On June 24, 2011, the IRS proposed new rules relating to the ability of a publicly held corporation to deduct executive compensation in excess of $1 million under Internal Revenue Code Section 162(m).

Under Section 162(m), a publicly held corporation is generally limited to a $1 million deduction in any tax year for compensation paid to the chief executive officer and the next three highest paid officers. However, in a widely used exception, the $1 million limit does not apply to “qualified performance based compensation.” Whether grants of stock options and stock appreciation rights constitute qualified performance based compensation is determined on a grant by grant basis. The new regulations specify that such awards will only constitute qualified performance based compensation if the following conditions are met:

  • the grant is made by the corporation’s compensation committee
  • the plan pursuant to which the grant is made specifies the maximum number of shares with respect to options or stock appreciation rights that may be granted during a specified period to any employee on an individual basis  
  • under the terms of the option or stock appreciation right, the amount of compensation the employee can receive is based solely on an increase in the value of the stock after the date of the grant or award

The new regulations further clarify that a plan which specifies the aggregate maximum number of shares to be granted but does not include a specific per employee limitation will not constitute qualified performance based compensation under Section 162(m).

In order to constitute qualified performance based compensation under Section 162(m), the material terms of the compensation must also be approved by the corporation’s shareholders prior to the grant. One item that must be disclosed is the maximum dollar amount or formula under which the maximum compensation could be determined by shareholders. The new regulations specify that this must be disclosed on a per employee, per period basis.

Section 162(m) also provides certain transition rules for stock options and stock appreciation rights which are paid pursuant to a plan or agreement that existed prior to the corporation becoming publicly held. The new regulations clarify that restricted stock units, phantom stock arrangements and other types of stock-based compensation other than stock options and stock appreciation rights do not qualify for this transition rule.