This article is reprinted with permission from the
January 31, 1996
edition of
New York Law Journal.
1996 NLP IP Company.


Final Regulations for Code 162(m)

By Joseph E. Bachelder.


On Dec. 19, the Internal Revenue Service issued final regulations under 162(m) of the Internal Revenue Code of 1986. 1 Relatively few changes are made in Treasury Regulation 1.162-27 from the regulations as proposed. 2 This column discusses the more material changes.

Code 162(m) disallows deductions in the case of a publicly held corporation for compensation paid to a covered executive (generally the chief executive officer and each of the four other highest paid executives) in excess of $1 million in any one taxable year of the employer. A very important exemption from this requirement is provided for compensation qualifying as "performance-based compensation." Most of the Treasury Regulation 1.162-27 is devoted to very complicated rules defining what is meant by "performance-based compensation."

Performance-Based Compensation

Before a discussion of the changes affecting this definition, a brief "refresher" will be provided on the statutory definition of "performance-based compensation." Under Code 162(m), to qualify as "performance-based," compensation must be

(i) based on performance goals set by a committee of outside directors (at least two);

(ii) disclosed and approved by shareholders, as to its material terms for payment, including performance goals, before such payment; and

(iii) certified before payment, by the committee of outside directors, as being payable based on such material terms, including achievement of performance goals.

As noted, the principal changes from the proposed regulations adopted in the final regulations concerns elements making up the definition of qualifying performance-based compensation. These changes effect:

* bonus pools;

* satisfaction of the requirement that bonus formulas generally be non-discretionary, notwithstanding that a target bonus is expressed as a percentage of salary and salary may be adjusted prior to payout of the bonus; and

* dividend equivalents in connection with stock options.

The final regulations also clarify that an "outside director" may include a former officer of a corporation formerly affiliated with the public corporation in question. Finally, the regulations contain certain clarifications regarding transition and effective date rules that should be noted.

Following is a discussion of these changes and clarifications:

1. Bonus pools. Bonus pools are a customary part of annual incentive programs. A standard practice in executive bonus plans has been to provide for allocation of a corporate "bonus pool" among participating executives after (i) the size of the pool has been determined (based on corporate, or other unit, performance targets) and (ii) performance has been determined for each of the participating executives, both as of the close of the year in question.

Code 162(m) requires that the amount of the bonus for an executive covered by Code 162(m) be determinable based on pre-established performance criteria. Thus it has become necessary to fix a target amount -- frequently expressed as a percentage of the bonus pool. Treasury Regulation 1.162-27(e)(2)(ii) requires that this target be established pursuant to a formula or standard so that a third party with "knowledge of the relevant performance results could calculate the amount to be paid to the employee." Treasury Regulation 1.162-27(e)(2)(iii) prevents discretionary adjustment upward of the amount based on the achievement of targets (although the regulation specifically permits discretionary adjustment downward in the bonus payable).

Bonus pools, accordingly, could not allow amounts not paid to executive A under a bonus pool to be paid to executive B without violating the requirement that either executive's bonus be determined by a pre-established target as just described.

Final regulation 1.162-27(e)(2)(iii)(A) provides:

[The] exercise of negative discretion with respect to one employee is not permitted to result in an increase in the amount payable to another employee. Thus, for example, in the case of a bonus pool, if the amount payable to each employee is stated in terms of a percentage of the pool, the sum of these individual percentages of the pool is not permitted to exceed 100 percent.

The second sentence is an awkward statement intended to address the following situation: If an employer otherwise wanted to "get around" Code 162(m), it might give out percentages to participating executives that add up to more than 100 percent of the bonus pool. For example, it might award to participating executives individual percentages of the bonus pool that add up to, say, 150 percentage points. Then the corporation might cut back the individual percentages of participating executives who did not perform up to standard so that the aggregate awards under the pool equal 100 percent after measuring performance.

The effect would be to take away from executive A, who was cut back and give to Executive B, who kept his original percentage, more than executive B would have received if the aggregate participant interests, to begin with, had totaled 100 percentage points. A corporate bonus pool administered in this manner would provide for discretionary adjustment upward, which the regulation does not permit, as already noted. Further illustrations regarding a corporate bonus pool are provided in Examples (7) and (8) in Final Regulation 1.162-27(e)(2)(vii).

Transition Relief?

Exception from bonus pool requirement for awards with performance periods commencing before Dec. 20, 1995. In view of the uncertainty as to the treatment of bonus pools under the proposed regulations, the final regulations afford transition relief to plans that provided for reallocation among executives for awards based on a bonus pool for any performance period commencing before Dec. 20, 1995, the date of publication of the final regulations in the Federal Register. The exception for amounts so awarded applies if they are paid before Jan. 1, 2001. 3

2. Bonuses based on a percentage of salary. Another bonus-related question addressed in the final regulations concerns a bonus tied to salary, which, in turn, may be increased from the salary in effect at the time of the original award. As already noted, the regulations require that a bonus, in order to qualify as performance-based compensation, must not be discretionary (except to the extent of negative discretion -- that is, the authority of the compensation committee to adjust it downward from the formula-based amount).

A bonus that is based on a percentage of salary, which could be increased at any time, would be subject to increase at the discretion of the compensation committee.

Final Regulation 1.162-27(e)(4)(i) provides that:

in the case of a formula that fails to preclude discretion to increase the amount of compensation (as described in paragraph (e)(2)(iii)(A) of this section) merely because the amount of compensation to be paid is based, in whole or in part, on a percentage of salary or base pay and the dollar amount of the salary or the performance goal is established, the maximum dollar amount of compensation that could be paid to the employee must be disclosed.

The final regulations also contain the following modification of this requirement in 1.162-27(j)(2)(v):

[The] requirement in paragraph (e)(4)(i) of this section that, in the case of certain formulas based on a percentage of salary or base pay, a corporation disclose to shareholders the maximum dollar amount of compensation that could be paid to the employee, will apply only to plans approved by shareholders after April 30, 1995.

3. Stock Options with Dividend Equivalents. It is not uncommon for stock option programs to provide that dividend equivalents may be paid in respect to the shares subject to the stock option grants. Dividend equivalents ordinarily are paid or credit to the account of optionees when dividends are declared by the corporation.

Discount Distinguished

This practice came into question under the proposed regulations, which contained a requirement (as do the final regulations) that a stock option, in order to qualify as a performance-based plan, must be exercisable at the fair market value of the stock on the date of the grant. Treasury Regulation 1.162-27(e)(2)(vi) requires that the option right be based solely on an increase in the value of the stock following the date of the grant or award. A discount in the exercise price below fair market value as of the date of grant would mean that part of the award would not be based solely on an increase in the stock value following the date of the award.

The IRS has concluded that payment of dividend equivalents should not prevent an option from meeting this requirement, provided the dividends are paid or credited without reference to whether the optionee exercises the option. Accordingly, Final Regulation 1.162-27(e)(2)(vi) contains the following provision:

Whether a stock option grant is based solely on an increase in the value of the stock after the date of grant is determined without regard to any dividend equivalent that may be payable, provided that payment of the dividend equivalent is not made contingent on the exercise of the option.

4. Outside director who is former officer of a former affiliate. As noted at the beginning of this column, one of the requirements of Code 162(m) for performance-based compensation is that it be administered (i.e., performance goals are established, performance in terms of those goals is certified, etc.) by a committee of "outside directors." Treasury Regulation 1.162-27(e)(3)(i) establishes the requirements for a director to qualify as an "outside director."

One of these requirements is that the director "has not been an officer of the publicly held corporation." Treasury Regulation 1-162-27(e)(3)(vi) clarifies that a former officer of a former affiliate of the publicly held corporation in question is not disqualified solely because of his being a former office of such former affiliate. Thus, for example, a director may qualify as an outside director of a publicly held parent of an affiliated group of corporations notwithstanding his previously being an officer of a member of that affiliated group that has been liquidated or spun off from the parent.

On the other hand, the regulation provides that "an outside director would no longer be an outside director if a corporation in which the director was previously an officer became an affiliated corporation of the publicly held corporation."

A Spin-Off

5. Shareholder approval: exception for former privately held companies. Treasury Regulation 1.162-27(f) provides an exception, during a "reliance period," from the public shareholder approval requirements for a performance-based plan in a case in which an initial public offering has included a prospectus that has disclosed information concerning the plan in question in accordance with securities laws then in effect.

A situation not covered by the proposed regulations is one in which a subsidiary of a publicly held corporation is spun off under circumstances in which no prospectus is required. 1.162-27(f)(2) of the final regulations provides a reliance period until "[the] first meeting of shareholders at which directors are to be elected that occurs after the close of . . . the first calendar year following the calendar year in which the corporation becomes publicly held" in the case of a corporation that becomes publicly held without an initial public offering.

6. Feb. 17, 1993, grandfather protection for contracts that give the executive unilateral right to renew. Employment agreements and certain plans and other arrangements that were legally binding before Feb. 17, 1993, are grandfathered from the provisions of Code 162(m). Such protection may be (or already may have been) lost if the agreement reaches an expiration date upon which automatic renewal occurs unless either party notifies the other than the contract is not to renew.

The final regulations provide that such automatic renewal provision (or, in cases requiring affirmative action, the right to elect renewal) does not take away the grandfather protection under Code 162(m), provided such right is only a unilateral right on the part of the executive. Treasury Regulation 1.162-27(h)(1)(i) provides as follows:

[If] the corporation will remain legally obligated by the terms of a contract beyond a certain date at the sole discretion of the employee, the contract will not be treated as a new contract as of that date if the employee exercises the discretion to keep the corporation bound to the contract.

The provision raising an interesting question. What if such discretion regarding renewal exists on the part of both the employer and the executive but the employer, in advance of the period during which renewal discretion can be exercised, relinquishes its renewal discretion, leaving the right solely in the executive? (This assumes there is a limited period prior to the scheduled expiration of the agreement during which such discretion must be exercised.)

Would such a release of a right constitute a "material modification" within the meaning of Treasury Regulation 1.162-27(h)(1)(iii)? If so, the grandfathering of the agreement would be lost. If not, the agreement might continue to be grandfathered during the renewal period.

7. Transition relief for stock-based compensation. Treasury Regulation 1.162-27(h)(3) provides, among other things, special transition relief for certain stock-based compensation, if shareholder approval was obtained before Dec. 20, 1993, the date the proposed regulations were issued, and if certain other requirements relating the the approval process and the maximum number of shares are met.

Stock-based compensation is described in Treasury Regulation 1.162-27(h)(3)(iii) as "a stock option or stock appreciation right, or . . . restricted property. . . ." Transition relief for this purpose means being excepted from the requirement that the performance goals be set by a committee of outside directors as set forth in Treasury Regulation 1-162-27(e)(3) and the requirement that shareholder approval be obtained with regard to elements of performance-based programs requiring shareholder approval, such as performance goal requirements (not applicable to stock options and stock appreciation rights) and other criteria as set forth in Treasury Regulation 1.162-27(e)(4).

This transition relief applies to awards made on or before the last date of the reliance period, regardless of when the exercise (in the case of stock options or stock appreciation rights) or vesting (in the case of restricted property) takes place. For this purpose the reliance period ends no later than the first meeting of shareholders at which directors are elected that occurs after Dec. 31, 1996. 4


The preamble to the final regulations clarifies that the IRS does not intend that the transition relief apply to other forms of long-term incentives, such as performance unit awards (and presumably performance share awards unless part of a restricted stock program). It has been hoped that the final regulations would extend the transition relief beyond stock options, stock appreciation rights and restricted stock to other stock-based compensation and deferred compensation in general.

The preamble, at 60 Federal Register 65537, makes it clear that the IRS reviewed requests that it extend transition relief to a broader category of long-term incentives and chose not to do so. Certain other transition relief specifically applies to stock-based compensation of companies that have become publicly held and subsidiaries that have become separate publicly held subsidiaries. 5


1 The final regulations, Treas. Reg. 1.162-27, appear as Treasury Decision 8650 in 60 Fed. Reg. 65534 (Dec. 20, 1995).

2 The proposed regulations were published in 58 Fed. Reg. 66310 (Dec. 20, 1993). Amendments to the proposed regulations were published in 59 Fed. Reg. 61844 (Dec. 2, 1994).

3 Treas. Reg. 1.162-27(j)(2)(iv).

4 Treas. Reg. 1-162-27(h)(3)(ii). The reliance period will end sooner than the first shareholders' meeting noted in the text upon the earlier occurrence of either of the following: "(A) [the] expiration or material modification of the plan or agreement; [or] (B) [the] issuance of all employer stock and other compensation that has been allocated under the plan. . . ."

5 Treas. Reg. 1.162-27(f) and (j)(2)(iii).