New Proposed Regs Would Clarify Exceptions To $1 Million Deduction Limit On Top Officers' Pay

Preamble to Prop Reg; Prop Reg §1.162-27

New proposed regs on the $1 million deduction limit paid to top corporate officers would clarify that in order to be exempt from the limit, qualified performance-based compensation attributable to stock options and stock appreciation rights (SARs) must specify the maximum number of shares with respect to which options or rights may be granted to each individual employee. The proposed regs also would clarify the application of a transition rule for non-publicly held corporations that become publicly held. The proposed regs would apply to tax years ending on or after the date final regs are issued.

Background. Subject to certain exceptions, Code Sec. 162(m) generally provides a deduction limit of $1 million for compensation paid by a publicly held corporation during any tax year to a covered employee (the principal executive officer or someone acting in that capacity) and the three highest paid officers (other than the principal executive officer or principal financial officer).

The deduction limit doesn't apply to, among other things, certain other performance-based compensation. (Code Sec. 162(m)(4)(C), Reg. §1.162-27(e)(2)) Stock options and SARs are deemed to satisfy the performance goal requirement if: (1) the grant or award is made by the compensation committee; (2) the plan under which the option or right is granted states the maximum number of shares with respect to which options or rights may be granted during a specified period to any employee; and (3) under the terms of the option or 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. (Reg. §1.162-27(e)(2)(vi))

Proposed regs refine qualifying language. Prop Reg §1.162-27(e)(2)(vi) would provide that the plan under which the option or right is granted must specify the maximum number of shares with respect to which options or rights 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 but does not contain a specific per-employee limitation on the number of options that may be granted, any compensation attributable to the stock options or rights granted under the plan would not be qualified performance-based compensation. The proposed regs also would make a conforming change to Example (9) of Reg. §1.162-27(e)(2)(vii), and Reg. §1.162-27(e)(4)(iv), relating to disclosure of option grant details to corporate shareholders.

Compensation paid by companies that go public. Under Reg. §1.162-27(f)(1), if a non-publicly held corporation becomes publicly held, the $1,000,000 deduction limit doesn't apply to any remuneration paid under a compensation plan or agreement that existed while the corporation was not publicly held. If a corporation becomes publicly held in connection with an initial public offering (IPO), then this exception applies only to the extent that the prospectus accompanying the IPO disclosed information concerning the existing compensation plans or agreements and satisfied all applicable securities laws.

A corporation may rely on Reg. §1.162-27(f)(1), until the earliest of: (1) the expiration of the plan or agreement; (2) the material modification of the plan or agreement; (3) the issuance of all employer stock and other compensation that has been allocated under the plan; or (4) the first meeting of shareholders at which directors are to be elected that occurs after the close of the third calendar year following the calendar year in which the IPO occurs or, in the case of a privately held corporation that becomes publicly held without an IPO, the first calendar year following the calendar year in which the corporation becomes publicly held. (Reg. §1.162-27(f)(2)) Under Reg. §1.162-27(f)(3), the relief in Reg. §1.162-27(f)(1), applies to any compensation received pursuant to the exercise of a stock option or SAR, or the substantial vesting of restricted property granted under a plan or agreement, if the grant occurs on or before the earliest of the events specified above.

Restrictions on exception where corporation becomes publicly held. The proposed regs would make it clear that only compensation attributable to stock options, SARs, and restricted property, and no other form of stock based compensation, are covered under Reg. §1.162-27(f)(3). Revised language would provide that, for example, compensation payable under a restricted stock unit arrangement or a phantom stock arrangement must be paid, rather than merely granted, on or before the occurrence of the earliest of the events specified in Reg. §1.162-27(f)(2) in order for Reg. §1.162-27(f)(1) to apply. (Prop Reg §1.162-27(f)(3))

References: For the deduction limit for compensation over $1 million paid to top officers, see FTC 2d/FIN ¶H-3776; United States Tax Reporter ¶1624.009; TaxDesk ¶276,001.1; TG ¶7531.