United States: Practical Advice For Compliance With Recent Amendments To The Internal Revenue Code Section 162(m) Regulations

The recent amendments to the Section 162(m) regulations largely follow the changes set forth in the proposed regulations issued in 2011, clarifying two exceptions from the Section 162(m) tax deductibility limit:

  • The treatment of restricted stock units (RSUs) and certain other forms of stock-based compensation under the transition rule applicable to newly public companies; and
  • The requirement under the "qualified performance-based compensation" exception to set a per-employee limit applicable to stock options and stock appreciation rights (SARs) under an equity plan intended to comply with such exception.

RSU Reliance Period Clarification

  • Generally, compensation paid by newly public companies under plans or agreements in effect prior to the company's initial public offering (IPO) (for which adequate disclosure is provided in the IPO prospectus) must be "paid" during the reliance period to be deemed performance-based compensation that does not count against the annual $1 million deduction limitation. 
    • The reliance period ends on the earliest of:  (a) the first annual shareholders meeting at which directors are to be elected that occurs after the third calendar year following the year of the company's IPO (or, if no IPO, the first calendar year following the year in which the company becomes a public company), (b) the issuance of all employer stock and other compensation allocated under the plan or agreement, or (c) the expiration or material modification of the plan or agreement.
  • Under a special equity award rule, stock options, SARs, and restricted stock that are granted during the reliance period will be deemed to be performance-based compensation (subject to meeting all the other specific requirements) even if the equity awards are exercised or vest after the end of the reliance period.
  • The final regulations clarify that other forms of stock-based compensation, most notably RSUs, do not qualify for the special equity rule and must be settled during the reliance period.  However, this clarification does not apply to stock-based compensation granted prior to April 1, 2015.

Practical Advice

Public companies that want to preserve both the flexibility of their pre-IPO equity plans (e.g., evergreen increases to the share reserve) and the tax deductibility of their equity award grants may want to consider the following grant practices:

  • Grant performance-based restricted stock in lieu of performance-based RSUs during the reliance period.  Assuming all of the other requirements are satisfied, the performance-based restricted stock will not count against the annual $1 million deduction limitation even if the vesting and income tax event occurs after the end of the reliance period.  Whether granting restricted stock or RSUs, the tax consequences to the employee generally will be the same (assuming the employee does not make a Section 83(b) election to be taxed on the restricted stock at grant and that the employee does elect to defer the settlement of the RSUs).
  • Grant only stock options during the reliance period.
  • Grant a lesser number of RSUs with modified vesting schedules such that all or a portion of the RSUs will be settled in stock during the reliance period.

Per-Employee Limit Clarification

  • The final regulations retain the rule that using an aggregate limit on the number of shares that could be granted under a stockholder-approved plan will not meet the requirement for establishing the maximum amount of compensation that may be received by an individual covered employee.
  • This clarification does not apply to stock options or SARs granted prior to the proposed regulations' effective date of June 24, 2011.  Further, the limit can be structured to include all types of equity-based awards, other than stock options and SARs.


Practical Advice

Public companies that want flexibility with their plans can have a single limit for all equity grants or separate limits for different classes of equity (e.g., separate limits for appreciation-based awards such as stock options and SARs versus full-value awards such as restricted stock and RSUs).  Set forth below are example plan provisions that generally will comply with the final regulations subject to the specific terms of the applicable plan:

  • Single Limit
    • No participant may be granted one or more awards during any calendar year covering more than 10,000,000 shares in the aggregate. 
  • Seperate Limits
    • Limits on Options.  Subject to adjustment pursuant to Section __, no key employee shall receive options to purchase shares during any calendar year covering in excess of 7,500,000 shares.
    • Limits on SARs.  Subject to adjustment pursuant to Section __, no key employee shall receive awards of SARs during any calendar year covering in excess of 7,500,000 shares.
    • Limits on Stock Grants and Stock Units.  Subject to adjustment pursuant to Section __, no key employee shall receive stock grants or stock units during any calendar year covering, in the aggregate, in excess of 7,500,000 shares.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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