Public companies should review their performance-based compensation arrangements in light of these pitfalls to maximize their tax deduction for compensation paid to their top executives. Permitting payment of performance-based compensation upon retirement, involuntary termination, or termination for good reason. Pursuant to IRS Revenue Rulingcompensation payable for performance periods beginning after January 1, or paid under employment agreements options into after February 21, or that are renewed or extended after that date, including automatic renewals or extensions will not qualify as performance-based if it may be paid without regard to whether the performance goals are met when the executive retires, is involuntarily terminated without cause, or terminates employment for good reason.
This rule applies without regard to whether any of these events actually occur or the performance goals are in fact attained; the mere presence of the provision disqualifies the arrangement. Allowing directors who are not "outside directors" to serve on the committee authorizing and administering section m performance-based compensation.
To qualify as performance-based compensation, compensation must be awarded and administered by a committee composed solely of two or more "outside directors.
Satisfying the NYSE or NASDAQ requirements for independent directors or the SEC requirements for nonemployee directors under Rule 16b-3 while generally mandatory is not sufficient-the section m requirements are different and can be more restrictive. Using a performance goal that is not based on the business criteria approved by shareholders.
Compensation other than stock options and stock appreciation rights SARs granted with an exercise price at least equal to grant date fair market value will qualify as performance-based compensation only if it is paid solely on the attainment of one or more pre-established, objective performance goals, based upon 162(m) criteria approved by shareholders.
The compensation committee may not deviate from the business criteria listed in the shareholder-approved plan. These criteria need not be specific as to the exact targets being used.
Rather, the plan need only provide that the performance goal may be based on earnings per share. However, pursuant to the SEC's compensation proxy disclosure requirements, a company must annually disclose and analyze the specific performance criteria and targets in its Compensation Discussion and Analysis unless the disclosure involves confidential trade secrets or confidential commercial or financial information, the disclosure of which would result in competitive harm to the company.
Failing to obtain shareholder reapproval of business criteria upon which performance goals are based. The specific targets that must be satisfied under a performance goal need not be approved by shareholders. However, if the compensation committee has the authority to change the targets under a performance goal from year to year after shareholders have approved the business criteria upon which performance goals are based, the business criteria must be disclosed to and re-approved by shareholders at least every five years.
Therefore, if shareholders last approved the business criteria in a plan inthe business criteria should be submitted to shareholders for reapproval in The material terms of the performance goals that must be reapproved include 1 the class of eligible employees, 2 the types of business criteria on which the payouts or vesting for performance-based awards are based, and 3 the maximum amounts of cash or shares that can be provided during a specified period to any employee for performance-based awards under the plan.
Failing to establish the performance goals on a timely basis or making changes to the performance goals or targets. For calendar-year service and performance periods, this means that the performance goals for an annual plan must be established by March 31, The performance goals cannot be changed after this initial period.
Paying compensation when the performance goals were not attained. To qualify as performance-based compensation, compensation must be paid solely on the attainment of one or more objective performance goals. In the current economic environment, many companies did not attain their performance goals and may be considering paying their executives discretionary bonuses for their efforts in A word of caution: On the flip side, compensation payable on account of attaining the performance goal must not exceed the limit that was approved by shareholders, and the plan should not provide the compensation committee discretion to pay more than the authorized amount.
Adjusting bonus amounts for subsequent events if such an adjustment is not included in the performance goal formula. To qualify as performance-based, compensation must be payable under an objective formula for computing the amount payable if a certain goal is attained. It is possible to adjust performance measures for certain objective subsequent events for examplereorganization and restructuring programs or other executive termination costs, integration and other one-time expenditures, the sale or acquisition of a business unit ; however, this feature must be included in the performance goal formula when it is initially established, and cannot be added at the end of the performance period.
If unanticipated circumstances arise, the compensation committee can use its discretion to reduce the payout to the desired level based on the circumstances, but the payment cannot be increased to disregard the impact of subsequent events if no adjustment mechanism is present. Increasing the amount of compensation that would otherwise be due upon attainment of the performance goals.
Compensation will not stock as performance-based if the compensation committee has discretion to increase the amount payable upon attainment of the performance goals. However, the committee may have discretion to reduce the payment.
Paying awards or bonuses without compensation committee certification that the performance goals were satisfied. Compensation committees must certify that the performance goals have been met in order for amounts paid upon attainment of those goals to be deductible under section m. This applies to any bonuses or awards, including the vesting of equity awards based on stock. This certification should be included in the compensation committee minutes.
Misstating or omitting required terms that must be approved by shareholders for compensation to qualify as performance-based. The material terms that must be approved by shareholders include the maximum amount of compensation that 162(m) be paid to any employee or the formula used to calculate the amount of compensation to be paid to individual employees if certain performance goals are attained, the employees eligible to receive the compensation, and a description of the business criteria on which the performance goals are based.
The description of the compensation payable must be specific enough so that shareholders can determine the maximum amount that could be paid to any employee during a specified period. With respect to options and SARs, the plan must state the maximum number of shares with respect to which options or SARs may be granted during a specified period to any employee.
Granting stock options or SARs in excess of the plan's limit or the amount that can be awarded to an individual in a specified time period. Stock options and SARs must be granted under a shareholder-approved plan that contains a limit on the maximum number of options or SARs that may be granted to any employee in a specified period and the exercise price. Allowing inside directors to participate options granting stock options or SARs. Stock options and SARs must be granted by "outside directors" in accordance with a shareholder-approved plan in order to qualify as performance-based compensation under section m.
Granting discounted stock options or SARs. The exercise shareholder or measurement of stock options and SARs intended to qualify with section m and to be exempt from Code section A must not be less than the fair market value of the underlying stock on the grant date-the amount of the compensation that the employee can receive must be based solely on an increase in the value of the stock after the grant date. A recent IRS generic Legal Advice Memorandum, dated July 6,emphasizes that discounted stock options or SARs can never qualify as performance-based compensation under section m and states that discounted options and SARs cannot be cured for purposes of qualifying as performance-based compensation under section m.
Not contemporaneously documenting stock option and SAR grants or failing to document grants altogether. Even though the section m regulations do not require stock committee meetings to grant options or SARs or even prompt documentation of those grants, on audit the IRS has taken the position that options are discounted and thus do not qualify as performance-based compensation under section m when grants are documented weeks after the grant date using "as of" grant dates or unanimous written consents UWCswhen there approval no contemporaneous documentation of compensation committee meetings or when there are only oral authorizations from the board or the compensation committee.
In the event that the IRS determines that it is not possible to determine the grant date, the IRS will use the financial accounting measurement date as a proxy for the grant date. To avoid this challenge, the compensation committee should be precise about when an option or SAR is granted and complete all corporate documentation in a timely manner, for example, by preparing, signing, and dating the committee minutes or UWCs at the committee meeting, or within a day or two after the meeting or after the decision is made to 162(m) options or SARs.
This also raises a question about "best practices" for granting equity compensation. Granting stock options or SARs or paying other compensation under a plan that was not approved by shareholders.
For companies having shareholder IPO, failing to obtain shareholder approval of a pre-IPO plan before the first shareholders meeting following the end of the third calendar year after the IPO. Accelerating the payment date of performance-based compensation without reducing the payment amount to reflect the time value of money. Companies can mitigate the adverse effect of failing to comply with section m by requiring deferrals of any amounts that would not be deductible by the company to a date after the employee's termination of employment.
Forcing executives to assume the credit risk in difficult economic times may be met with resistance, however. Also, keep in mind that any such deferral must be made in accordance with section A. Companies should consider instituting clawback policies with respect to performance-based compensation. A clawback policy allows the company to recover approval if subsequent review indicates that payments were approval calculated accurately or performance goals were not met.
If you have any questions or would like more information on any of the issues discussed in this Hot Topics alert, please contact any of the following Morgan Lewis attorneys: New York Craig A.
James DiBernardo Zaitun Poonja. Lee Falk Amy Pocino Kelly Robert J. Spencer Mims Maynard Zabriskie David B. The regulations also warn that compensation actually paid on account of those events would not qualify as performance-based.
However, separate exceptions generally ensure a deduction for such payments, since the payees after the death or disability of an executive or the payor in the event of a change in control are likely exempt from section m in any event.
In Revenue Rulingthe IRS concluded that a director did not qualify as an "outside director" based options the following facts: SELECT THE LOCATION OR LANGUAGE TO MEET YOUR NEEDS: Skip to main navigation Skip to content Skip to footer. Morgan Lewis Consulting Private Client Private Equity Private Investment Funds Project Finance: Africa Asia Pacific Europe Latin America Middle East North America. Search our people now: Sector, service or region". Locations Locations Almaty Astana Boston Brussels Chicago China Dallas Dubai Frankfurt Hartford Houston London Los Angeles Miami Moscow New York Orange County Paris Philadelphia Pittsburgh Princeton San Francisco Santa Monica Silicon Valley Singapore Tokyo Washington, DC Wilmington.
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Pro Bono Committee Pro Bono Clients and Achievements. In the News Press Releases. LawFlash Section m Pitfalls March 09, Common Section m Pitfalls Permitting payment of performance-based compensation upon retirement, involuntary termination, or termination for good reason. Other Pitfalls Granting stock options or SARs or paying other compensation under a plan that was not approved by shareholders.
Materially amending a plan without shareholder approval. Planning Opportunities Companies can mitigate the adverse effect of failing to comply with section m by requiring deferrals of any amounts that would not be deductible by the company to a date after the employee's termination of employment. Joseph Dallas Erin Turley New York Craig A.
Rothstein Palo Alto S. James DiBernardo Zaitun Poonja Philadelphia Robert L. Zelikoff Pittsburgh John G. Randall Tracht Washington, D. Needles  Compensation may qualify as performance-based even if the plan allows the compensation to be payable upon death, disability, or change of ownership or control without attainment of the performance goals. Contact Us Client Access Login Sitemap.