The Wilds of Section 162(m) Are your Stock Deductions
Safe?
Connecticut/Boston NASPP
Conference
July 19, 2013
Agenda
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PwC
Introduction and application
Pitfalls and case studies
Questions
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Section 162(m)
Section 162(m) – Introduction and
Application
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Section 162(m)
• Compensation paid to covered employees over $1 million/year is not
deductible UNLESS it is "performance-based" compensation
- Covered employees are the:
◦ CEO
◦ Next 3 highest paid officers other than CEO and CFO
• To be “performance-based,” the compensation must meet
requirements in 3 separate categories:
- Pre-establishment of goals by “compensation committee”
- Shareholder approval of plan
- Certification of attainment of goals
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Performance-Based Compensation
Category #1
• Pre-established, written goal
– By “compensation committee”
– Two or more "outside" directors
– Within 90 days of start of the performance period and while
outcome is substantially uncertain
– Not less than 25% of period has elapsed
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Performance-Based Compensation
Category #1 continued
• Goal is set out as an objective compensation formula or standard
- Third party in possession of relevant facts could determine whether met
- Compensation is contingent on attainment of performance goal
◦ Salary, pension benefits, perks are not performance-based
◦ No “make up” plans or arrangements (employment or severance)
› Must ensure that payment is made only if performance goal is met
- Any adjustments are hard-wired into the formula
◦ Changes in GAAP accounting, impact of acquisitions/sales
- No upward discretion
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Stock options and SARs
Category #1 continued
• Stock options and SARs are deemed to meet the pre-established goal
requirements (Category #1)
– Must still meet: (a) other 162(m) requirements and (b) additional
requirements, such as:
o Include a cap on number of shares that may be granted during a
specific period
o Requirements recently tightened by “proposed” regulations
• Restricted Stock, RSUs or any other equity awards are not eligible for
this special rule
- But can still be performance-based under the normal rules
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Performance-Based Compensation
Category #1 continued
• Transition rules for companies that become publicly-held
- Deduction limit does not apply to arrangement “that existed” while
the company was private
- The arrangement must be disclosed in the IPO prospectus
◦ Special rule applies to Options, SARs and Restricted Stock
› Special rule does not apply to RSUs and phantom awards;
must meet normal transition rule
• This relief extends through a “Reliance Period”
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Performance-Based Compensation
Category #2
• Shareholder approval
– Material terms of the performance goal must be approved
o Eligible employees
o Description of business criteria that may be used
o Description of compensation
 Either a maximum dollar amount or a formula
– Shareholder approval required prior to payment
o Re-approval generally required every 5 years
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Performance-Based Compensation
Category #3
• Compensation Committee certification
– Certify that goals were met
– Prior to payment
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Section 162(m)
Pitfalls and Case Studies
• Plan Creation and Design
• Performance Goal Setting
• Certification of Goals
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Section 162(m) – Plan Creation and Design
Share Limits
• Authorized share caps
- Granting more shares than are authorized under the plan
◦ Some plans have complicated share counting systems
› Shares credited back
› Fungible ratios
◦ Establish a process for tracking shares granted
• Per participant/per period plan limits
◦ Are there different limits for different classes?
◦ Does plan’s cap meet new IRS standards?
◦ Establish a process for tracking shares granted
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Section 162(m) – Plan Creation and Design
Share Limits Case Study #1
Plan grants Restricted Shares, RSUs, Options and SARs.
Which of these plan provisions meet the 162(m) rules?
Example #1:
“The maximum number of Options or SARs that can be granted to
any Eligible Participant during a single calendar year cannot exceed
2,000,000”
Example #2:
“The maximum number of Shares available for grant under the Plan
is 120,000”
Example #3:
“No individual Participant may be granted in any fiscal year Awards
that are denominated or to be settled in Shares that relate to more
than 600,000 Shares”
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Section 162(m) – Plan Creation and Design
Share Limits Case Study #1
Plan grants Restricted Shares, RSUs, Options and SARs.
Which of these plan provisions meet the 162(m) rules?
Example #1: Probably good
“The maximum number of Options or SARs that can be granted to
any Eligible Participant during a single calendar year cannot exceed
2,000,000”
Example #2: Probably bad
“The maximum number of Shares available for grant under the Plan
is 120,000”
Example #3: Might pass muster
“No individual Participant may be granted in any fiscal year Awards
that are denominated or to be settled in Shares that relate to more
than 600,000 Shares”
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Section 162(m) – Plan Creation and Design
Share Limits Case Study #2
Plan permits grants of up to 1,000,000 shares in any 36 month
period. Company makes the following grants to the CEO:
2012 – 500,000 options
2013 – 1,000,000 restricted shares
Are any of these grants non-performance-based? Which ones?
• Issues
- Will exchange listing requirements permit awards to be granted
outside a shareholder approved plan?
- Does the executive have a claim over any disregarded awards?
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Section 162(m) – Plan Creation and Design Pitfalls
Share Limits Case Study #2
Plan permits grants of up to 1,000,000 shares in any 36 month
period. Company makes the following grants to the CEO:
2012 – 500,000 options
2013 – 1,000,000 restricted shares
• Approaches
- Treat the excess 500,000 in the 2013 grant as non-deductible Is
there support for an out-of-plan grant?
- Treat the entire 2013 grant as non-deductible Most
conservative
- Treat some or all of the 2013 as a void transaction (i.e., no grant)
Will the executives accept this approach?
- Grant outside of the plan, contingent on shareholder approval
Also a conservative approach
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Section 162(m) – Plan Creation and Design
Compensation Committee - Case Study #3
One member of the Compensation Committee was the interim CEO
five years ago. He had been a member of the Board of Directors and
agreed to act as CEO during a three month gap before “real” CEO
was hired. He remained a board member during and following this
interim position. He was not paid for his CEO services. No major
decisions were made during this short period.
Is the Compensation Committee composed “solely” of 2 or more
outside directors?
• Issues:
- What if he is considered “outside” for SEC and NYSE purposes?
- If there are more than 3 people on the Compensation Committee,
can his vote be disregarded?
- Can any tainted grants be cured by ratifying them with a “clean”
committee vote?
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Section 162(m) – Plan Creation and Design
Compensation Committee - Case Study #3
One member of the Compensation Committee was the interim CEO
five years ago. He had been a member of the Board of Directors and
agreed to act as CEO during a three month gap before “real” CEO
was hired. He remained a board member during and following this
interim position. He was not paid for his CEO services. No major
decisions were made in this short period.
Is the Compensation Committee composed “solely” of 2 or more
outside directors?
- Could be viewed as “inside” if he had full authority to
act as the CEO, and if he served for an indefinite period
of time, not just for a special and single transaction.
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Section 162(m) – Performance Goal Setting
Documentation
• Confirm the Compensation Committee’s documentation is clear
- A specific recitation of the goals and compensation amounts
- Avoid a simple cut and paste of consultant’s power point slide
◦ Adjustments may be made at the meeting
◦ Slide may not have sufficient specificity, may include “bad”
words
- Avoid any discretionary language
◦ “The Committee may exclude the impact of an event or
occurrence which the Committee determines should
appropriately be excluded”
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Section 162(m) – Performance Goal Setting
Documentation
• Confirm that the metrics used by the Compensation Committee are
appropriate
- Do the metrics named in the Committee’s minutes match the list in
the plan (approved by shareholders) and the description in the
proxy?
◦ Plan lists “earnings per share calculated in accordance with US
GAAP” and Compensation Committee minutes read “earnings
per share”
◦ “The performance goals that may be used for a performance
award may include . . .”
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Section 162(m) – Performance Goal Setting
Employment Agreements
• Does an employment or severance agreement impact the 162(m) plan?
- Look for provisions that would pay a bonus upon a termination of
employment
◦ “Will receive an amount equal to the prior year’s bonus”
◦ “Will receive the current year’s bonus based on the company’s
actual performance”
◦ “Will receive an amount equal to the executive’s target bonus for the
year”
• Does an employment agreement provide rights not otherwise provided
under the plan?
◦ “Executive shall be entitled to a hire grant of 500,000 RSUs and
shall receive dividend equivalents at the same time and in the same
manner as shareholders holding an equal number of shares”
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Section 162(m) –Performance Goal Setting
Private – Public Transition Relief
• Did the arrangement “exist” as of the IPO date?
- IRS is discrediting plans that are “effective upon” the IPO
• When does the reliance period end?
- Track share/compensation limits
- Beware of “material modifications”
- Earlier termination of the plan, under its terms
◦ Employment agreement with a 3-year term and automatic
renewal provision
• RSU and Phantom stock awards
- Can these be converted to Options or Restricted Stock
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Section 162(m) – Performance Goal Setting
Umbrella Plan - Case Study #1
Plan provides for two tiers of performance goals
Tier One – Bonus pool will be created each year equal to 5% of
operating earnings. Each executive is assigned a share of the pool,
totaling no more than 100% of the total pool
Tier Two – Each executive has a secondary set of performance goals
and bonus targets, some discretionary.
Does this arrangement work?
• Issues:
- Is the target substantially uncertain?
- Is the potential pool amount so large compared to actual grants
that the lower (actual) amount is substantially certain?
- Does disclosure of the very large potential amount that could be
earned create a shareholder optics issue / say on pay concern?
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Section 162(m) – Performance Goal Setting
Umbrella Plan - Case Study #1
Plan provides for two tiers of performance goals
Tier One – Bonus pool will be created each year equal to 5% of
operating earnings. Each executive is assigned a share of the pool,
totaling no more than 100% of the total pool
Tier Two – Each executive has a secondary set of performance goals
and bonus targets, some discretionary.
Does this arrangement work?
A bonus pool approach is approved in the IRS regulations
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Section 162(m) – Performance Goal Setting
Adjustments - Case Study #2
Annual performance goal requires company to achieve 10% growth
in net profits over prior year. Mid-year, the company spun off a
large division. The loss of that division’s sales artificially impact the
net profits results, but the long-term prospects of the sale are
excellent.
If the spin-off was backed out of the numbers, the company would
more than achieve its performance goals for the year, but if the spinoff is included, the payout is reduced to 30% of target. Can the
metric be adjusted to back-out the impact of the sale.
• Issues:
- Did the minutes that set the goal address the impact of interim events?
- Would the entire payout be tainted or just the 70% over the unadjusted
results?
- Can the Compensation Committee pay a separate bonus to “make up” the
lost bonus opportunity?
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Section 162(m) – Performance Goal Setting
Adjustments - Case Study #2
Annual performance goal requires company to achieve 10% growth
in net profits over prior year. Mid-year, the company spun off a
large division. The loss of that division’s sales artificially impact the
net profits results, but the long-term prospects of the sale are
excellent.
If the spin-off was backed-out of the numbers, the company would
more than achieve its performance goals for the year, but if the spinoff is included, the payout is reduced to 30% of target. Can the
metric be adjusted to back-out the impact of the sale.
- Would the entire payout be tainted or just the 70% over the unadjusted
results? May depend on how goals were defined
- Can the Compensation Committee pay a separate bonus to “make up” the
lost bonus opportunity? Risky
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Section 162(m) – Certification of Goals
Acceleration of Payment
• Confirm that the Compensation Committee is scheduled to confirm
the goals PRIOR to the payment of the amount
- Monitor the different deadlines carefully
◦ Section 461 and 409A – March 15
• In 2012, many companies looked to accelerate payments to beat 2013
tax rate increases
- Could the Committee actually certify the goals were met prior to
2013?
◦ Exceed prior year sales by 10%
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Section 162(m) – Certification of Goals
Legal Claims
Plaintiffs’ lawyers are suing under 162(m):
• Confirm the deduction taken is actually valid
• Confirm wording of proxy statement
- Does proxy guarantee awards will be deductible
- Does the 162(m) boilerplate match the rest of the proxy, and the
Committee’s/Board’s intent?
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Section 162(m) – 162(m) Compliance Review
• Perform a 162(m) compliance check
- Have your plans stayed up to date with developments?
- Are your administrative practices in strong order?
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Questions?
AmyLynn Flood
Sharmon Priaulx
(267) 330-6274
(617) 530-5279
amy.lynn.flood@us.pwc.com
sharmon.priaulx@us.pwc.com
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