IRS Uncovers Significant Noncompliance with Sec. 162(m) Limits

A recent IRS initiative designed to gauge the level of compliance with the tax rules governing executive compensation, has detected significant noncompliance with Sec. 162(m), which limits deductions for compensation paid to certain executives to $1 million per year. This item discusses this issue and the actions employers can take to mitigate the risk of noncompliance with Sec. 162(m).

Overview

The Sec. 162(m) limits apply only to publicly held corporations and to compensation paid to covered employees. According to Sec. 162(m)(2), a “publicly held corporation” is any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934. A corporation is not publicly held if registration of its securities is purely voluntary. If a corporation is publicly held, Sec. 162(m) limits the deduction for remuneration paid to a covered employee to $1 million per year.

“Covered” employees: Only compensation paid to covered employees is subject to this deduction limit. Sec. 162(m)(3) defines a “covered employee” to include the chief executive officer and the four other highest compensated officers. Under the IRS’s interpretation of this rule, an individual can be a covered employee only if he or she is one of the officers named on the Summary Compensation Table (SCT) that the corporation attaches to its annual proxy. Except in the situation discussed below, a corporation’s covered employees will coincide precisely with the individuals it lists on the table.

“Last day of year” rule: Both the definition of “publicly held corporation” and “covered employee” contain a “last day of the year” rule. A corporation is publicly held only if it is subject to Securities and Exchange Commission (SEC) reporting requirements on the last day of its tax year; an individual is a “covered employee” only if he or she is serving as an officer on the last day of the tax year. In some cases, SEC rules require an individual to be listed on the SCT, even though he or she is no longer serving as an officer on the last day of the year. Even though listed, such an individual is not a covered employee for Sec. 162(m) purposes.

Exception for performance-based compensation: There are exceptions to the $1 million deduction limit; the most common is for qualified performance-based compensation. To qualify, compensation must satisfy a detailed set of rules, including being payable based on the achievement of specified, pre-established and objective performance goals set by a compensation committee comprised solely of two or more outside directors.

In general, under Sec. 162(m)(4)(C), compensation must satisfy the following requirements to be considered performance-based:

• It must be payable only on the attainment of specified pre-established, objective performance goals (the performance goal requirement).
• The goals and the compensation payable must be “pre-established” by a “compensation committee” comprised solely of two or more outside directors (the outside director requirement).
• The material terms of the performance goal must be disclosed to and approved by shareholders before the compensation is paid (the shareholder approval requirement).
• The compensation committee must formally certify that the performance goals were attained before the compensation can be paid (the certification requirement).

In qualifying for this exception, the requirements listed above apply to compensation paid in any form, except the exercise of certain stock options or stock appreciation rights (SARs). The certification requirement does not apply to stock options issued with an exercise price equal to the stock’s fair market value (FMV) on the grant date and to SARs in which the amount to be received is limited to the appreciation in the stock after the grant; see Regs. Sec. 1.162-27(e)(2)(vi)(A). The remaining requirements continue to apply, but there are different rules for the performance goal requirement and the shareholder approval requirement. A detailed discussion of the specifics of these rules is beyond this item’s scope.

IRS Executive Compensation Pilot Examination Program

Based on concerns about the level of noncompliance with the various tax rules that govern executive compensation, the IRS implemented a pilot program in 2003 to examine various aspects of executive compensation. The examinations covered equity compensation, fringe benefits, deferred compensation, certain sales of stock options to related parties, offshore employee leasing, split-dollar life insurance, compliance with the Sec. 280G rules governing parachute payments and compliance with Sec. 162(m). For details, see Neuhauser, Tax Clinic, “Executive Compensation Compliance Initiative,” TTA, May 2004.

A total of 24 companies were selected for audit under this pilot program. The IRS found violations for one or more issues (though not all) for most of the companies selected. However, it found that 23 of the 24 companies examined had some type of noncompliance with Sec. 162(m). According to public statements of IRS officials, the noncompliance included the following:

1. Changing performance criteria without obtaining shareholder approval;

2. Changing performance targets during the performance period, but after the deadline for “pre-established” goals;

3. Failing to obtain shareholder approval;

4. Appointing individuals other than outside directors to compensation committees; and

5. Paying performance-based compensation even when the performance goals were not satisfied.

Given the significant degree of noncompliance, IRS officials have indicated that they will expand the executive compensation program and pay particular attention to Sec. 162(m) issues.

What Employers Should Do

In light of the IRS’s increased focus on Sec. 162(m) compliance, publicly held companies should review their procedures for determining the deductibility of compensation paid to high-level executives. In public comments, IRS officials have described the requirements listed in the Sec. 162(m) regulations as a “checklist” for determining whether there are deductions potentially disallowed under Sec. 162(m), or whether compensation satisfies the performance-based exception.

The following list includes some specific actions a company can take to ascertain the extent to which it is subject to Sec. 162(m), to ensure compliance with the limits and to position itself to take advantage of the performance-based exception:

1. Develop procedures for identifying covered employees.

2. Create procedures for tracking compensation payments made to covered employees, and individuals who are potentially covered employees. Scrutiny should go beyond current covered employees, because the final determination of who is a covered employee cannot be made before year-end. For example, an executive officer may resign his or her position during the year. Such a resignation will cause a different individual, previously not a covered employee, to become one.

3. Ensure that the material terms of performance bonus plans that pay bonuses to executives are disclosed to and approved by shareholders. Although there are many ways of communicating plans to shareholders, a common technique involves a narrative description of the plan in the company’s annual proxy with an attachment of the actual plan.

4. Periodically review the membership of the corporation’s compensation committee to ensure that only individuals who qualify as outside directors serve on the committee that establishes the performance goals. The membership should be reviewed annually, because, in certain cases, an individual may be qualified to serve one year, but not the next. To ensure that actions required of a compensation committee are undertaken by a valid committee, this review should be undertaken before the compensation committee takes a specific action for a year. Committee members whose qualifications are suspect should be replaced.

5. Review proposed performance goals for a specific period against the criteria previously approved by shareholders. For example, if the performance bonus plan previously approved by shareholders authorizes bonuses only for attaining earnings per share targets, the compensation committee should avoid establishing a bonus tied to other criteria (such as increases in sales).

6. Consider including a wide variety of performance criteria in the performance bonus plan, so that the compensation committee is not limited in a performance period to a narrow range of performance goal options. This will maximize the compensation committee’s flexibility in designing performance-based compensation, by giving it authority to choose from among a wide variety of performance criteria.

7. Ensure that compensation payable on account of attaining the performance goal does not exceed the limit previously approved by shareholders, and that the compensation committee has no discretion to pay more than the pre-established amount.

8. In any newly established stock option plan, ensure that it is drafted with a specific, per-employee limit on the number of options that may be granted over a specified period. A plan-wide aggregate limit on the number of shares available under the plan is not sufficient to comply with the requirements for the performance-based exception. Even though an individual is not a covered employee at the time of a stock option grant, he or she may become a covered employee by the time the option is exercised. Ensuring that the plan is designed with a per-employee limit that applies to all individuals will help avoid potential problems with the performance-based exception.

9. Consider making all of the company’s stock option grants subject to compensation committee approval. For an at-the-money stock option, the performance-based exception requires it to be issued by a compensation committee. A stock option’s status under the performance-based exception is determined by the circumstances at the time of grant, even if at that time the individual is not a covered employee. Having the compensation committee involved with all grants will help satisfy the performance-based exception if an option happens to be exercised later, when the individual becomes a covered employee.

10. When granting stock options to employees who are (or may become) covered employees, the option exercise price should be reviewed to ensure that it is no less than FMV on the grant date.

From Thomas R. Pevarnik, Jr., J.D., Washington, DC