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Section 162(m) Pitfalls

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Section (m) of the IRS Code places a $1 million-dollar limit on the amount of deductible compensation that a company can pay to their CEO, CFO, and other three most highly paid executives. The proposed Treasury Regulations under Section (m) clarify that if a plan states the maximum number of shares that may be granted but does not contain a per-employee limitation on the number of options or rights that may be granted, then any compensation attributable to the stock options or rights under the plan is not performance-based.

Equity-based awards—such as options, SARs, or restricted stock—granted prior to Jan. 1, , are not subject to the deduction limitation. Implications The first step in applying Sec. (m)(6) is determining whether the controlled group is a CHIP.

For calendar-year service and performance periods, this means that the performance goals for an annual plan must be established by March 31, The performance goals cannot be changed after this initial period. Paying compensation when the performance goals were not attained. To qualify as performance-based compensation, compensation must be paid solely on the attainment of one or more objective performance goals.

In the current economic environment, many companies did not attain their performance goals and may be considering paying their executives discretionary bonuses for their efforts in A word of caution: On the flip side, compensation payable on account of attaining the performance goal must not exceed the limit that was approved by shareholders, and the plan should not provide the compensation committee discretion to pay more than the authorized amount.

Adjusting bonus amounts for subsequent events if such an adjustment is not included in the performance goal formula. To qualify as performance-based, compensation must be payable under an objective formula for computing the amount payable if a certain goal is attained. It is possible to adjust performance measures for certain objective subsequent events for example , reorganization and restructuring programs or other executive termination costs, integration and other one-time expenditures, the sale or acquisition of a business unit ; however, this feature must be included in the performance goal formula when it is initially established, and cannot be added at the end of the performance period.

If unanticipated circumstances arise, the compensation committee can use its discretion to reduce the payout to the desired level based on the circumstances, but the payment cannot be increased to disregard the impact of subsequent events if no adjustment mechanism is present. Increasing the amount of compensation that would otherwise be due upon attainment of the performance goals.

Compensation will not qualify as performance-based if the compensation committee has discretion to increase the amount payable upon attainment of the performance goals. However, the committee may have discretion to reduce the payment. Paying awards or bonuses without compensation committee certification that the performance goals were satisfied.

Compensation committees must certify that the performance goals have been met in order for amounts paid upon attainment of those goals to be deductible under section m. This applies to any bonuses or awards, including the vesting of equity awards based on performance. This certification should be included in the compensation committee minutes. 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. 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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Granting discounted stock options or SARs.

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Satisfying the NYSE or NASDAQ requirements for independent directors or the SEC requirements for nonemployee directors under Rule 16b-3 while generally mandatory is not sufficient-the section m requirements are different and can be more restrictive.

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