The Department of the Treasury has issued final regulations setting forth changes to the current regulations under Internal Revenue Code (Code) Section 162(m). Code Section 162(m) precludes a deduction by a public corporation for compensation paid to a "covered employee" to the extent that the compensation exceeds $1,000,000 in any taxable year. "Covered employees" include the company's chief executive officer and the three highest paid officers (excluding the chief executive officer and the chief financial officer).
The final regulations require that the plan specifically state the maximum number of shares with respect to which stock options or stock appreciation rights may be granted during a specified period to any individual employee. With respect to newly public companies, the final regulations clarify that restricted stock units and phantom stock units must be paid—rather than merely granted—before the end of the Reliance Period (as defined below) in the regulations.
Specifying the Individual Employee Limit
Code Section 162(m) includes an exception from the deduction limit for "performance-based compensation" that meets certain requirements, including requirements relating to performance goals. Compensation attributable to stock options or stock appreciation rights satisfy the requirement if the plan specifies the maximum aggregate number of shares with respect to which stock options and stock appreciation rights may be granted to any individual employee during a specified period (ordinarily, one year). The per employee limitation requirement applies to compensation attributable to options or rights granted on or after June 24, 2011—the date on which proposed regulations were issued.
The final regulations provide that the per employee requirement may be satisfied by specifying the aggregate maximum number of shares with respect to which stock options, stock appreciation rights, restricted stock, restricted stock units, and other equity-based awards may be granted to any individual during a specified period under the plan approved by the shareholders. As a result of the changes, public companies should review their plans to determine whether they clearly set forth the applicable individual maximum number of shares.
Transition Rule for Newly Public Companies
The final regulations clarify the application of the transition rule for newly public corporations issuing equity awards. When a corporation first becomes publicly held, the $1,000,000 deduction limitation does not apply to any compensation received pursuant to a compensation plan or agreement that existed before the corporation became publicly held, such as the substantial vesting of ownership rights to restricted property or the exercise of stock options or stock appreciation rights issued under such a pre-existing plan or agreement. A corporation may rely on this transition rule until the earliest of the expiration of the relevant plan or agreement; a material modification of the relevant plan or agreement; the issuance of all stock or other compensation that has been allocated under the plan or agreement; or the first shareholder meeting at which directors are to be elected that occurs after the close of the third calendar year following the year in which an initial public offering occurs (or for corporations that become public without an offering, the first calendar year following the year in which the corporation becomes publicly held) (Reliance Period).
Effective for grants on or after April 1, 2015, the transition rule applies to the exercise of stock options or stock appreciation rights or the vesting of restricted stock during the Reliance Period. However, under the regulations, it is important to note that restricted stock units and phantom stock will not qualify for the transition rule unless actual payment is made (i.e., the awards are actually settled) before the end of the Reliance Period for any grants made after March 31, 2015. Newly public companies should evaluate their equity plans to make sure that the transition rule is not claimed for restricted stock units or phantom stock unless actual payment is made before the end of the Reliance Period.
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