"IRS Cracks Down on Corporate Deductions Taken for Executive Compensation in Excess of $1 Million" |
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Section 162(m) of the Internal Revenue Code has been in place for almost twelve years, yet the Internal Revenue Service (the "IRS") has reportedly found that failure to administer bonus plans in compliance with the requirements for exemption from Section 162(m) was surprisingly common among the 24 large-cap public companies that it has been auditing under a pilot program focusing on executive compensation. We understand that the IRS expects future audits of public companies to examine Section 162(m) compliance as a routine matter. This will be a significant departure from IRS past practice of benign neglect of Section 162(m) issues. Section 162(m) disallows a public company’s deductions for compensation in excess of $1 million per year for its CEO and its next four highest-paid officers, unless the compensation meets the requirements for an exception for "performance-based compensation" paid under shareholder-approved plans. The exception requires, among other things, that a committee comprised solely of independent directors establish one or more objective performance goals within a specified period of time after the performance period begins, that achievement of the goals be a prerequisite to payment of the compensation, and that the compensation be paid only after the committee certifies that the goals have been achieved. We understand that among other mistakes uncovered by the IRS were failures to establish objective performance goals in a timely manner, and payment of bonuses under the shareholder-approved plans even when the pre-established performance goals had not been met. These types of violations can lead to loss of all or a portion of a company’s tax deductions for the compensation in question, and to various penalties. This heightened IRS scrutiny comes at a time when compliance with the requirements for the exception from Section 162(m) is increasingly important. Many companies are granting restricted stock and other "full value" equity awards, such as restricted stock units, instead of stock options. It is relatively easy for stock options to qualify for the "performance-based" compensation exception, because if an option’s exercise price is not less than the fair market value of the underlying stock on the date of grant, the procedural requirements for performance goals outlined above do not apply. By contrast, full value awards can only qualify for the exception if vesting or award of the shares is based not merely on an employee’s continued service, but also on the achievement of performance goals that comply with those requirements. In the years since Section 162(m) was enacted, practitioners have often focused on difficult interpretive issues about which the law and regulations remain unclear. However, the IRS’s audit program serves as a reminder that the exception from Section 162(m) also requires following certain relatively straightforward procedures, violation of which can deprive a company of the benefit of the exception. We recommend that all public companies review their incentive compensation plans and arrangements and the manner in which they are administered to determine whether they are in fact complying with the clear requirements of the exception from Section 162(m). Provided By WACHTELL, LIPTON, ROSEN & KATZ |