Public Companies May Need to Amend Stock Option Plans Soon to Qualify for Exception to $1 Million Compensation Deduction Limit

Publicly traded companies may need to act quickly to review,
and, if necessary, amend their stock option and stock appreciation right
(“SAR”) plans in order to preserve tax deductions for compensation in
excess of $1 million paid to certain executives. The reason for this
review is that the Internal Revenue Service (the “IRS”) and the United
States Treasury Department recently issued proposed regulations that
clarify a few items with respect to the application of Section 162(m) of
the Internal Revenue Code (the “Code”) to such plans. One item relates
to requirements that stock options and SARs must meet to qualify as
performance-based compensation. Another item relates to a transition
rule for companies that initially are privately held but that later
become publicly traded companies.

As background, Code Section 162(m) limits
the deduction a publicly traded company may take with respect to
remuneration paid to its “covered employees”– its CEO and three most
highly paid officers (other than the CEO and CFO) — to the extent that
such compensation exceeds $1 million. The deduction limit does not
apply, however, to qualified performance-based compensation. Publicly
traded companies often structure their stock options and SARs in a
manner to qualify as performance-based compensation.

The proposed regulations clarify that in order for stock options and
SARs to qualify as performance-based compensation, the plan under which
such awards are granted must specify the maximum number of shares
relating to those awards that may be granted to any individual employee
during a specified period. Previously, some commentators had argued that
stating an aggregate share limit for all awards granted under the plan
should satisfy the performance-based compensation exception
requirements. The preamble to the proposed regulations, however, states
that this aggregate approach is inconsistent with the purpose of Code
Section 162(m), and that an individual employee limit is necessary to
assist a third party in determining the maximum amount of compensation
that could be payable to any individual employee during a specified
period. Additionally, the proposed regulations require that publicly
traded companies disclose to their shareholders these individual
employee share limits in order for the options and SARs to qualify as
performance-based compensation.

Finally, the proposed regulations clarify that an existing limited
transition period will not apply to grants of restricted stock units
(“RSUs”) or phantom stock by a company that, at the time the grants are
made, is not a publicly traded company in the event that the company
later becomes a publicly traded company when the grants still are
outstanding. This position is a reversal of a position taken by the IRS
in previously issued private letter rulings. The transition period rule
generally provides that compensation related to the exercise of stock
options or SARs, or the substantial vesting of more...