August 16, 2011

Proposed & Temporary Regulations Clarify Deduction Limits for Compensation Exceeding $1 Million

Background

The tax deduction for a public company's compensation paid to certain executives can be limited to the extent it exceeds $1 million per year. The limitation is set forth under Internal Revenue Code (IRC) Section 162(m). This limitation, however, does not apply to qualified performance based compensation. Under Internal Revenue Service (IRS) regulations, stock options and stock appreciation rights (SARs) are qualified performance based compensation if: 1) the grant or award is made by an organization's compensation committee; 2) the plan under which the option or SAR is granted states the maximum number of shares that may be granted during a specified period to any employee; and 3) under the terms of stock option or SAR, the amount of the compensation the employee can receive is based solely on an increase in the stock value after the grant or award date.

The IRS and Treasury Department believe that "the limit on the maximum number of shares" requirement is appropriate because it is consistent with the performance goal requirement. This performance goal requirement requires a formula for determining the maximum amount of compensation that an individual employee can receive if the performance goal is satisfied.

The IRS and Treasury Department have received many inquiries about the requirement that a stock based compensation plan must state the maximum number of shares that can be granted to any employee and therefore have now issued proposed regulations to clarify this provision.

Proposed Regulations

1. The proposed regulations clarify the "maximum number of shares to any individual employee" requirement. In order for a plan to qualify as performance based, it must not only indicate the maximum number of shares that may be granted, but also contain a specific per employee/per period limitation on the number of options or share rights to be granted. This clarification is effective June 24, 2011.
   
   Observation: All options and SARs exercised on or after this date, under a plan that does not provide the above per employee limitations, will not qualify as performance based compensation. It is recommended that any public company plan that currently does not include the required per person/per period limits be amended and reapproved by shareholders prior to exercise of an option or SAR so that the compensation will be treated as performance based.
   
   
2. The proposed regulations also clarify the shareholder approval requirement. Specifically, the disclosure part of the approval process is satisfied where the maximum number of shares for which grants may be made to each individual employee during a specified period and the exercise price are disclosed to the shareholders.

Clarification of Rules for Private Companies Going Public

According to current regulations, an exception to the $1 million deduction limit exists for privately held company compensation plans that existed prior to the company going public. The exception applies where the prospectus accompanying the Initial Public Offering discloses information concerning the existing compensation plans and satisfies all securities laws.

Observation: Under current regulations, this exception applies, in the case of compensation received on the exercise of stock options or SARs, only to those granted before specified events such as the expiration or material modification of the plan.

Questions have arisen as to whether this same exception applies to restricted stock or so-called phantom stock. Temporary regulations clarify that this exception to the compensation deduction limitation under Section 162(m) does not apply to benefit restricted stock or phantom stock arrangements which preceded a privately held company becoming publicly held.

This publication is intended to provide general information to our friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.

If you have any questions, please contact Bauerle and Company.

This publication has been prepared by EisnerAmper LLP for informational purposes only. These materials do not constitute accounting, tax or legal advice and cannot be relied upon by any taxpayer for the purpose of avoiding penalties imposed under the Internal Revenue Code.

Redistributed by Bauerle and Company, P.C. with permission

PKF North America is an association of independently owned public accounting firms who share educational, client service, best practice and marketing resources, and benefit from various ranges of expertise.

PKF NA provides its members with specialized technical resources and thought leadership as well as invaluable networking and professional development opportunities, empowering them to better serve growth-minded businesses across all industries (or sectors).