In accordance with its 2010-2011 Priority Guidance Plan, the Internal Revenue Service published in the June 24, 2011 Federal Register proposed regulations (the “Proposed Regulations”) covering certain aspects of Internal Revenue Code Section 162(m).

Brief Overview of Section 162(m) and Certain Exemptions from Section 162(m)

Section 162(m) limits the tax deduction that a publicly held corporation may take with respect to annual compensation paid to its chief executive officer and the three other most highly compensated executive officers, other than the chief financial officer, (such four officers are collectively referred to as the “Covered Employees”). In particular, if a Covered Employee’s fiscal year annual compensation (excluding “qualified performance-based” compensation) exceeds $1 million, then the employer may not take an income tax deduction with respect to any such compensation amounts that exceed $1 million.

However, the Section 162(m) regulations provide certain exemptions from this annual $1 million deduction limit. “Qualified performance-based” compensation paid pursuant to a stockholder-approved compensation plan that sets forth certain maximum payment limits can be excluded from counting towards the $1 million limit. In addition, under Treas. Reg. section 1.162-27(f), there is a transitional relief period during which Section 162(m) does not apply to certain compensation paid by a “new” publicly held corporation. For example, with respect to companies that become publicly held as a result of an initial public offering, compensation that is paid from a compensation plan that was in existence before the corporation’s IPO (and which was adequately described in the IPO’s prospectus) can be exempt from Section 162(m) for a specified time period after the IPO (the “Transitional Relief Period”). This Transitional Relief Period can potentially extend until the corporation’s annual meeting to elect directors in the fourth year after the calendar year of the corporation’s IPO. This relief is amplified with respect to stock-based compensation since stock options, stock appreciation rights and restricted stock grants which are granted during the Transitional Relief Period are exempt from Section 162(m) even if their exercise or vesting occurs after the expiration of the Transitional Relief Period. This can be particularly valuable because, for example, a typical ten year term stock option may not be exercised until several years after the expiration of the Transitional Relief Period and may possess considerable built-in gain at the time of exercise. The Transitional Relief Period also effectively means that new public corporations do not have to immediately post-IPO put their employee stock plans up to a vote of its public stockholders solely for Section 162(m) purposes in order to qualify for the performance-based exemption.

However, the current Section 162(m) regulations do not expressly recite whether or not the transitional relief provisions fully apply to restricted stock unit or phantom stock unit grants (“RSUs”). This uncertainty caused practitioners to query the IRS on this point. In 2004, the IRS issued two favorable private letter rulings (i.e., PLR 200406026 and PLR 200449012) that essentially provided that RSUs granted during the Transitional Relief Period would be exempt from Section 162(m) even if their settlement date (i.e., the date that compensation was actually paid to the Covered Employee) occurred after the expiration of the Transitional Relief Period. While a PLR is technically only applicable to the taxpayer receiving the PLR, the guidance provided in these 2004 PLRs gave comfort to practitioners that RSUs would be accorded the same transitional relief treatment as the other forms of equity compensation. This has been especially beneficial given the increasing use of omnibus stock plans and the granting of RSUs to public company executives.

Summary of Proposed Regulations

In a surprising reversal of the IRS’ position espoused in the 2004 PLRs, the Proposed Regulations state that RSU compensation paid after the end of the Transitional Relief Period to Covered Employees will not be exempt from Section 162(m) under the transitional relief provisions. In order to be exempt from Section 162(m) under the transitional relief provisions, an RSU must be settled and paid before the end of the Transitional Relief Period. Since RSUs typically will contain vesting durations of several years (with actual settlement possibly extending even further out), this could produce a harsh result for corporations which have outstanding RSUs that would be affected by this tax position. Such companies may be reluctant to accelerate payment of an RSU so that it is paid during the Transitional Relief Period in order to be tax deductible particularly since the typical purpose of an RSU is to foster retention and long-term alignment with stockholders. And, in some cases, acceleration of an RSU’s payment could be a violation of Internal Revenue Code Section 409A.

The Proposed Regulations also attempt to clarify two other requirements related to qualified performance-based compensation. First, the Proposed Regulations reiterate that a stock plan seeking to qualify for the performance-based compensation exemption must expressly enumerate a maximum limit on the stock options or other stock rights that can be granted to any employee during a specified period of time. In other words, grants issued under a stock plan that merely recites a maximum aggregate grant limit, without expressing a per employee grant limit over a specified time period, will not be able to qualify for the Section 162(m) qualified performance-based exemption.

Secondly, the Proposed Regulations state that the disclosure requirement connected to stockholder approval of the stock plan’s maximum grant limits will be satisfied if the disclosure to stockholders includes (i) the maximum number of shares for which grants can be made to each individual employee during a specified period and (ii) the exercise price of stock options that would be granted under the stock plan.

Effectiveness of Regulations and Next Steps

The Proposed Regulations state that the regulations will be applicable with respect to all tax years ending on or after the date of publication of the Treasury decision adopting the final regulations. If the regulations are implemented as is, then it means that there would be no “grandfathering” for outstanding RSUs and stock plans without the requisite per employee grant limits.

Before final regulations can be adopted, there will be a public comment period on the Proposed Regulations. To be considered, comments must be provided to the IRS by September 22, 2011.

Therefore, companies may wish to consider providing the IRS with comments on the Proposed Regulations. In addition, companies may wish to review their: stock plans, proxy statement disclosures for proposals requesting stockholder approval of a stock-based compensation plan, and affected outstanding RSUs (or planned RSU grants) to determine if they would each comply with the applicable provisions of the Proposed Regulations if and when such Proposed Regulations become final.

If you have any questions regarding this information, please contact Greg Schick at (415) 774-2988.

Disclaimer

This update has been prepared by Sheppard, Mullin, Richter & Hampton LLP for informational purposes only and does not constitute advertising, a solicitation, or legal advice, is not promised or guaranteed to be correct or complete and may or may not reflect the most current legal developments. Sheppard, Mullin, Richter & Hampton LLP expressly disclaims all liability in respect to actions taken or not taken based on the contents of this update.