares reserved under the plan). Shareholder approval of an omnibus plan for other purposes will typically constitute reapproval of the material terms for section 162(m) purposes. Some companies, however, grant cash-based performance-based compensation under one or more plans that are separate from the company’s omnibus plan or other stock-based plans. Unlike omnibus plans or other stock-based plans, there is usually no need to resubmit a cash-based plan to shareholders for approval apart from the performance-based compensation exemption under section 162(m) and so it is easy to overlook the five year approval rule with respect to such plans.
Therefore, although it is important to monitor the five year reapproval requirement for all types of plans, particular focus is appropriate on the rule as it applies to plans that are not typically resubmitted for shareholder approval for other purposes. The reapproval is critical to preserving a company’s ability to continue to grant awards that satisfy the performance-based compensation exemption of section 162(m).