IRS uncovers significant noncompliance with sec. 162(m) limits.

• Author: Pevarnik, Thomas R., Jr.

A recent IRS initiative designed to gauge the level of compliance with the tax rules governing executive compensation, has detected significant noncompliance with Sec. 162(m), which limits deductions for compensation paid to certain executives to $1 million per year. This item discusses this issue and the actions employers can take to mitigate the risk of noncompliance with Sec. 162(m).

Overview

The Sec. 162(m) limits apply only to publicly held corporations and to compensation paid to covered employees. According to Sec. 162(m)(2), a "publicly held corporation" is any corporation issuing any class of common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934. A corporation is not publicly held if registration of its securities is purely voluntary, lf a corporation is publicly held, Sec. 162(m) limits the deduction for remuneration paid to a covered employee to $1 million per year.

"Covered" employees: Only compensation paid to covered employees is subject to this deduction limit. Sec. 162(m)(3) defines a "covered employee" to include the chief executive officer and the four other highest compensated officers. Under the IRS'S interpretation of this rule, an individual can be a covered employee only if he or she is one of the officers named on the Summary Compensation Table (SCT) that the corporation attaches to its annual proxy. Except in the situation discussed below, a corporation's covered employees will coincide precisely with the individuals it lists on the table.

"Last day of year" rule: Both the definition of "publicly held corporation" and "covered employee" contain a "last day of the year" rule. A corporation is publicly held only if it is subject to Securities and Exchange Commission (SEC) reporting requirements on the last day of its tax year; an individual is a "covered employee" only if he or she is serving as an officer on the last day of the tax year. In some cases, SEC rules require an individual to be listed on the SCT, even though he or she is no longer serving as an officer on the last day of the year. Even though listed, such an individual is not a covered employee for Sec. 162(m) purposes.

Exception for performance-based compensation: There are exceptions to the $1 million deduction limit; the most common is for qualified performance-based compensation. To qualify, compensation must satisfy a detailed set of rules, including being payable based on the achievement of...