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Compensation paid by a publicly-traded corporation to its Chief Executive Officer and three other highest compensated officers (other than the Principal Financial Officer) is generally not tax deductible to the extent the officer’s compensation exceeds $1,000,000 per year. This limitation, however, does not apply to qualified performance-based compensation that complies with the requirements of Section 162(m).

The failure to comply with the requirements of Section 162(m) with respect to performance-based equity awards can result in the corporation’s loss of substantial income tax deductions. The costs associated with non-compliance, however, can far exceed the loss of the corporation’s tax deductions, as the corporation also may be subject to derivative suits brought by plaintiff’s lawyers and, in the worst case scenario, the corporation may have to rescind grants, restate previously issued financial statements and/or make additional public disclosures.

Common Errors: There are numerous conditions that must be satisfied for awards to be considered performance-based compensation under Section 162(m), and IRS audit activity in this area continues to reveal a number of common failures, including:

  • Making ad hoc adjustments to the performance goals that were not pre-determined (e.g., adjusting for subsequent events);
  • The failure to obtain shareholder approval or re-approval of the plan;
  • Paying awards out upon retirement or an involuntary termination regardless of whether the performance goals were satisfied;
  • Using performance measures that are not included in the shareholder approved plan;
  • Paying out the compensation before the compensation committee certifies in writing that the performance goals were obtained; and
  • Issuing performance awards, stock options and SARs in excess of approved plan limits.

In an effort to assist employers in their compliance efforts, set forth below is a list of action items that employers should consider in order to enhance compliance.

Employer Action Items to Enhance Compliance

Timely Seek Shareholder Re-Approval: Under Section 162(m), the material terms under which compensation is to be paid, including the performance goals, must be disclosed to and approved by the corporation’s shareholders. Where a plan allows the compensation committee to annually establish the performance goals and targets (the most common plan design), the performance goals must be disclosed and re-approved by shareholders every five (5) years.

  • 2017 Shareholder Approval Reminder – If the corporation’s equity incentive plan or annual bonus plan was last approved by shareholders in 2012, the plan must be submitted to shareholders for re-approval in 2017 in order to ensure that future awards qualify as performance-based compensation under Section 162(m).

Compensation Committee Written Certification: In order to comply with Section 162(m), the compensation committee also must certify in writing that the performance goals are in fact satisfied before the payment is made. For this purpose, the approved minutes of the compensation committee meeting in which the certification is made shall be treated as written certification.

  • Stand-Alone Certification – In practice, however, the minutes of a compensation committee meeting are commonly approved at the next meeting, which may not precede the actual payment date. Accordingly, corporations should consider having the Chairman of the compensation committee sign a separate written certification confirming the attainment of the performance goals.

Monitor and Verify “Outside Director” Status of Compensation Committee Members: Under Section 162(m), the performance goal under which compensation is paid must be established by a compensation committee comprised solely of two or more outside directors. In practice, however, confirming a person’s status as an “outside director” can be quite complicated.

  • Established Procedures – The failure of a compensation committee member to qualify as an outside director can result in the loss of significant tax deductions, particularly if the failure taints awards granted over a period of years. Accordingly, it is essential that the corporation have established procedures for confirming and monitoring outside director status.

Review Proxy Disclosures: In light of the recent derivative suits alleging Section 162(m) violations, corporations should carefully review their proxy disclosures to ensure that they do not suggest or imply that the corporation’s plan and awards will qualify as performance-based compensation under Section 162(m). The use of language such as “may comply” or “is intended to comply” may protect the corporation from allegations of false or misleading statements in the proxy materials.

Update/Establish Grant Procedures: The majority of failures identified by the IRS on audit are readily preventable. In this regard, corporations should establish and/or update grant procedures to ensure that awards are made in compliance with the plan’s terms and that award limits are properly monitored.

Third-Party Compliance Review and Training: Over time, a corporation’s plan documents, award agreements and grant procedures can become out-of-date. Additionally, as personnel turnover or transition to new positions, new personnel may not be adequately informed on the requirements of Section 162(m). Accordingly, corporations should periodically have a Section 162(m) compliance review and training program performed by a qualified tax professional.