Current developments in employee benefits.

• Author: Kundin, Elizabeth A.
• Position: Part 2

This two-part article provides an overview of recent developments in employee benefits, qualified retirement plans and executive compensation. Part I, published in November, focused on current developments affecting qualified retirement plans, including IRS determination letters, the Voluntary Compliance Resolution program, new final regulations, and developments in case law applicable to qualified plans. Part II, below, will focus on the Sec. 162(m) limits on deductions for executive compensation, cases involving voluntary employees' benefit association (VEBA) and deferred compensation deductions, IRS guidance relating to travel and entertainment expense deductions, developments under the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) regulations and the new "Nanny" tax provisions.

Executive Compensation

* Deduction limits

On Dec. 15, 1993, the IRS released proposed regulations implementing the Sec. 162(m) limit on deductions for certain executive compensation in excess of $1 million annually.(38) The preamble indicates that, to the extent that an issue is not covered by the proposed regulations, taxpayers should follow a reasonable, good-faith interpretation of the statutory provisions. The proposed regulations were later modified by Notice 94-2(39) and Notice 94-68.(40)

The Sec. 162(m) limit on deductions paid to "covered employees" applies to the chief executive officer (CEO) and the four highest paid executives (other than the CEO) of publicly traded companies for compensation that is not "performance-based." Both for purposes of determining what is a publicly held company and who is a "covered employee," the status on the last day of the tax year controls. A company that "goes private" during a year will not be subject to Sec. 162(m).

A "publicly held corporation" includes all corporations in the affiliated group of the publicly held corporation (as defined in Sec. 1504, without regard to Sec. 1504(b)) whether or not they file a consolidated return. Therefore, a group consisting of several affiliated corporations may still have as few as five covered employees among the entirety of the group.

A performance goal will not be considered to be "preestablished," and hence, exempt from the $1 million cap, unless it has been established by the compensation committee in writing before the employee performs the services, and while the outcome of the goal is substantially uncertain. Further, both the performance goal and the amount of compensation under it must be objective. The committee may retain the discretion to lower the compensation under the plan if the goal is reached, but not to increase compensation under the performance goal. The standard for "objectivity" requires that a third party with knowledge of the relevant facts should be able to determine whether (and to what extent) the goal was satisfied, and the amount of the compensation that would be payable to the employee.

According to Notice 94-68, the final regulations will provide that a performance goal based on a period of service will be "preestablished" if it is established in writing by the compensation committee no later than 90 days after the commencement of that period of service and if the outcome is substantially uncertain at that time. This will allow compensation committees to use year-end financial information in setting performance goals, while satisfying the requirement that goals be set while the outcome is substantially uncertain. The final regulations will also provide that in no event will a performance goal be considered preestablished if it is established after 25% of the period of service has elapsed.

Stock options and appreciation rights will be considered "performance-based" compensation if the grant is made by the compensation committee, the plan includes a per-employee limitation on the number of shares for which options or rights may be granted during a specified period, and the exercise price or base price is no less than the fair market value of the stock on the date of the grant or award. An unconditional grant of discounted stock, appreciation rights and restricted stock will not be considered performance-based compensation. The fact that discounts are granted on some stock options or rights will not cause other compensation attributable to qualified grants or awards to become includible in the $1 million cap. If, however, the grant of a discount option or restricted stock is contingent on the attainment of a performance goal, the compensation attributable to those shares could meet the requirements for performance-based compensation.

If options or other rights are repriced after their initial issuance, the repricing will be treated as the issuance of a new option and a cancelation of the original grant. Both the original grant and the stock repriced will count against the employee's individual limit on the number of shares contained in the original performance-based compensation plan.

The compensation committee must consist solely of outside directors. The proposed regulations describe an outside director as an individual who is not a current employee, is not a former employee receiving compensation for prior services (other than from a tax-qualified retirement benefit plan), has not been an officer of the company, and does not receive remuneration from the company directly or indirectly other than as a director. Remuneration includes other than de minimis payments for goods and services, including payments to entities in which the director has at least a 5% ownership interest or is employed. Under a transition rule, a "disinterested director" within the meaning of Securities and Exchange Commission (SEC) Rule 16b-3 is treated as an outside director until the first shareholders' meeting at which directors are to be elected occurring after July 1, 1994.

Shareholder disclosure must include a description of the broad class of employees covered by the performance goal arrangement, a general description of the goals, and the formula for computing the compensation or the maximum dollar amount that will be paid if the goal is attained. Specific targets need not be disclosed, and general SEC disclosure standards that protect confidential and commercial business information can be followed. For example, the "third party" disclosure requirement establishing the objectivity of the performance goal is not the shareholder disclosure standard. Redisclosure and reapproval are required only when material terms are changed, or at least once every five years.

Sec. 162(m) does not apply to copensation paid under written binding contracts in existence on Feb. 17, 1993. State law determines whether the contract is binding. Any material modification will be treated as a new, non-grandfathered contract. For plans that meet the grandfather rule as of Feb. 17, 1993, an individual who was an employee as of that date or had a contract to participate eventually in the plan as of that date is not subject to the deduction limit, even though the employee was not actually eligible to participate in the plan on that date.

* Proxy disclosure

On Nov. 29, 1993, the SEC announced several changes to the executive compensation disclosure rules, intended to make compensation disclosure clearer and more useful to shareholders.(41)

Prior to the changes, the rules covered only executive officers employed at fiscal year-end. The amendments broaden the group of persons covered by the rules to include CEOs and no more than two other top-paid executive officers who left the company during the latest completed fiscal year. The salary and bonus reportable are those paid, earned or accrued. Amounts are not to be annualized for the period after departure.

Previously, disclosure of year-end restricted stock holdings for named executive officers was required only when an award of restricted stock appeared in the Summary Compensation Table. The amended rule requires disclosure of all year-end restricted stock holdings.

Registrants using a Black-Scholes or binomial pricing model to value options were previously permitted to limit their disclosure to a simple declaration of the use of such model. Under the amended rules, registrants must disclose specific assumptions and adjustments underlying the option valuations.

The amended rules also change the point at which the market capitalization of a peer group index or market capitalization index is calculated, from the end of the period for which a return is indicated, to the beginning of the period.

The SEC has specified that the compensation committee report should address the registrant's policy with respect to qualifying compensation paid to its executive officers for deductibility under Sec. 162(m). At a minimum, this would include a statement that the compensation committee has structured compensation paid to the CEO and other named officers to be deductible to the extent possible. Further explanation may be necessary, depending on the circumstances.

VEBA Deductions

In General Signal Corp.,(42) the Tax Court ruled that VEBA sponsors may not automatically rely on the safe harbor in Sec. 419A(c)(5)(B), or on reserve numbers reported by insurance administrators before plan year-end, to establish the account limit for a qualified asset account in calculating the appropriate employer deduction for VEBA funding contributions under Sec. 419A. The Tax Court also upheld the IRS's denial of deductions for additions to the account limit to fund postretirement medical and life insurance benefits under Sec. 419A(c)(2) when contributed assets were used to pay for active employees' benefits.

At the urging of a consultant to take advantage of perceived tax savings, the taxpayer established a VEBA for several benefits, including health care benefits for active employees, and postretirement medical and death benefits. On the basis of actuarial calculations, the taxpayer contributed more than $35 million to...