It’s no April Fool’s joke—on March 31, the IRS and Treasury issued final regulations under Section 162(m). The final regs are largely the same as the proposed regs that were issued back in 2011 (don’t believe me—check out the redline I created); so much so that I considered just copying my blog entry on the proposed regs and changing the word “proposed” to “final” throughout.  But I’m not the sort of person that takes short-cuts like that, so I’ve written a whole new blog for you.

For more information on the final regs, check on the NASPP alert, which includes several law-firm memos.

The IRS Says “We Told You So”

The final regulations implement the clarification in the proposed regs that, for options and SARs to be exempt from the deduction limit under Section 162(m), the plan must specify a limit on the maximum number of shares that can be granted to an individual employee over a specified time period.  It is not sufficient for the plan to merely limit the aggregate number of shares that can be granted, even though this creates a de facto per-person limit; the plan must separately state a per person limit (although the separately stated per-person limit could be equal to the aggregate number of shares that can be issued under the plan). One small change in the final regs was to clarify that the limit doesn’t have to be specific to options/SARs; a limit on all types of awards to individual employees is sufficient.

When the proposed regs came out, I was surprised that the IRS felt the need to issue regs clarifying this.  This had always been my understanding of Section 162(m) and, as far as I know, the understanding of most, if not all, tax practitioners.  In his sessions over the years at the NASPP Conference, IRS representative Stephen Tackney has said that everyone always agrees on the rules until some company gets dinged on audit for not complying with them—then all of a sudden the rules aren’t so clear. I expect that a situation like this drove the need for the clarification.

In the preamble to the final regs, the IRS is very clear that this is merely a “clarification” and that companies should have been doing this all along, even going so far as to quote from the preamble to the 1993 regs.  Given that the IRS feels like this was clear all the way back in 1993, the effective date for this portion of the final regs is retroactive to June 24, 2011, when the proposed regs were issued (and I guess maybe we are lucky they didn’t make it effective as of 1993). Hopefully, you took the proposed regs to heart and made sure all your option/SAR plans include a per-person limit.  If you didn’t, it looks like any options/SARs you’ve granted since then may not be fully deductible under Section 162(m).

Why Doesn’t the IRS Like RSUs?

Newly public companies enjoy the benefit of a transitional period before they have to fully comply with Section 162(m). The definition of this period is one of the most ridiculously complex things I’ve ever read and it’s not the point of the new regs, so I’m not going to try to explain it here. Suffice it to say that it works out to be more or less three years for most companies.

During the transitional period, awards granted under plans that were implemented prior to the IPO are not subject to the deduction limit. Even better, the deduction limit doesn’t apply to options, SARs, and restricted stock granted under those plans during this period, even if the awards are settled after the period has elapsed. It’s essentially a free pass for options, SARs, and restricted stock granted during the transition period. The proposed regs and the final regs clarify that this free pass doesn’t apply to RSUs. For RSUs to be exempt from the deduction limit, they must be settled during the transition period.  This provides a fairly strong incentive for newly public companies to grant restricted stock, rather than RSUs, to executives that are likely to be covered by Section 162(m).

I am surprised by this.  I thought that some very reasonable arguments had been made for treating RSUs the same as options, SARs, and restricted stock and that the IRS might be willing to reverse the position taken in the proposed regs. (In fact, private letter rulings had sometimes taken the reverse position). I think the IRS felt that because RSUs are essentially a form of non-qualified deferred comp, providing a broad exemption for them might lead to abuse and practices that are beyond the intent of the exemption.

This portion of the regs is effective for RSUs granted after April 1, 2015.

– Barbara