This proxy season, publicly held companies should be thinking about the following important issues relating to Section 162(m) of the Internal Revenue Code of 1986 (“Section 162(m)”).
1. Quick Overview of Section 162(m).
Section 162(m) generally limits a publicly held corporation's deduction for compensation paid to each of its CEO and its next three most highly compensated officers (other than the CFO) to $1 million per year. See, Employee Benefits and Executive Compensation Update, “IRS Issues Guidance on Identifying ‘Covered Employees’ for Purposes of Section 162(m),” June 11, 2007, regarding the exclusion of the CFO from being a “covered employee.” However, "performance based compensation" ("Performance Compensation"), which is paid pursuant to a bonus or other plan which only pays the compensation if the covered officer attains objective performance targets set by a committee composed solely of two or more "outside directors" based on shareholder approved performance goals, is not subject to the $1 million cap. In the case of stock options or SARs, special Section 162(m) rules generally only require that such a grant be made by "outside directors" under a shareholder approved plan which contains a participant award limit and that the option or SAR have an exercise price which is not less than the fair market value of the stock on the date of grant.
2. Shareholder Reapproval of Performance Compensation Plans Approved in 2003.
The Section 162(m) regulations require that shareholders reapprove the goals with respect to which Performance Compensation (other than stock options and SARs) is paid every five years. This means that companies which obtained shareholder approval of such goals in 2003 must resubmit the goals for shareholder approval in 2008. This is generally done by having the shareholders reapprove an updated plan.
3. Consider Adopting Performance Compensation Plans.
Companies which pay Performance Compensation bonuses or equity-based compensation, other than options and SARs, should consider adopting Performance Compensation plans and submitting them to shareholders for approval in 2008. If companies are submitting other option or omnibus equity plan amendments to shareholders for approval this year, they should consider adding a few simple provisions to qualify other equity compensation payable under the plans as Performance Compensation.
4. Review Status of Grandfathered Plans.
Under certain circumstances, compensation plans which are in effect before a corporation becomes publicly held, are subject to special transition rules which defer compliance with Section 162(m) for between one and three years after the corporation becomes publicly held, depending on whether the company becomes publicly held through an IPO, spin-off, or otherwise. Adoption of material amendments to grandfathered plans can truncate the transition period. Any of your clients with plans covered by these rules should check to see whether Section 162(m) compliance is now required for 2008 and thereafter. (For example, these rules require that companies which became publicly held in 2004 through an IPO and whose plans have not otherwise been materially modified, be submitted to shareholders for approval in 2008 in order for grants which are made after the 2008 shareholders’ meeting at which directors are elected to qualify as exempt Performance Compensation).
5. Review Outside Director/Independent Director Status.
Compensation only qualifies as Performance Compensation for Section 162(m) if it is awarded and administered by "outside directors," generally defined as members of the corporation’s Board of Directors who are not employees, current or former officers, and who do not receive remuneration other than director compensation from the corporation (directly or as paid to entities of which they are employees or owners) unless it qualifies as "de minimis remuneration" under narrow and tricky rules. Publicly held companies should make certain at least annually that the directors administering their Performance Compensation plans continue to qualify as "outside directors."
Note that directors who qualify as “outside directors” under Section 162(m) do not always qualify as “independent directors” under the NYSE or Nasdaq standards. The reverse is also true – a director who is independent under the NYSE or Nasdaq standards may, in some cases, not satisfy the Section 162(m) outside director standard. See, NYSE’s new corporate governance listing standards (Section 303A of the NYSE's Listed Company Manual) and Nasdaq Marketplace Rule 4200, which defines "independent director," and Rule 4350, which sets forth qualitative listing requirements for issuers listed on the Nasdaq National Market or Nasdaq SmallCap Market.
6. Compensation Discussion and Analysis.
Pursuant to the SEC's compensation disclosure requirements, "the impact of the tax and accounting treatments of the particular form of compensation" is one of 15 examples provided by the Commission for discussion in the Compensation Discussion and Analysis ("CD&A"), if material to the company. Thus, any tax or accounting treatment, including but not limited to Section 162(m), that is material to a company's compensation policy or decisions with respect to a named executive officer, is to be covered in the CD&A. This could include any tax consequences to the named executive officer, as well as to the company. In our experience, most companies continue to include disclosure in their CD&As similar to the "Section 162(m) policy" disclosure required under the SEC's old compensation disclosure rules. However, public company clients should review their CD&A annually to determine if they have discussed all material tax or accounting implications of their compensation programs, including Section 162(m), and whether they paid or awarded any compensation during the prior year that was not deductible pursuant to Section 162(m). Even for companies that intend to compensate executives through fully deductible compensation, the statement should be written to express a clear preference for 162(m) exempted compensation, but not so as to preclude the payment of compensation in excess of the 162(m) deductibility limit.