SECTION 162(M): Pitfalls for the Unwary

As you know, Section 162(m) of the Internal Revenue Code generally provides that compensation paid to certain executives of public corporations will not be deductible by the employers to the extent the compensation exceeds $1,000,000 per individual in any one-year period. However, currently a “performance-based compensation” exception to this limitation is set forth under the statute. The Internal Revenue Service is engaged in an ongoing audit program related to enforcement of Code Section 162(m) and has uncovered a significant number of problems with regard to the following:


A. Many employment and/or severance agreements provide for payment of bonuses at “target” or at some other level in the event of retirement or other termination of employment, even if the required performance goals are not met. This type of provision will result in the entire program failing to satisfy the “performance-based compensation” rules that provide for an exception to the $1,000,000 deduction limitation.


B. The regulations promulgated under Section Code 162(m) provide, in part, that stock options and SARs generally will satisfy the performance-based compensation rules if (i) the maximum number of options/SARs that can be granted to any one individual during a specific period of time is “hard wired” in the related equity plan and (ii) the exercise price under the options/SARS is no less than the fair market value of the underlying shares of stock on the date of grant. The IRS has uncovered a number of plans that do not provide for the individual limitation and has also found instances where the options/SARs were issued at a discount.


C. Code Section 162(m) requires that a committee of “outside directors” must establish the performance goals under a performance-based compensation program within the first 25% of the performance period (but no later than 90 days after the beginning of the performance period) and that it must certify in writing that the performance goals and targets have been met before the performance-based compensation can be paid. The IRS has found that these requirements are all-too-often overlooked.


D. The regulations set forth under Code Section 162(m) provide that a corporation’s shareholders must approve the performance goals established by the outside directors prior to the payment of the performance awards and that, if the outside directors have the authority to determine the actual performance targets under the performance goals, the shareholders must reapprove the goals every five years. On audit, the IRS has found that both of these requirements have been violated in a significant number of situations.


E. Often, senior executive are granted “sign-on” options or other forms of equity at commencement of employment that are not granted under a shareholder approved plan. These options/equity grants will not satisfy the performance-based compensation requirements set forth under Code Section 162(m).


F. Certain intricate transition rules apply to “grandfathering” pre-IPO compensation plans. The IRS has found that many of these rules have not been followed.


In light of the ongoing IRS audit program, and of your potential liability for drafting a compensation plan that does not comply with the detailed requirements necessary to satisfy performance-based compensation exception to the $1,000,000 deduction limitation, it is vitally important that all incentive programs intended to satisfy this exception be reviewed for compliance with Code Section 162(m).

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