IRS Releases Clarifying 162(m) Regulations

The IRS recently released final regulations clarifying two aspects of the “performance-based compensation” exception to the $1,000,000 limit on deductible compensation paid to covered employees under Section 162(m) of the Internal Revenue Code.

Proposed regulations issued in 2011 provided that in order to qualify awards as “performance-based compensation” a shareholder approved equity plan must specify the maximum number of shares with respect to which options and stock appreciation rights may be granted during a specified period to any individual employee. Under the final regulations, a plan will satisfy this “per-employee limitation” requirement if the plan specifies an 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 employee during a specified period.  Prior to the clarification, some believed that an overall plan limit on the maximum number of shares granted to all employees satisfied this requirement of Section 162(m).

If certain requirements are met, the deduction limitations of Section 162(m) will not apply to new public companies until the first of certain events (e.g., the first shareholder meeting that occurs after the end of the close of the third calendar year following the calendar year of an initial public offering) (the “Reliance Period”).  Under the current 162(m) regulations, stock options, stock appreciation rights and restricted stock granted prior to the expiration of the Reliance Period are exempt from the deduction limitation imposed by 162(m) even if such awards are settled after the expiration of the Reliance Period.  Under the current regulations, it was unclear whether the favorable treatment described in the preceding sentence would be extended to restricted stock units or phantom stock awards granted prior to the expiration of the Reliance Period if such awards could be paid after the expiration of the Reliance Period.  In the final regulations, the IRS clarified that restricted stock units and phantom stock awards that are paid after the Reliance Period will be subject to the deduction limitations imposed by Section 162(m) regardless of when they were granted.

The final regulations are effective April 1, 2015 so the IRS position set forth in the paragraph above will not apply to restricted stock units and phantom stock awards that were granted prior to April 1, 2015 even if such awards are paid after the expiration of the applicable Reliance Period.  The full text of the final 162(m) regulations is available here.