Section 162(m) Pitfalls

In anticipation of Section (m), which took effect on January 1, , most companies thoroughly reviewed their compensation programs to assess the impact of Section (m). Many companies concluded that the limit did not apply to them since their executive pay consisted of cash compensation that was below the limit and stock options.

Companies should consider instituting clawback policies with respect to performance-based compensation. This applies to any bonuses or awards, including the vesting of equity awards based on performance.

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In addition, §(m) previously provided that performance-based compensation (which included stock options and other performance-based equity awards) and commissions were not subject to .

Misstating or omitting required terms that must be approved by shareholders for compensation to qualify as performance-based. The material terms that must be approved by shareholders include the maximum amount of compensation that could be paid to any employee or the formula used to calculate the amount of compensation to be paid to individual employees if certain performance goals are attained, the employees eligible to receive the compensation, and a description of the business criteria on which the performance goals are based.

The description of the compensation payable must be specific enough so that shareholders can determine the maximum amount that could be paid to any employee during a specified period. With respect to options and SARs, the plan must state the maximum number of shares with respect to which options or SARs may be granted during a specified period to any employee. Granting stock options or SARs in excess of the plan's limit or the amount that can be awarded to an individual in a specified time period.

Stock options and SARs must be granted under a shareholder-approved plan that contains a limit on the maximum number of options or SARs that may be granted to any employee in a specified period and the exercise price. Allowing inside directors to participate in granting stock options or SARs. Stock options and SARs must be granted by "outside directors" in accordance with a shareholder-approved plan in order to qualify as performance-based compensation under section m.

Granting discounted stock options or SARs. The exercise price or measurement of stock options and SARs intended to qualify with section m and to be exempt from Code section A must not be less than the fair market value of the underlying stock on the grant date-the amount of the compensation that the employee can receive must be based solely on an increase in the value of the stock after the grant date.

A recent IRS generic Legal Advice Memorandum, dated July 6, , emphasizes that discounted stock options or SARs can never qualify as performance-based compensation under section m and states that discounted options and SARs cannot be cured for purposes of qualifying as performance-based compensation under section m.

Not contemporaneously documenting stock option and SAR grants or failing to document grants altogether. Even though the section m regulations do not require formal committee meetings to grant options or SARs or even prompt documentation of those grants, on audit the IRS has taken the position that options are discounted and thus do not qualify as performance-based compensation under section m when grants are documented weeks after the grant date using "as of" grant dates or unanimous written consents UWCs , when there is no contemporaneous documentation of compensation committee meetings or when there are only oral authorizations from the board or the compensation committee.

In the event that the IRS determines that it is not possible to determine the grant date, the IRS will use the financial accounting measurement date as a proxy for the grant date.

To avoid this challenge, the compensation committee should be precise about when an option or SAR is granted and complete all corporate documentation in a timely manner, for example, by preparing, signing, and dating the committee minutes or UWCs at the committee meeting, or within a day or two after the meeting or after the decision is made to grant options or SARs.

This also raises a question about "best practices" for granting equity compensation. Granting stock options or SARs or paying other compensation under a plan that was not approved by shareholders.

For companies having an IPO, failing to obtain shareholder approval of a pre-IPO plan before the first shareholders meeting following the end of the third calendar year after the IPO. Accelerating the payment date of performance-based compensation without reducing the payment amount to reflect the time value of money.

Companies can mitigate the adverse effect of failing to comply with section m by requiring deferrals of any amounts that would not be deductible by the company to a date after the employee's termination of employment.

Forcing executives to assume the credit risk in difficult economic times may be met with resistance, however. Also, keep in mind that any such deferral must be made in accordance with section A. Companies should consider instituting clawback policies with respect to performance-based compensation.

A clawback policy allows the company to recover compensation if subsequent review indicates that payments were not calculated accurately or performance goals were not met. If you have any questions or would like more information on any of the issues discussed in this Hot Topics alert, please contact any of the following Morgan Lewis attorneys: New York Craig A. James DiBernardo Zaitun Poonja. The regulations also warn that compensation actually paid on account of those events would not qualify as performance-based.

However, separate exceptions generally ensure a deduction for such payments, since the payees after the death or disability of an executive or the payor in the event of a change in control are likely exempt from section m in any event. In Revenue Ruling , the IRS concluded that a director did not qualify as an "outside director" based on the following facts: LawFlash Section m Pitfalls March 09, Common Section m Pitfalls Permitting payment of performance-based compensation upon retirement, involuntary termination, or termination for good reason.

Other Pitfalls Granting stock options or SARs or paying other compensation under a plan that was not approved by shareholders. Materially amending a plan without shareholder approval. Planning Opportunities Companies can mitigate the adverse effect of failing to comply with section m by requiring deferrals of any amounts that would not be deductible by the company to a date after the employee's termination of employment.

Rothstein Palo Alto S. Zelikoff Pittsburgh John G. Randall Tracht Washington, D. Needles [1] Compensation may qualify as performance-based even if the plan allows the compensation to be payable upon death, disability, or change of ownership or control without attainment of the performance goals. A stock option by its nature is performance-based, as the optionee generally receives a benefit only if the value of the stock at the time of exercise exceeds the exercise price.

For other types of awards, the stockholders must approve the maximum amount that can be paid to an individual either through a fixed amount or a formula that allows a stockholder to calculate the maximum amount. Typically, a plan will set forth a maximum number of shares or value of shares that may be granted as a performance-based full-value award, for example, restricted stock units or restricted stock upon which vesting is conditioned upon the achievement of performance goals. It is best practices for a company to avoid compromising the qualification of equity compensation as "performance-based" by taking preventative measures.

For example, a company may have its stockholder services department calculate the maximum amount of shares that may be granted, under a stock option or full-value award, to any individual in advance of a meeting of the board of directors or compensation committee in which equity awards are to be approved.

A cancellation and re-grant of a stock option is not without challenges. The company may not wish to tackle the complexities of re-granting a stock option at the original exercise price, if the stock price has increased, as the re-grant would be considered a discounted stock option and subject to Section A of the Internal Revenue Code. Nevertheless, unless the plan has a provision invalidating an excess grant, the cancellation of the stock option is an adverse action requiring the consent of the optionee.

If the stock price has decreased, the company would be prudent to re-grant the stock option at the original exercise price as a re-grant at a lower price may be deemed a repricing, which would require stockholder approval under certain listing rules. A company should be aware that a grant in excess of the plan limits will not always create a tax issue. Also, whether or not an award is deductible may not matter to a company that is currently operating at a loss.

We recommend that companies conduct an internal audit of their equity plans in advance of receiving a demand letter from, or notice of a lawsuit filed by, a stockholder.

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