Home | Contact Us | About Us
 
 
 

Section 162(m) Compliance

  1. IRS Focus on Section 162(m) Compliance
  2. Common Section 162(m) Violations
  3. How Inadvertent Section 162(m) Violations Occur
  4. Why You Should Designate a 162(m) Compliance Person
  5. Section 162(m) Compliance Checklist
  6. Other Section 162(m) Practice Pointers
  7. Media Articles on Section 162(m)
  8. Video Webcast Panel: The IRS Focus on Executive Compensation: What It Means For You
  9. Section 162(m) Disclosure Practice Area
  1. IRS Focus on Section 162(m) Compliance

    As of late 2004, the IRS was wrapping up an executive compensation audit pilot program in which it found Section 162(m) violations surprisingly common among the two dozen large-cap companies that it audited. As a result, we understand that the IRS has targeted 162(m) non-compliance as a focus area for future audits. 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 "performance-based compensation" paid under shareholder-approved plans.

    Common 162(m) compliance problems include: options granted under a non-shareholder approved plan; restricted stock (or restricted stock units), where neither the award nor the vesting is tied to objective, pre-established performance criteria; failure by the compensation committee to certify in writing prior to payment that the performance goals have been satisfied; or failure to timely set the performance goals — e.g., not set within the first 90 days of a one-year performance period.  Read more in IRS Cracks Down on Corporate Deductions Taken for Executive Compensation in Excess of $1 Million.

  2. Common Section 162(m) Violations

    Tim Sparks, President of Compensia, notes these common Section 162(m) violations:
     

    • Options granted under a non-shareholder approved plan. For example, options may be granted to a new officer under an "inducement" plan that has not been approved by shareholders.
    • Options granted under a plan in excess of the plan’s periodic (e.g. annual)grant limit.
    • Bonus or other incentive payments (including option grants) made under a pre-IPO plan that was not timely approved (or re-approved) as required following the IPO.
    • Restricted stock (or restricted stock units) or other full value awards, where neither the grant nor the vesting is tied to objective, pre-established performance criteria under a shareholder approved plan.
    • Bonus or other incentive payments made under a plan that gives the compensation committee authority to change performance measures that was not re-approved by shareholders on or before the fifth year following the year of prior shareholder approval.
    • Non-performance-based compensation exceeds $1 million in a year. This may result where the officer’s base salary is high and (i) the bonus plan is not "performance-based," (ii) there’s a restricted stock vesting event or a payout under a deferred compensation or restricted stock unit arrangement, or (iii) as a result of significant perquisites.
    • The compensation committee changes the performance targets or otherwise exercises impermissible discretion under the plan.
    • The compensation committee includes someone who does not meet the technical requirements to be an "outside director."
    • Discretionary authority (e.g. option grants) is exercised other than by a qualifying compensation committee (by the full Board, for example).
    • The compensation committee fails to certify in writing prior to payment that the performance goals have been satisfied.
    • The performance goals are not set soon enough – e.g., not set within the first 90 days of a one-year performance period.
       
  3. How Inadvertent Section 162(m) Violations Occur

    Tim Sparks, President of Compensia, also notes that Compensation Committees may not be aware that certain elements of their company’s executive compensation program are not fully deductible. As a result, Compensation Committees may be making executive compensation decisions without taking the full cost of those decisions into account.

    Section 162(m) of the Internal Revenue Code imposes a limit on the deductibility of compensation paid to top executives of public companies. The limit does not apply to compensation that qualifies as "performance-based" as defined in Section 162(m). Significantly, the limit does not apply to compensation attributable to most employee stock options.

    In anticipation of Section 162(m), which took effect on January 1, 1994, most companies thoroughly reviewed their compensation programs to assess the impact of Section 162(m). Many companies concluded that the limit did not apply to them since their executive pay consisted of cash compensation that was below the limit and stock options. Other companies took steps to mitigate the impact of Section 162(m) by, among other things, structuring compensation programs to qualify as "performance based."

    Since 1994, cash compensation at public companies has increased significantly and many companies have begun to expand their long-term incentive programs beyond traditional stock options. In addition, compensation programs that were initially structured to qualify as "performance-based" may no longer qualify. As a result, companies may be paying compensation that is non-deductible under Section 162(m). Compensation Committees may not be aware of this additional cost. Worse yet, companies may be taking tax deductions in violation of Section 162(m).

    There are several common patterns that can lead to inadvertent non-deductibility under Section 162(m). The sheer increase in cash compensation over the past 10 years can result in compensation that exceeds the $1,000,000 per year deduction limit. Or, companies with bonus plans tied to objective, financial performance metrics may mistakenly believe that the plan meets the technical requirements of Section 162(m). Other companies that qualified their bonus plans when Section 162(m) first took effect may have forfeited that qualification by failing to renew shareholder approval of the plan. or otherwise violating the requirements of Section 162(m). This could occur, for example, where the plan gives the Compensation Committee wide latitude in picking the financial metrics to be used in determining bonus payouts. Under the Section 162(m) regulations, such a plan must be re-approved by the shareholders every five years. Qualification might also be lost if a plan has been materially amended without shareholder approval.

    Companies that have begun to grant full value shares (restricted stock, restricted stock units) may also discover that the tax deduction associated with those grants is limited. Unless the grant or vesting of those awards fits the technical requirements of "performance-based" under Section 162(m), such amounts would be subject to the deduction limit. This could occur, for example, where the company grants restricted stock that vests based on continued employment, even if the grant includes accelerated vesting tied to performance. 

    Compensation Committees need to understand the Section 162(m) consequences of each element of the company’s executive pay program to fully understand the program’s true cost. Moreover, Committees should ensure that the company’s policy with regard to Section 162(m), as reflected in the proxy, accurately and thoroughly addresses each element of the company’s executive pay program. Finally, as part of its internal controls, companies should include an examination of tax deductibility under Section 162(m).  

  4. Why You Should Designate a 162(m) Compliance Person

    Many companies make technical foot-faults in attempting to qualify compensation as performance-based under Internal Revenue Code Section 162(m) – the $1 million executive compensation deduction limit.  The Internal Revenue Service recently completed an executive compensation audit of 24 public companies.  As a result, the IRS has apparently decided that 162(m) non-compliance is a significant problem and has targeted it as a focus area for future audits.

    Non-compliance can arise in a number of ways, including:

    • Sometimes the company does not understand that executive grants need to be made by a compensation committee consisting of outside directors, and not the entire board;
    • Sometimes the composition of the Compensation Committee is flawed, as when a former officer of the Company is a member;
    • Sometimes grants can be made in excess of plan limits;
    • Sometimes the requirements for ongoing shareholder approval, such as when the private-to-public exception expires, are not properly observed;
    • Sometimes imputed income from perquisites can drive total non-performance-based compensation over $1 million;
    • Sometimes management does not like the inflexibility of a negative discretion only bonus plan, and the plan is modified without consulting the plan documents or properly considering the 162(m) consequences; and
    • Sometimes the requirement for written certification prior to payment is not observed.

    Because qualifying compensation as performance-based is technical and requires an attention to detail, companies should seriously consider appointing an employee with over-all responsibility for understanding and monitoring 162(m) compliance.  This could be someone in the company’s legal department.  Additionally, the appointed person should be given the requisite authority to properly discharge his or her new duties, including the ability to attend compensation committee meetings in which 162(m)-related business is being conducted. 

    Ideally, the Compensation Committee would also appoint at least one member with responsibility for 162(m) compliance, who would co-ordinate with the company’s 162(m) compliance person.

    It is also a good idea to schedule some time on the Compensation Committee’s agenda every couple of years for a presentation/refresher on 162(m) and the requirements to qualify compensation as performance-based thereunder.

  5. Section 162(m) Compliance Checklist

  6. Other Section 162(m) Practice Pointers
  7. Media Articles on Section 162(m)
  8. Video Webcast Panel: The IRS Focus on Executive Compensation: What It Means For You
    • What compensation problem areas the IRS is now targeting
    • How compensation committees can ensure that these problems don’t exist for them
    • What actions compensation committees can take to avoid Section 162(m) violations

    Speakers: Bob Misner, IRS; Tim Sparks, Compensia

     

  9. Section 162(m) Disclosure Practice Area
     
 

For more information, contact info@compensationstandards.com or call 925.685.5111.
© 2006, Executive Press, Inc.
Terms & Conditions, Disclaimer, Register/Subscribe, Contact Us