IRS Issues Clarifications to Internal Revenue Code § 162(m)

September 1, 2011

By Debra J. Linder

Internal Revenue Code (IRC) § 162(m) imposes a $1 million deduction limit on compensation paid by a public corporation to certain executive officers. However, an exception applies to “qualified performance-based compensation,” which does not count against the deduction limit. Stock options may qualify for this exception if certain conditions are met, one of which is to specify a limit on the stock option grants. The Internal Revenue Service recently issued proposed regulations that clarify that the stock option plan must specify the maximum number of shares that may be granted to any individual employee during a specified period. If the plan merely states an aggregate maximum number of shares that may be granted during a specified period, and does not contain a specific per-employee limit, stock options will not qualify for the exception.

The proposed regulations also clarify the transition rules for companies that become publicly traded. In general, the transition relief applies to compensation paid pursuant to a plan that existed while the company was privately held. The transition period expires on the earliest of several events, one of which is the first shareholders meeting after the third calendar year following the year of the IPO. The relief also applies to compensation resulting from stock options, stock appreciation rights, and restricted stock awards granted under a plan that was in existence during the transition period. The proposed regulations clarify that the transition relief will apply only to stock options, stock appreciation rights, and restricted stock awards granted during the transition period. Restricted stock units, phantom stock, and other stock-based compensation awards that are granted during the transition period will not qualify for the relief. Those types of awards must be paid, not just granted, during the transition period.

If you have questions concerning IRC § 162(m) or other executive compensation matters, please contact a member of our Compensation Planning & Employee Benefits Group.