Thursday, July 21, 2011

Proposed Regulations Would Require Individual Employee Limits on Stock Options to Qualify as Performance-Based under §162(m)

The IRS has proposed regulations under Code Section 162(m) clarifying that qualified performance-based compensation attributable to stock options and stock appreciation rights must specify the maximum number of shares with respect to which options or rights may be granted to each individual employee. Comments on the proposal are invited until September 22, 2011. Section 162(m) caps the deduction a public company may take for executive compensation at $1 million, but excludes from the cap qualified performance-based compensation that meets all of the requirements of relevant regulations, such as that the award be made by the company’s compensation committee and the amount of compensation is based solely on an increase in the value of the stock after the date of the award.

While noting that some have questioned why the regulations would require an individual employee limit on the number of the shares for which options or stock appreciation rights may be granted where shareholder approval of an aggregate limit is obtained for securities law purposes, the IRS and Treasury said that a limit on the maximum number of shares for which individual employees may receive options or other rights is appropriate because it is consistent with the broader requirement that a performance goal include an objective formula for determining the maximum amount of compensation that an individual employee could receive if the performance goal were satisfied.

A third party attempting to make this determination with respect to a stock option plan would need to know both the exercise price and the number of options that could be granted. In addition, the regulations follow the legislative history, which suggests that a per-employee limit be required under the terms of the plan.

Thus, under the proposed regulations, if a plan states that an aggregate maximum number of shares that may be granted but does not contain a specific per-employee limitation on the number of options that may be granted, then any compensation attributable to the stock options or rights granted under the plan is not qualified performance-based compensation for purposes of Section 162(m).

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