IRS Issues Regulations on Performance‐Based Compensation Exception

• Date: 01 September 2015
• DOI: http://doi.org/10.1002/jcaf.22089
• Author: Shirley Dennis‐Escoffier
• Published date: 01 September 2015

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© 2015 Wiley Periodicals, Inc.

Published online in Wiley Online Library (wileyonlinelibrary.com).

DOI 10.1002/jcaf.22089

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IRS

IRS Issues Regulations on

Performance‐Based Compensation Exception

Shirley Dennis‐Escoffier

The Internal Revenue Service

(IRS) recently issued final

regulations to clarify the

definition of deductible

performance‐based compensa-

tion paid to highly compen-

sated officers. These regulations

state that equity‐based awards

must specify a limit on the

maximum number of shares

that can be granted to an indi-

vidual employee to qualify for

the performance‐based excep-

tion for deductibility of that

employee’s compensation in

excess of the $1 million limit.

The final regulations also

address the transition rules

for private corporations that

become publicly held. These

rules are particularly important

when restricted stock units

or phantom stock are part of

the compensation plan. Cor-

porations should review their

employment agreements and

performance plans to ensure

that the deduction for these

types of performance‐based

compensation is not lost.

BACKGROUND

Internal Revenue Code

(IRC) Section 162 allows

a deduction for reasonable

compensation paid or incurred

during the year. However, IRC

Section 162(m) denies a pub-

licly held corporation a tax

deduction for compensation

in excess of $1 million that

is paid to certain officers.

The executives affected by

this provision include the

chief executive officer and

the four highest compensated

officers whose compensation

is required to be reported to

shareholders under the Secu-

rities and Exchange Com-

mission’s disclosure rules. To

prevent the loss of the tax

deduction, a corporation must

ensure that any compensation

for these executives in excess

of $1 million qualifies under

one of the exceptions.

Compensation not subject

to the $1 million limit includes

commissions, payments to a

tax‐qualified retirement plan,

amounts excludable from gross

income (such as employer‐

provided health benefits), and

certain types of performance‐

based pay. To be considered

performance‐based, the com-

pensation must meet all of the

following conditions:

1. The compensation must be

paid solely on account of

the attainment of one or

more preestablished objec-

tive performance goals.

2. The performance goals

must be established by a

compensation committee of

the board of directors com-

posed exclusively of two or

more outside directors.

3. The material terms of the

compensation package

(including the performance

goals) must be disclosed to

shareholders and approved

by the shareholders in a

separate vote before the

compensation is paid.

4. Prior to payment, the com-

pensation committee must

certify that the performance

goals and other material

terms were satised.

The performance goals

must be established by the com-

pensation committee in writ-

ing no later than 90 days after

the beginning of the period

of service to which the goals

relate; the outcome must be sub-

stantially uncertain at the time

the goals are established; and

the goals must be determined