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.
The Chairman of the House Ways and Means Committee has released a discussion draft of proposed legislation that could dramatically change the tax treatment of stock compensation as we know it. Here is a summary of the proposals.
No More Deferrals of Compensation
The good news is that Section 409A would be eliminated; I still don’t fully understand that section of the tax code and maybe if I just wait things out a bit, I won’t have to. But the bad news is that it would no longer be permissible to defer taxation of stock compensation beyond vesting. Instead, all awards would be taxed when transferable or no longer subject to a substantial risk of forfeiture.
This would eliminate all elective deferral programs for RSUs and PSUs. The NASPP has data showing that those programs aren’t very common, so you probably don’t care so much about that. On the other hand, according to our data, about 50% of you are going to be very concerned about what this will do to your awards that provide for accelerated or continued vesting upon retirement. In addition to FICA, these awards would be subject to federal income tax when the award holder is eligible to retire. Say goodbye to your good friends the rule of administrative convenience and the lag method (and the FICA short-term deferral rule)–those rules are only available when the award hasn’t yet been subject to income tax. This could make acceleration/continuation of vesting for retirees something we all just fondly remember.
As drafted, this proposal would also apply to stock options, so that they too would be subject to tax upon vest (the draft doesn’t say anything about repealing Section 422, so I assume that ISOs would escape unscathed). But one practitioner who knows about these things expressed confidence that there would be some sort of exception carved out for stock options. I have to agree–I don’t have data to support this, but I strongly suspect that the US government gets a lot more tax revenue by taxing options when they are exercised, rather than at vest (and that someone is going to figure this out before the whole thing becomes law).
Section 162(m) Also Targeted
The proposal also calls for the elimination of the exception for performance-based compensation under Section 162(m). This means that both stock options and performance awards would no longer be exempt from the deduction limitation. At first you might think this is a relief because now you won’t have to understand Section 162(m) either. I hate to rain on your parade, but this is going to make the tax accounting and diluted EPS calculations significantly more complex for options and performance awards granted to the execs subject to this limitation.
And that’s a bummer, because the proposal says that once someone becomes subject to the 162(m) limitation, they will remain subject to it for the duration of their employment. Eventually, you could have significantly more than five execs that are subject to 162(m). That’s right–five execs. The proposal would make the CFO once again subject to 162(m), a change that’s probably long overdue.
And There’s More
The proposal would also change ordinary income tax rates, change how capital gains and dividends are taxed, and eliminate the dreaded AMT (making the CEP exam just a little bit easier). And those are just the changes that would impact stock compensation directly. There is a long list of other changes that will impact how you, your employees, and your employer are taxed. This memo by PwC has a great summary of the entire discussion draft. In addition, we are in the process of recording a podcast with Bill Dunn of PwC on the draft–look for it soon in the NASPP podcasts available on iTunes.
When Does This All Happen?
That’s a very good question. This proposal has a long ways to go on a road that is likely to be riddled with compromise. As far as I can tell, it hasn’t even been introduced yet as a bill in the House. It has to be passed by both the House and the Senate and then signed into law by the President. So I wouldn’t throw out those articles you’ve saved on Sections 409A and 162(m) and the AMT just yet. It’s hard to say what, if anything, will come of this.
Today I have a grab bag of short topics for you, each worth mentioning but none are really long enough for their own blog.
The Most Ridiculous Section 162(m) Lawsuit Ever Last year, a Delaware federal court ruled in favor of a company that was the subject of lawsuit alleging that their incentive plan had not been properly approved by shareholders for Section 162(m) purposes. The plaintiff argued that because Section 162(m) requires the plan to be approved by the company’s shareholders, all shareholders–even those holding non-voting shares–should have been allowed to vote on it. Shareholder votes are governed by state law but the plaintiff attorney argued that the tax code preempted state law on this matter. Luckily the judge did not agree.
The plaintiff also argued that the company’s board violated their fiduciary duties because they used discretion to reduce the payments made pursuant to awards allowed under the plan. The plaintiff stipulated that this violates the Section 162(m) requirement that payments be based solely on objective factors. In a suit like this, the plaintiff attorney represents a shareholder of the company; it seems surprising that a shareholder would be upset about award payments being reduced–go figure. In any event, it’s fairly well established that negative discretion is permissible under Section 162(m) and the judge dismissed this claim.
Glass Lewis Policy Update Glass Lewis has posted their updated policy for 2014. For US companies, the policy was updated to discuss hedging by execs (spoiler alert: Glass Lewis doesn’t like it) and pledging (they could go either way on this). With respect to pledging, Glass Lewis identifies 12–count ’em, that’s 12–different factors they will consider when evaluating pledging by execs.
The policy was also updated to discuss the SEC’s new rules related to director independence and how the new rules impact Glass Lewis’s analysis in this area. Although we now have three perfectly good standards for director independence (Section 16, Section 162(m), and the NYSE/NASDAQ listing standards), Glass Lewis has developed their own standards and they’re sticking to ’em. I’m sure I’ve asked this before, but really, how many different standards for independence do we need? I’m not sure director independence is the problem here.
Should Your Plan Limit Awards to Directors? As you are getting this year’s stock plan proposal ready for a shareholder vote, one thing to consider is whether to include a limit on awards to directors. In 2012, a court refused to dismiss one of the plaintiff’s claims in Seinfeld v. Slager because the plan did not place sufficient limits on the grants directors could make to themselves and, thus, were not disinterested in administration of the plan, at least with respect to their own grants.
In today’s blog I’m going to deviate a bit from our normal format and invite you to take a little quiz. Don’t worry, nobody’s keeping score except for you, so this is just for fun. Why a quiz, you ask? Have you ever wondered where to find something in the massive IRS Tax Code? Many of us have memorized the names and basics about various tax code sections that apply to stock compensation (e.g. Sections 421, 422, 423, 424, 83, 162 and so on). Or, you’ve heard of some pending regulations, but aren’t really sure whether there’s a pending regulation that covers your area of interest? I personally found it fairly straightforward to memorize the basics about all the major tax code sections, but what I find more challenging is keeping on top of all the subsequent revenue rulings and other guidance that emerges from the IRS. If you’re having the same challenge, you’ll want to be sure to visit our new Tax Code portal. It’s simple and concise – there’s a list and description of the various tax code sections, as well as related rulings and other interpretive guidance that apply to stock compensation. Call it a tax code crib sheet, if you may. Wait! Before you check it out, pause for a moment, in that spirit, to take the Tax Code Challenge!
Tax Code Challenge:
1. Where would you find information about the procedures to revoke an 83(b) election?
a. In Code Section 83(b)(2)
b. The IRS had not provided guidance on any specific procedures
c. Section 83 of the Code is clear that an 83(b) election may never be revoked for any reason
d. In Revenue Proc. 2006-31, which became effective June 13, 2006
2. Which revenue ruling provides guidance on the treatment of dividends and dividend equivalents on restricted stock and restricted stock units for 162(m) purposes?
a. There is no revenue ruling that covers dividends/dividend equivalents
b. Revenue Rul. 2012-19
c. Revenue Rul. 98-34
d. There is no revenue ruling, but there are proposed regulations pending on this topic
3. Which of the following reflect pending regulations?
a. Rules relating to the additional medicare tax
b. Rules related to valuing employee stock options that have been gifted for estate planning purposes
c. Rules regarding new information disclosures for Section 6039 related information returns
d. There are no pending revenue rulings that would affect stock compensation
The answers are listed below. If you knew all of the answers – great! You’re a tax guru. For the rest of us that may have been stumped by one or more questions, a visit to the Tax Code portal may help gain clarity in this area.