This article is reprinted with permission from the
June 30, 1994
edition of
New York Law Journal.
1994 NLP IP Company.


The Response to Internal Revenue Code 162(m)

By Joseph E. Bachelder.


TODAY'S COLUMN discusses several recent developments: (1) compensation committee responses to 162(m) of the Internal Revenue Code (the $1 million limitation on the deductibility by publicly traded corporations of certain compensation) in proxy statements filed during the 1994 proxy season by 200 of the largest U.S. corporations, (2) a recent Internal Revenue Services release addressing two points concerning the proposed regulations under Code 162(m) and (3) the status of two projects of the Financial Accounting Standards Board (FASB).

Responses to Code 162(m)

On Oct. 15, 1992, the Securities and Exchange Commission amended Item 402 of Regulation S-K under the Securities Exchange Act of 1934, which governs disclosure of executive compensation in SEC filings (e.g., the annual proxy statements of publicly traded corporations). 1 The changes include expanded coverage of pay for a chief executive officer (CEO) and generally the pay of the other four highest paid executives (these officers sometimes are referred to as the Named Officers). Item 402, as amended, also requires a compensation committee report. 2

As part of the Omnibus Budget Reconciliation Act of 1993, Congress enacted Code 162(m), which generally limits to $1 million the amount of current compensation paid to a Named Officer (described as a "covered employee" in 162[m]) that can be deducted by a publicly traded corporation in a taxable year. 3

Section 162(m) is the product of a highly politicized effort to "reel in" CEO Pay. Before the enactment of 162(m), members of both the Senate and the House of Representatives had sponsored various bills intended to curb CEO pay. 4 In addition, there was frequent criticism of CEO pay by candidates during the 1992 political campaigns.

In a release in November 1993, the SEC stated that compensation committee reports are to "address the registrant's policy with respect to qualifying compensation paid to its executive officers for deductibility under 162(m) of the Internal Revenue Code."5 On Dec. 20, 1993, the IRS published Proposed Regulation 1.167-27 setting forth the proposed rules pursuant to 162(m). 6

The most important exemption from the impact of 162(m) is that provided for "performance-based compensation," incentive compensation plans generally must be approved by shareholders and, except in the case of stock options and stock appreciation rights (SARs), must be subject to "objective performance goals" established by "outside directors" at the beginning of the period to which the performance relates (see further discussion on these points in the second part of this column).

Thus, to qualify for the "performance-based plan" exemption, a number of requirements must be met that very few corporations, before Jan. 1, 1994, the effective date of 162(m), satisfied with respect to all their existing incentive plans. (Generally speaking, stock option and SAR plans, typically approved by shareholders, were the most likely already to have met the statutory requirement. However, even stock option and SAR plans may require further action in order to qualify as performance-based plans.)

For the foregoing reasons, compensation committees of many corporations faced a significant issue in determining whether to adopt a policy of compliance with the requirements of 162(m).

In June, the author's law firm undertook a survey of the proxy statement of 200 of the largest U.S. public corporations (the Top 200) represent the largest 100 of the Fortune 500 (industrial corporations) and the largest 100 of Fortune's Service 500 as to which proxy statements for the 1994 proxy season were available. 7 /The following chart and accompanying discussion summarize their responses: 8


1. Full compliance. 23 11.5%
2. No policy stated but no tax impact expected. 11 5.5%
3. No policy stated but steps being taken to comply. 26 13.0%
4. No policy stated. No discussion given. 5 2.5%
5. "Wait and see" (e.g., until final regulations are adopted). 50 25.0%
6. Company/Committee reserves discretion not to comply (usually couched in affirmative language, e.g., "will take into account Section 162(m) to the extent feasible"). 85 42.5%


1. Full compliance (11.5 percent). It is noteworthy that only 23 of the compensation committees of the Top 200 corporations were prepared to state, without condition, a policy of full compliance with 162(m).

2. No policy stated, but no impact expected (5.5 percent). Some of the compensation committees in this group stated that they had reviewed their compensation programs and determined that 162(m) would have no tax impact on compensation paid in 1994 and, in some cases, determined it would have no tax impact on compensation payable in the foreseeable future. Others simply stated that they were, or believed they were, currently in compliance with 162(m).

3. No policy stated, but steps being taken to comply (13 percent). Steps taken by corporations in this group included amending their existing long-term incentive plans and asking the shareholders to approved various new performance-based incentives. Corporations in this group generally indicated certain actions were being taken for the purpose of qualifying the plans involved as performance-based plans under 162(m). However, absent a statement as to policy regarding 162(m), it is difficult, if not impossible, to discern whether the corporations in this group intended to comply fully and whether their intent regarding compliance related to 1994 or extended to later years as well.

4. No policy stated and no discussion provided (2.5 percent). The Top 200 survey included five corporations that made no reference to 162(m) and gave no indication that any action was taken (or was needed) to comply.

5. "Wait and see" (25 percent). Most of the corporations in this group noted that since the regulations were proposed, not final, they had decided to wait for final regulations (or some other definitive guidance) to be issued by the IRS before adopting a policy with regard to 162(m). Some in this group stated that they were currently conducting their own study of 162(m) (sometimes without any reference to the status of the regulations) and were deferring adoption of a policy until completion of the study. It is noted that in a number of cases, while a "wait and see" policy was adopted, the corporations also indicated that steps were being taken to comply.

6. Discretion reserved whether to comply with 162(m) (42.5 percent). Some of the corporations in this group stated that they would qualify executive compensation to the extent it was "practicable" or "feasible." Others stated they intended to retain flexibility in respect of their executive compensation programs, including the issue of whether to comply with 162(m). Frequently justifications for their positions were provided including the need to design effective (or competitive) compensation programs, to retain the ability to reward extraordinary contributions (not easily quantifiable) or to better serve shareholders' interests.


There is little evidence in the compensation committee reports of the Top 200 that 162(m) has "reeled in" CEO pay. Only a small minority of compensation committees was willing to commit to a policy of complying with 162(m). A substantial majority declined to express itself as ready to comply fully, expressly reserved discretion (i.e., rejected a policy of compliance) or simply made no comment as to policy. In summary, the compensation committees of most major U.S. corporations are not, as yet, willing to commit themselves in their proxy statements reports to a policy of compliance with 162(m)'s restrictions.

Since the publication of Proposed Regulation 1.162-27 on Dec. 20, 1993, there has been very little in the way of published comment on 162(m) by the IRS.

On June 7 the IRS announced it will be publishing a Notice covering two points that are the subject of Proposed Regulation 1.162.27. 9

The first concerns when a performance goal must be adopted in order for a plan to qualify as a "performance-based plan." Such a goal must be "preestablished." The proposed regulation says: "A performance goal is considered preestablished if it is established in writing by the compensation committee prior to the commencement of the services to which the performance goal relates and while the outcome is substantially uncertain." 10

After the proposed regulations were published, the IRS adopted a transition rule permitting a goal established by the compensation committee before April 1, 1994, to qualify as a preestablished goal for purposes of any period ending no less than nine months after the date the committee established the goal. 11

The new notice, in effect, adopts the transition rule as the permanent rule. It provides that under final regulations (yet to be adopted) a performance goal will be deemed preestablished provided it is adopted within 90 days of the commencement of the period to which the goal relates. However, no more than 25 percent of the period of service to which the goal relates can have elapsed when the goal is established.

The second item covered by the new notice relates to the qualification of an "outside director." The meaning of "outside director" is important because under 162(m) the requisite performance goals to qualify a compensation plan as a "performance-based plan" must be established (and later certified as to whether they have been met) by a committee composed exclusively of "outside directors."

Proposed Regulation 1.162-27(h)(2) provides as a transition rule that a "disinterested director" within the meaning of Rule 16b-3(c)(2)(i) under the Securities Exchange Act of 1934 will qualify as an "outside director" for purposes of 162(m) until the first meeting of shareholders at which directors are to be elected that occurs after July 1, 1994. (The test for qualifying as a "disinterested director" under the SEC insider rule is much more lenient than the rule to qualify as an "outside director" within the meaning ultimately to take effect under Proposed Regulation 1.162-27[e][3][i].)

The new notice provides as a modified transition rule that a "disinterested director" under the SEC rule will continue to satisfy the "outside director" requirement until the first meeting of shareholders at which directors are to be elected that occurs on or after Jan. 1, 1995.

Status of FASB Projects

Pursuant to its Stock-Based Compensation Project, the FASB issued in Exposure Draft on June 30, 1993, in which it required pro forma disclosure of the consequences of a charge against earnings for option grants made on or after Jan. 1, 1994, and actual recognition in the income statement of a charge against earnings for grants made on or after Jan. 1, 1997.

On June 8, 1994, the FASB voted to delay to Jan. 1, 1995, from Jan. 1, 1994, the date for commencing pro forma disclosure. It did not, however, change the date for actual recognition of an earnings charge for stock option grants made on or after Jan. 1, 1997. The FASB also indicated it may decide that companies must disclose information about stock options granted in both 1994 and 1995 in connection with the companies' 1995 financial statements. 12

The FASB is conducting another project, in coordination with the International Accounting Standards Committee (IASC), for the purpose of adopting an accounting standard on earnings per share (EPS) that could be applied on a uniform, international basis. Among the issues to be considered is the dilutive impact that stock options should have on EPS (currently governed by Accounting Principles Board Opinion No. 15). It does not appear that the FASB will issue its proposals on this subject much before the end of 1994.


1 Securities and Exchange Commission (SEC) Rel. No. 33-6962, 34-31327, IC-19032 (Oct. 15, 1992), 57 Fed. Reg. 48,126 (Oct. 21, 1992) (amending 17 CFR 229.402).

2 17 CFR 229.402(k).

3 Pub. L. No. 103-66, 13211 (Aug. 10, 1993). It is noted that under 162(m)(3)(A), an individual who is serving as a CEO will have the status of a "covered employee" if the individual is serving as the CEO at the close of the taxable year. In contrast, under Item 402(a)(3)(i) of Regulation S-K, an individual who serves as the CEO at any time during the last completed fiscal year will have the status for that year of a "Named Officer" for executive compensation disclosure purposes.

4 See this column, New York Law Journal, July 29, 1991, and March 30, 1992.

5 SEC Rel. No. 33-7032, 34-33229 (Nov. 22, 1993), 58 Fed. Reg. 63,310 (Nov. 29, 1993).

6 58 Fed. Reg. 66,310 (Dec. 20, 1993).

7 The Top 200 survey group is comprised of (a) the top 100 Fortune 500 (industrial corporations) (as listed in Fortune [April 18, 1994]) and (b) the top 100 Fortune's Service 500 companies (as listed in Fortune [May 30, 1994]) that have issued proxy statements after Dec. 31, 1993, in which a 162(m) policy was [or should have been] discussed. Because Fortune's Service 500 is actually composed of eight separate lists, the "top 100" of Fortune's Service 500 is selected from the following six Fortune's Service 500 lists:
* the top 30 diversified service companies
* the top 30 commercial banking companies
* the top 10 individual financial companies
* the top 10 retailers
* the top 10 transportation companies
* the top 10 utilities
Two Fortune's Service 500 lists, savings institutions and life insurance companies, have been excluded because certain of these companies are not subject to 162(m).

8 In some cases the responses to 162(m) in the compensation committee reports did not fit neatly into a single survey category. In such cases the category selected was based on a judgment as to which category best reflected the company's position with respect to 162(m).

9 "Memo to Tax Services," Communications Division, Internal Revenue Service (June 7, 1994). The memo states that "notice 94-68 dealing with the deductibility of executive compensation . . . will appear in Internal Revenue Bulletin 1994-26 on June 27, 1994."

10 Prop. Treas. Reg. 1.162-27(e)(2)(i).

11 Notice 94-2, IRB No. 1994-2 (Jan. 10, 1994).

12 News Release, Financial Accounting Standards Board (June 8, 1994).