On June 23, 2011, the IRS issued proposed regulations under Internal Revenue Code Section 162(m) relating to the $1 million deduction limit for certain employee compensation paid by a publicly-held company. If finalized in their current form, the proposed regulations would contradict the current IRS guidance related to the treatment of restricted stock units (“RSUs”) and phantom stock under the transition rule for companies undergoing an initial public offering (“IPO”). In addition, the proposed regulations reinforce that plans utilizing the Code Section 162(m) exception for “qualified performance-based compensation” with respect to stock options and stock appreciation rights (“SARs”) must specify the maximum number of shares with respect to which options or SARs may be granted to each individual employee during a specified period.

Code Section 162(m) limits a publicly-held company’s deduction for a “covered employee’s” compensation to $1 million per year, unless the compensation comes within an exception under these rules. “Covered employees” are a publicly-held company’s CEO and three highest paid employees (other than the CFO).

Transition Rule for Companies Undergoing an IPO

Under a transition rule under the current Code Section 162(m) regulations, the $1 million deduction limit does not apply to compensation paid under a plan that existed while a company was not publicly held, provided that the prospectus accompanying the company’s IPO disclosed information concerning the plan that satisfied all applicable securities laws. The regulations provide that the company may rely on this transition rule until the expiration of a “reliance period” that can extend until the first shareholders meeting to elect directors that occurs after the third calendar year following the year of the IPO.

The current regulations also provide that if a stock option, SAR or restricted property award (which does not otherwise satisfy the qualified performance-based compensation exemption) is granted on or before the end of the reliance period, then compensation received upon the exercise or vesting of the award is also exempt, regardless of when the award is exercised or vests. For example, such a stock option granted in the year after an IPO with a typical 10-year term may be exercised after the expiration of the reliance period and still be exempt under this rule.

In the preamble to the proposed regulations, the IRS stated that practitioners have asked whether compensation payable under an RSU or phantom stock arrangement is eligible for this relief granted to options, SARS and restricted property.1 The IRS noted that the preamble to the final Code Section 162(m) regulations issued in 1994 specifically discussed that the special rule applicable to options, SARS and restricted property did not extend to cover “other stock-based compensation and deferred compensation.” Thus, the proposed regulations provide that only compensation attributable to stock options, SARs and restricted property is covered under this rule, and that compensation payable under an RSU or phantom stock arrangement must be paid on or before the end of the reliance period. For example, an RSU award (which does not otherwise satisfy the qualified performance-based compensation exemption) granted in the year after an IPO must be settled on or before the end of the reliance period to be exempt under the IPO transition rule.

The IRS stated in the preamble that the proposed regulations are not intended to substantively change the current regulations. However, the conclusion reached in the proposed regulations is at odds with two Private Letter Rulings (“PLRs”) issued by the IRS in 2004.2 These rulings provided that compensation paid pursuant to RSUs granted during, and paid after, the reliance period was not subject to the $1 million limit. While a PLR is technically only applicable to the taxpayer receiving the PLR, the guidance provided in these PLRs gave comfort to practitioners that RSUs would be accorded the same transitional relief treatment as options, SARs and restricted property.

The proposed regulations’ changes to the IPO transition rule will apply on and after the date the related final regulations are published. Given the departure by the IRS from the holdings of the PLRs, we hope that the proposed regulations will be applied only to grants made following the finalization of the proposed regulations. However, it may be that the rules, once finalized, will apply to existing grants of RSUs and phantom stock arrangements, and these existing grants may be scheduled to be paid after the end of a company’s reliance period. Unfortunately, there may be significant obstacles to accelerating the payment of previously granted RSUs or phantom stock arrangements to come within this deadline if they are subject to Code Section 409A.

Any pre-IPO or newly-public clients granting RSUs or phantom stock awards will need to make sure the awards will be settled or paid on or before the end of the reliance period or will satisfy the requirements to be qualified performance-based compensation.

Maximum Share Limitation

Code Section 162(m) excludes qualified performance-based compensation from the $1 million limit. The current regulations provide that stock options and SARs generally are deemed to be qualified performance-based compensation if certain requirements are satisfied, including that the plan under which the option or SAR is granted states the maximum number of shares with respect to which options or SARs may be granted during a specified period to any employee.

Some practitioners have taken the view that an aggregate limit on the shares that may be issued under the plan during its term could also serve to satisfy this requirement of a maximum limit on shares with respect to which options or SARs may be granted during a specified period to any employee.

The proposed regulations clarify that the plan under which the option or SAR is granted must specify the maximum number of shares with respect to which options or SARs may be granted to any individual employee during a specified period. Thus, if a plan states an aggregate maximum number of shares that may be granted during the term of the plan, but does not contain a specific per-employee limitation on the number of options or SARs that may be granted, then any compensation attributable to the stock options or SARs granted under the plan is not qualified performance-based compensation.

The proposed regulations further clarify that a plan satisfies this requirement where the terms of the plan specify 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.

Thus, clients should ensure that future plans are drafted with both an aggregate number of available shares and a separate limit on individual grants.

The clarifications in the proposed regulations to the maximum share limitation apply on and after June 24, 2011.