Public corporations generally cannot deduct more than $1 million in compensation per year for covered employees (i.e., certain key executives). Certain types of compensation, most notably performance-based compensation subject to shareholder approval, are excluded from this limitation. Recent guidance provides insight on several issues, including who are covered employees, whether shareholders actually had the ability to approve performance-based compensation and whether dividends on restricted stock units were subject to the $1 million limitation.

Background

Code Section 162(m) provides that no deduction is allowed any publicly held corporation for applicable employee remuneration for any covered employee in excess of $1 million for the tax year.

 A publicly held corporation for this purpose means a corporation that has equity securities that must be registered under Section 12 of the Securities Exchange Act (the "Act"). The Act requires a corporation to register under Section 12 if its securities are listed on a national exchange or if the corporation has more than $10 million in assets and 500 or more shareholders.

Section 162(m) defines a covered employee as any employee of the taxpayer if as of the close of tax year such employee is the chief executive officer or the total compensation of the employee is required to be reported to shareholders under the Act by reason of being one of the 4 highest compensated officers for the taxable year other than the chief executive officer.

The SEC amended its disclosure requirements under the Act in 2006 to include individuals serving as the principal executive officer, the principal financial officer, and the three highest compensated executives other than the principal executive officer and the principal financial officer. In response, the IRS issued Notice 2007-49 which stated that in light of amended SEC executive compensation disclosure rules, it would interpret "covered employee" under Section 162(m) to mean any employee of the taxpayer if at the close of the year, the employee is the principal executive officer or if the compensation of the employee is required to be reported under the Act because the employee is among the three highest compensated officers for the year other the principal executive officer or principal financial officer. Under the notice, the term covered employee does not include those individuals for whom disclosure is required as a result of being the taxpayer's principal financial officer.

Generally all compensation paid to a covered employee during the year is includable in determining the $1 million limit unless the compensation falls under one the following exceptions:

• Commission payments
• Performance-based compensation
• Compensation under a binding contract in effect on February 17, 1993
• A payment to an employee under a qualified retirement plan
• An employee benefit that can be excluded from income

In order to qualify for the performance-based compensation exception, the compensation must meet several requirements, including approval by vote of the shareholders.

Recent Developments

In Private Letter Ruling 201321017, the IRS clarified that for purposes of the limitation under Code Section 162(m), principal financial officers are not covered employees under Notice 2007-49 and that the determination of who is a covered employee is made at the end of the year.

In the ruling, the taxpayer, a publicly held corporation, had one employee serving as principal financial officer for part of the year and a second individual serving as principal financial officer for the rest of the year. The Service ruled that as principal financial officers, both employees' compensation had to be disclosed to shareholders under the Act; however, they were not covered employees for purposes of the 162(m) deduction limit.

The Service also ruled that although a third employee was one of the taxpayer's three highest compensated executive officers (other than the principal executive officer or the principal financial officer), he was not a covered employee because he was not serving as an executive officer at the end of the year.

In another recent development, a district court has ruled that language contained in a public corporation's proxy statement did not deprive its shareholders of a real choice as to whether to approve performance based compensation.

Qualcomm, a public corporation, had a performance-based compensation plan put in place in 2006. In 2011 when it wished to amend the plan, Qualcomm issued a proxy statement that included the language, "Should stockholder approval not be obtained, then the proposed amendments will not be implemented, and the 2006 Long Term Incentive Plan will continue in effect pursuant to its current terms. However, the shares reserved for issuance will be depleted and the 2006 Long Term Incentive Plan will not achieve its intended objectives of helping attract and retain employees."

One of Qualcomm's shareholders sued on the basis that the proxy statement language would prevent the company from receiving tax deductions under Section 162(m). In siding with the company, the court noted that 162(m) will prevent deductions where the shareholders are not provided a real choice as to whether to accept the compensation plan. The court, however, did not find the language of the proxy statement to prevent the shareholders from making a choice. The court distinguished this case from Shaev v. Saper in which the proxy statement informed the shareholders a bonus payment would be made regardless of their vote, and they were only determining if the payment would be tax deductible. 

Finally in Revenue Ruling 2012-19, the Service provided guidance on whether or not dividends and dividend equivalents paid on restricted stock grants or restricted stock units are includable in determining if the covered employee's compensation exceeds the $1 million threshold. The Service evaluated two scenarios covering plans in which the publicly held corporations granted restricted stock and restricted stock units to participating employees that vested on attainment of objective performance goals. In both cases, dividends were paid on the stock and stock units from the time of grant through the time of vesting. In one plan, however, the dividends accumulated and only became payable to the employees when the performance goals were achieved. In the other plan, the dividends were paid to the employees regardless of whether the performance goals were achieved.

The Service ruled that only when receipt of the dividends is dependent on meeting the performance goals under the plan could they be excluded from total compensation in calculating the $1 million limit under Section 162(m).

For more information on the $1 million compensation limitation, consult your local CBIZ MHM tax professional.

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