Proposed Section 162(m) regulations on deductions for executive compensation.

• Position: Tax Executives Institute Federal Tax Committee Employee Benefits Subcommittee

On March 11, 1994, Tax Executives Institute submitted the following comments to the Internal Revenue Service on proposed regulations under section 162(m) of the Internal Revenue Code. The proposed regulations provide guidance concerning the $1 million limitation on deductions for compensation paid to certain corporate executives. The Institute's comments were prepared under the auspices of the Employee Benefits Subcommittee of TEI's Federal Tax Committee. The chair of the subcommittee is David L. Klausman of Westinghouse Electric Corporation, and the chair of the full committee is Michael A. DeLuca of Household International, Inc. In addition, the following individuals materially contributed to the Institute's comments: George B. Bauernfeind of Humana Inc., Louis DeMattei of lntel Corporation, Edmond J. Downing of Philip Morris Management Corporation, Richard N. Kappler of MCI Communications Corporation, Robert Levy of ACCO World Corp., and Paul J. Schaffhausen of McDonald's Corporation.

On December 15, 1993, the Internal Revenue Service issued proposed regulations under section 162(m) of the Internal Revenue Code. The proposed regulations provide guidance concerning the $1 million limitation on deductions for compensation paid to certain corporate executives. The proposed regulations were published in 'the Federal Register on December 20, 1993 (58 Fed. Reg. 66310), and in the Internal Revenue Bulletin (19944 I.R.B. 24) on January 24, 1994.(1) A public hearing on the proposed regulations is not yet scheduled.

1. Background

   Tax Executives Institute is the principal association of business tax executives in North America. The Institute's approximately 4,700 members represent more than 2,400 of the largest companies in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and the government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply.

   TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the temporary and proposed regulations relating to the $1 million limitation on deductions for compensation paid to individual corporate executives.

2. Overview and

   General Comments

   The Omnibus Budget Reconciliation Act of 1993 added new section 162(m) to the Internal Revenue Code to deny deductions to any publicly held corporation for compensation in excess of $1 million paid to a "covered employee" in a taxable year. A publicly held corporation means any corporation issuing a class of common equity securities required to be registered under section 12 of the Securities Exchange Act. A "covered employee" under new section 162(m)(3) is the chief executive officer (or acting CEO) on the last day of the taxable year or any other individual whose compensation is required to be reported to shareholders under disclosure rules issued by the Securities Exchange Commission (SEC) by reason of being among the four highest compensated officers.

   The deduction limit applies to any compensation that would otherwise be deducted in a taxable year, except for certain enumerated payments set forth in section 162(m)(4), including amounts (i) payable under compensation agreements in effect on February 17, 1993, (ii) excludible from gross income, (iii) paid from qualified plans, or (iv) payable as commissions or that otherwise meet specified requirements for performance-based compensation.

   On an on-going basis, the most important of the exceptions to the deduction limitation is that for performance-based compensation. Under section 162(m)(4)(C), compensation will not be subject to the $1 million limitation where (i) it is payable on account of attainment of one or more performance goals; (ii) the performance goals are established by a compensation committee of the board of directors that is comprised solely of two or more "outside" directors; (iii) the material terms of the compensation and the performance goals are disclosed to and approved by shareholders before payment; and (iv) the compensation committee certifies that the performance goals have been satisfied before payment.

   Given the short period for taxpayer reaction between the release of the preliminary guidance on December 15, 1993, and the January 1, 1994, effective date, the Treasury and IRS are to be commended for recognizing that complying with certain proposed rules--in particular, obtaining the requisite board of director compensation committee approvals for the objective, pre-established performancebased goals--would be extremely difficult. Consequently, the transition rule relief set forth in Notice 94-22 for approval of performance-based compensation payable by calendar-year companies was welcomed.

   The proposed rules generally represent a reasonable attempt to administer the highly questionable tax policy underlying the limitation on corporate officer compensation? We believe, however, that final rules should not become effective until all publicly held corporations--regardless of yearend--have been afforded a reasonable opportunity to analyze their existing compensation programs, to seek and obtain proper guidance under these rules (or any material modifications to these rules that may be made as a result of taxpayer comments), and to revise their compensation programs. Furthermore, because the announced comment period on the proposed regulations will have ended before many companies have completed their 1993 annual shareholder reports, SEC Form 10-K reports, and associated shareholder proxy statements, we recommend the IRS consider both reopening the comment period and delaying a hearing on the proposed rules until late June or early July. By postponing the hearing until after the relatively heavy "proxy-filing" and shareholder-meeting season for calendar-year publicly held corporations, the IRS will provide taxpayers an opportunity to detect latent administrative and interpretative problems within the proposed rules.(4)

3. Covered Employees

   Under Prop. Reg, [sections] 1.16227(c)(2)(i), an employee's compensation is subject to the $1 million deduction limitation if, as of the last day of the employer's taxable year, the employee is either (i) the corporation's chief executive officer (CEO) or acting CEO or (ii) is among the four highest compensated officers of the corporation other than the CEO. Under the proposed regulations, an individual is a covered employee if the individual's compensation is reported on the "summary compensation table" under the SEC's executive compensation disclosure rules as set forth in Item 402 of Regulation S-K under the Securities Exchange Act of 1934.(5)

   The application of the proposed rules to corporations whose fiscal year for shareholder and SEC reporting purposes differs from its taxable year is unclear. One practical means of administering the interaction of section 162(m) with the SEC-reporting rules is for the compensation of the officers disclosed for the SEC year that ends with or within the taxable year of the corporation to be subject to the deduction limitation and its attendant exceptions. For example, assume a corporation reports to shareholders on a calendar-year basis but files its tax returns on the basis of a June 30 yearend. Based on our suggested approach, the compensation paid to executives listed in the proxy statement for the December 31, 1994, SEC year would be subject to the limitation (and its exceptions) for the corporation's taxable year ending June 30, 1995.6 TEI recommends that the regulations provide additional guidance concerning covered employees where the SEC reporting and taxable years differ.

4. Objective Compensation

   Formula

   1. Time for Establishing

      Objective Performance Based Goal

      Prop. Reg. [sections] 1.162-27(e) sets forth rules concerning the principal exception to the $1 million limitation on deductions for corporate officer compensation, viz., the performancebased exception of section 162(m)(4)(C). Prop. Reg. [sections] 1.16227(e)(i) states that qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals? A performance goal is considered pre-established if it is established in writing by the compensation committee before the commencement of the services to which the performance goal relates and while the outcome is substantially uncertain? The preamble explains that these requirements are intended to preclude post hoc performance goals?

      Many corporations establish garden-variety incentive bonus plans depending in whole or in part upon the company's meeting or exceeding an earnings-per-share (EPS) or other financial performance target. In practice,. companies offering such incentive plans nearly...