Back in July, I blogged about Barnes & Noble’s grant to their CEO that was in excess of the per-person limit in their plan (“What’s Your Limit?,” July 31, 2012). I thought that was an isolated incident, but now another company has done the same thing, three years in a row! If one more company does it, I think we’ll have to call it a “trend.”
Devry Makes Repeated Grants in Excess of Plan Limit A recent lawsuit against Devry alleges that the company granted options to its CEO in excess of the per-person limit included in its stock plan for Section 162(m) purposes for three years in a row. The total number of excess shares granted to the CEO is almost 160,000 (34,100 shares in excess of the limit in 2010; 20,200 in 2011; and 105,425 in 2012).
Devry has several stock plans and it’s a little hard to tell which plan the options were granted out of. Ultimately, though, it doesn’t matter because, with the exception of their 1994 plan, which, according to their June 30 2012 Form 10-K, is no longer in use, all of the plans limit the number of option shares that can be granted to an individual to 150,000 per year.
Unlike Barnes & Noble’s limit, which was over a three-year period, this is a nice, clean annual limit, so it seems a little surprising that no one at Devry noticed the error. Even more surprising that they managed to make the same error three years in a row.
According to their 10-K, Devry currently has two plans that they grant options out of (a 2003 plan and a 2005 plan). As far as I can tell, based on the Form 4 reporting the grants, the options granted to the CEO were granted out of just one plan (although I can’t ascertain this for certain). I believe that the limit applies only to options granted under the plan in which it is stated. Thus, if a portion (no more than 150,000 shares worth) of each year’s options were granted under one plan with the remaining portion granted under the other plan, it seems to be that neither plan limit would have been exceeded and there’d be no problem under Section 162(m).
Don’t Be My Next Blog Entry!
This is such an easy mistake for shareholders and the IRS to find. The per-person limit is clearly stated in your plan, which is filed with the SEC–there’s list of exhibits in your 10-K telling readers which filing it is included in. And all of your executives’ grants are reported on Form 4 filings. At “The IRS Speaks” panel at this year’s NASPP Conference, Deb Walker of Deloitte pointed out that Section 162(m) is one of the first areas IRS auditors target, because it is an area where there are a lot of compliance failures that are relatively easy to uncover. Make sure your company doesn’t make this mistake; compare all grants to your executives against the per-person limit in your plan. Do this every time an executive is granted an option.
The last couple of weeks have been fun but it’s time to get back to serious stuff. Last week, my Google alert for stock options exploded with articles on Barnes & Noble’s snafu relating to an option granted to their CEO. One day’s alert had three articles on this topic, with more articles in subsequent alerts. For today’s blog entry, I offer my take on the blunder.
Oops–Can We Have That Grant Back? Back in early December 2011, Barnes & Noble’s compensation committee decided to grant the CEO an option to purchase 1,000,000 shares. Unfortunately, no one noticed that a grant of this size exceeded the plan’s limitation on the number of shares that can be granted to an individual. The error wasn’t discovered until somewhere around six months later (the amended Form 4 correcting the original report of the grant was filed on June 28, so I’d guess they discovered the error towards the end of June).
Barnes & Noble really had no choice but to rescind the portion of the grant that exceeded the limitation (500,000 shares), as if it had never been granted. The grant wasn’t valid under the terms of the plan and, as an NYSE-traded company, Barnes & Noble can’t make grants outside of its shareholder approved plans (unless the grants themselves are approved by shareholders). They are now asking shareholders to approve an amendment to the plan that will increase the individual limit; if passed, another option to purchase 500,000 shares will be granted to the CEO at the then-current FMV.
What the Heck?
This individual limit is required for options granted under the plan to be considered performance-based compensation under Section 162(m). If your company is public, you probably have a limit like this stated in your plan. If you don’t know what it is, now would be a good time to dig out your plan and look it up. 10 pts to anyone who already knows what the limit in their plan is without peeking. You might also want to verify whether the limit is adjusted for stock splits.
Last year, the IRS issued proposed regs to clarify that just stating a maximum number of shares available for grant under the plan isn’t sufficient to satisfy this requirement (even though this does effectively limit how many shares can be granted to an individual). The plan must have a separately stated individual limit (see the NASPP alert, “Proposed Regulations Under Section 162(m),” July 2011).
Shouldn’t Someone Have Noticed?
It seems like this error should have been caught sooner. Ideally, stock plan administration would be informed of any grant recommendations to be submitted to the compensation committee for approval in advance, so that they can review the grants to for problems like this (and also so they can get a head start on the Form 4 filing, if they are responsible for it).
I understand that this doesn’t always happen–sometimes stock plan administration is the last to know about new grants to executives. But they should be informed of the grants shortly after approval, so that the grants can be entered into the administrative system and properly accounted for. Part of this process should include reviewing all grants to ensure that the plan limit isn’t exceeded. Remember that this isn’t an individual grant limit; it’s a limit on the cumulative number of shares that can be granted to an individual over a period of time. Even a relatively modest grant could be the fabled straw that breaks the camel’s back, if an individual has previously received an excessive number of grants or excessively large grants. Having an appropriate control procedure in place here can allow stock plan administration to raise the red flag before the grants are publicly reported and a media circus ensues.
Don’t Do That
Diligent readers of my blog already know my opinion of mega grants like this (see “And Another Thing,” May 5, 2009). Running afoul of the individual grant limit in your plan is just one other reason to avoid them.
On June 21, 2012, the IRS issued Rev. Rul. 2012-19 to clarify the treatment of dividends paid on awards that satisfy the requirements to be considered performance-based compensation under Section 162(m). For today’s blog entry, I summarize this ruling.
Background on Section 162(m) (That You Probably Already Know But I Feel Compelled to Include Anyway, Just in Case)
Section 162(m) limits the tax deduction companies can claim for compensation paid to specified executive officers to $1 million per year. Performance-based compensation, as defined under the code and associated regulations, is exempt from this limitation. There are numerous conditions that must be met for awards to be considered performance-based, including that the awards must be payable only upon achievement of performance targets and cannot be paid out prior to certification (by the compensation committee) that the targets have been satisfied.
Treatment of Dividends Under Section 162(m)
Under the ruling, the dividends (and dividend equivalents) are viewed as separate awards–thus, they don’t taint the status of the underlying awards even if they will be paid to award holders before the performance conditions have been met (or will be paid even if the conditions aren’t met). But the dividends or equivalents themselves are considered performance-based compensation only if they also meet the requirements for this treatment under Section 162(m)–i.e., if they will be paid only upon attainment of performance targets and meet the other requirements specified under Section 162(m).
The easiest way to ensure that the dividends/equivalents will be considered performance-based under Section 162(m) is to pay them out only when the underlying award is paid out. If the award is forfeited, the dividends/equivalents accrued on it are forfeited as well. This is also a best practice for accounting purposes and from a shareholder-optics standpoint (ISS specifically identifies paying dividends on unvested performance awards as a “problematic pay practice”–see my December 15, 2010 blog entry, “ISS Policy Updates“).
Interestingly–in a grotesque-but-can’t-look-away sense–the ruling says that the dividends/equivalents don’t have to be subject to the same performance criteria as the underlying award–you could have one set of goals for the award and different goals for the dividends. That seems like a disaster just waiting to happen–a mess from both an administrative and participant education standpoint (as if your executives really need another set of goals to focus on, in addition to the award goals and the cash bonus plan goals). But now that the IRS has suggested it, I fear there is a compensation consultant already trying to design a plan that incorporates this feature. Just say “No!”
No Deduction for Dividends Paid on a Current Basis
Where the dividends will be paid out prior to satisfaction of the performance conditions–i.e., where they are paid to award holders at the same time they are paid to shareholders–the dividends are not considered performance-based compensation and are subject to the limit on the company’s tax deduction under Section 162(m).
This is just one more nail in the coffin for paying out dividends on a current basis. Even if the dividend payments aren’t that significant, I imagine trying to separate them from the original award for purposes of computing the company’s tax deduction will be a challenge. I have a headache just thinking about it.
No Surprises
My sense, from reading Mike Melbinger’s blog on CompensationStandards.com (“Code Sec. 162(m), RSUs, Dividends and Dividend Equivalents,” July 2, 2012) and the Skadden memo we posted on this, is that this is pretty much what everyone was doing anyway. It certainly seemed like common sense to me–if there is such a thing when it comes to the tax code. So, just like last month’s “Section 83 Update” (June 12, 2012), I’m a little surprised that the IRS doesn’t have anything more important to worry about. I’m sure this will be discussed at the IRS and Treasury Speak panel at the NASPP Conference–it will be interesting to hear why the IRS felt the need to issue this ruling.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so we keep an ongoing “to do” list for you here in our blog.
Don’t miss the Silicon Valley chapter all-day conference this Wednesday, July 11. Robyn Shutak and I will be presenting on life events and equity compensation, with Liz Stoudt of Radford–we hope to see you there!
Chapter meetings are also being held in Chicago, Los Angeles, NY/NJ, and Philadelphia. I’ll be speaking at the NY/NJ and Philadelphia meetings–be sure to stop by and say hello!
This week, we feature another installment in our series of guest blog entries by NASPP Conference speakers. Today’s entry is written by Ellie Kehmeier of Steele Consulting, who will lead a session on Section 162(m) at the NASPP Conference.
If any code section warrants the old adage “the devil is in the details,” it’s got to be Section 162(m), which disallows corporate tax deductions for compensation paid to top executives in excess of $1 million. Complying with the requirements of this section can be devilishly tricky, especially when it comes to trying to preserve tax deductions for equity awards by meeting the exception for performance-based compensation.
My fellow panelists, Danielle Benderly of Perkins Coie and Art Meyers of Choate Hall & Stewart, and I have presented on 162(m) before. We realize that, while it’s an incredibly important topic, it can also be an incredibly dry topic. For our session in New Orleans, we plan to bring 162(m) to life with lively back-and-forth discussion of issues raised in a detailed case study we’re putting together for this session that hits on many of the stumbling blocks that we’ve seen trip up HR, legal, and tax professionals alike.
For example, while most people understand that stock options and SARs generally qualify as performance-based compensation as long as the awards aren’t granted with a discounted exercise price, it’s easy to overlook the additional requirement that the compensation committee that grants equity awards to 162(m) covered employees must be comprised solely of two or more “outside directors”. Easy enough, you might think: if we’re already following the NASDAQ and NYSE listing requirements for independent directors, we should be okay, right? Not so fast! The tax rules are different, and in some respects more stringent, than the exchange listing requirements. For example, if your company pays any amount, no matter how immaterial, to an entity that is more than 50% owned by a director (directly or beneficially)–such as a caterer or florist that happens to be owned by a family member of that director–then you have a problem! If your compensation committee fails to meet these requirements, then all the equity awards granted by the committee similarly fail. That’s a harsh result, and can cause a pretty big hit to your company’s bottom line!
We will also use our case study to explore other outside director challenges, as well as tricks and traps related to when performance goals need to be established, if and how they can be changed, and when and how to get shareholder approval. For example, do your plans explicitly address how your compensation committee can adjust performance goals to reflect the effect on an acquisition? Can your company pay bonuses outside of your performance plan if the established goals are not met? Can you structure compensation for executives hired mid-year to comply with 162(m)? Our case study will also address the transition rules for newly public companies. Finally, we’ll discuss planning opportunities and best practices, and cover recent developments, including proposed 162(m) regulations that may be finalized by the time we meet in New Orleans. We’ll see you there!
On October 18, ISS issued a preview of some of the policy changes it is considering for the 2012 proxy season. In today’s blog, I take a look at proposed policy changes relating to how ISS evaluates CEO pay and stock plans submitted for shareholder approval for Section 162(m) purposes.
ISS, CEO Pay, and Company Performance
ISS currently evaluates CEO pay and company performance by comparing the company’s TSR to that of its GICS industry group to identify underperformance, then applying a qualitative analysis of various other factors that relate the CEO’s pay to TSR.
Under the newly proposed policy, ISS will apply a relative measure that compares the company’s TSR to that of its peers, which will be determined based on market capitalization, revenue, and GICS industry group. ISS will compare the company’s TSR ranking within the group to that of its CEO pay ranking. ISS will also consider the multiple of the CEO’s pay to the peer-group median.
In addition to the relative measure, ISS will apply an absolute measure that tracks changes in the company’s TSR against changes in its CEO’s pay.
The results of ISS’s pay-for-performance evaluation can impact recommendations ISS issues for the company’s Say-on-Pay proposal and stock plan proposals (if a significant portion of the CEO’s misaligned pay is in the form of equity), as well as individual director nominations.
ISS and Section 162(m)
In the past, when stock plans have been submitted for shareholder approval solely for the purpose of qualifying for exemption under Section 162(m), ISS has generally recommended that shareholders approve the plans. Under the newly proposed policy, however, ISS states that they will complete a full analysis of future plans submitted to shareholder vote for this purposes.This will include consideration of the total shareholder value transfer, burn rate analysis (if applicable), and specific plan features (such as repricing and change-in-control provisions).
This may particularly be a concern for newly public companies that wish to qualify performance unit awards for exemption under Section 162(m). Under recently proposed rules, the IRS clarified that the Section 162(m) exemption for post-IPO grants of stock options, SARs, and restricted stock made during a transition period does not apply to RSUs. Thus, newly public companies that wish to grant exempt performance unit awards will need to submit their plans for shareholder approval, triggering a full analysis of the plan by ISS.
Comments and More Information
ISS accepted comments on the policy through the end of October. (We posted an NASPP alert on the policy changes shortly after ISS issued the proposal. If you follow the NASPP on Twitter or Facebook, then you knew about our alert in time to submit comments to ISS.)
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
It was great to see everyone at the NASPP Conference last week. One session I look forward to every year at the Conference is “The IRS Speaks“–which I consider to be my chance to get the inside scoop on various IRS projects that impact stock compensation. For today’s blog, I have a few updates from this year’s panel, as well as some other recent tax news.
For highlights of the NASPP Conference, check out my blog entries on November 2 and November 4.
COLAs for 2012 The maximum amount of earnings subject to Social Security tax will increase to $110,100 in 2012 (up from $106,800 this year) (those of you that follow the NASPP on Facebook and Twitter already know this). The tax rate is also scheduled to return to 6.2% (up from 4.2% this year), making the maximum withholding $6,826.20 for 2012 (see the NASPP alert). But stay tuned on this one; President Obama has proposed reducing Social Security tax for 2012.
Also, if any of you exclude highly compensated employees from your ESPP, note that the threshold for who is considered highly compensated increases to $115,000 in 2012.
BTW–COLAs stands for “cost of living adjustments.”
Updates from “The IRS Speaks“ Here are areas where the IRS hopes to issue guidance in the next year or so:
409A income inclusion rules. Note however, that this doesn’t include Code Y reporting. That isn’t likely to happen until some time after the 409A income inclusion rules are finalized.
Finalizing the proposed regs that were issued earlier this year under Section 162(m).
The treatment of dividends and dividend equivalents under Section 162(m).
A model election under Section 83(b) that includes examples illustrating the tax consequences of making (or not making) the election. (Fascinating–I had no idea the IRS even thought there was a need for this.)
Guidance on Section 162(m)(6), which relates to the deduction limit that applies to health insurance providers.
Something about foreign pension plans under Section 402(b) (I have no idea what this is–sorry, when I hear the words “foreign pension plans,” I tune out).
The panel also covered a number of issues relating to Section 6039 returns for ISOs and ESPPs. I don’t have time to cover them all today, but maybe in a future blog.
In terms of cost-basis reporting, the panel did say that the IRS is considering adding a checkbox to Form 1099-B that would indicate whether the reported cost basis includes W-2 income recognized in connection with the shares. We think this brilliant suggestion from Andrew Schwartz of BNY Mellon Shareowner Services would be a big help in explaining the form to employees, but if the IRS makes this change, it won’t be until the 2012 form comes out.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Earlier this summer, Senator Carl Levin (D-MI), introduced another bill that would limit corporate tax deductions for stock options to the expense recognized for them, the “Ending Excessive Corporate Deductions for Stock Options Act.” His cohort on this year’s bill is Senator Sherrod Brown (D-Ohio) (Senator Claire McCaskill, D-OH, has also signed on since the bill was introduced).
A Bi-Annual Event I say “this year’s bill” because this is becoming a bi-annual event. Levin has been introducing bills like this for at least the past 20 years. He didn’t even bother to change the name of the bill this year. In fact, just for kicks, I did a redline comparison of this bill to his 2009 bill; the two bills are almost exactly the same. His co-sponsors have varied over the years but often include Senator John McCain (R-AZ).
The bill would limit the tax deduction corporations could take for stock options to the amount of expense recognized for them (i.e., the grant date fair value). According to Levin’s press release, this would raise $24.6 billion in tax revenue over the next ten years (assuming, apparently, that the market doesn’t have too many more days like yesterday). The press release states that Levin has released IRS data showing that, from 2005 to 2009, corporations took tax deductions that were “billions of dollars” greater than the expenses shown on their financial statements.
This is surprising to me because I’m not sure how the IRS would even have this data. The tax deductions companies took in those years would relate to options that were granted in prior years–many may have been granted before FAS 123(R) (now ASC 718) even went into effect. Comparing the tax deduction the company claimed to the option expense for that year is not a valid comparison.
You can usually get an idea of whether a company’s tax deductions for stock compensation exceed the expense recorded for it from their financial statements, but most of the financial statements I’ve seen only provide this information in aggregate for all types of arrangements the company offers–stock options, restricted stock, RSUs, performance awards, ESPP, etc. Levin’s bill only applies to stock options.
Section 162(m)–No More Free Pass
The bill would also make stock options subject to the limitation on corporate tax deductions under Section 162(m). Currently, stock options are exempt from the limit by virtue of being considered inherently performance-based (because the stock price must appreciate for the option to deliver a benefit). This clearly would raise revenue–maybe that’s where a good chunk of the $25 billion comes from. What was the tax deduction your company claimed for the options exercised by your NEOs last year?
Given that, after twenty years, Levin still hasn’t had any success with this agenda, I think chances are nothing will happen with this bill either, so I don’t expect it to be a hot topic at this year’s NASPP Conference. But you can catch up on all hottest tax topics–straight from the IRS–with the session “The IRS Speaks” at the 19th Annual NASPP Conference.
It’s Not Too Late to Enroll in the NASPP’s Financial Reporting Course The NASPP’s newest online program, “Financial Reporting for Equity Compensation” started on Thursday, July 14, but it’s not too late to get into the course. All webcasts have been archived for you to listen to at your convenience.
Designed for non-accounting professionals, this course will help you become literate in all aspects of stock plan accounting, from expense measurement and recognition, to EPS and tax accounting. Register today so you don’t miss any more webcasts.
NASPP “To Do” List We have so much going on here at the NASPP that it can be hard to keep track of it all, so I keep an ongoing “to do” list for you here in my blog.
Don’t miss your local NASPP chapter meetings in Denver, Houston, and San Francisco. I’ll be at the San Francisco chapter annual all-day event at the lovely Wente Vineyard in Livermore, CA, on Wednesday–I hope to see you there!
On June 23, the IRS and Treasury proposed new regulations under Section 162(m) relating to the requirements for options and SARs to be considered performance-based compensation and the transition period for newly public companies.
Not-So-Surprising Proposed Regs for Section 162(m) (Well, Maybe a Little Surprise for IPO Companies)
Section 162(m) limits the tax deduction public companies can take for compensation paid to specified executive officers to $1 million per year. As I’m sure you all know, however, performance-based compensation is exempt from this limitation.
The recently issued proposed regs are not nearly as controversial as the IRS’s 2008 surprise ruling on 162(m), but are still worth taking note of–especially since, as the Morgan Lewis memo we posted on the proposal points out, some of these clarifications are the direct result of compliance failures the IRS has encountered during audits.
Stock Options and SARs
Normally, for compensation to be considered performance-based, it must meet a number of rigorous requirements. At the time that Section 162(m) was implemented, however, at-the-money stock options and SARs were considered inherently performance-based, so the requirements applicable to them are significantly more relaxed (a decision I can only imagine regulators regret today, given current public sentiment towards stock options). The primary requirements are that the options/SARs be granted from a shareholder approved plan, individual grants are approved by a committee of non-employee directors, the exercise price is no less than the FMV at grant, and the plan states the maximum number of shares that can be granted to an employee during a specified period.
The proposed regs clarify that, for this last requirement, the plan must state a per-person limit; the aggregate limit on the number of shares that can be granted under the plan is insufficient (although, the stated per-person limit could be equal to the aggregate limit).
Disclosure
For all performance-based compensation, including stock options and SARs, the regs already require that the maximum amount of compensation that may be paid under the plan/awards to an individual employee during a specified period must be disclosed to shareholders. For stock options and SARs, it’s pretty hard to determine what the maximum compensation is, since this depends on the company’s stock price over the ten years or so that the grant might be outstanding. The proposed regs clarify that it is sufficient to disclose the maximum number of shares for which options/SARs can be granted during a specified period and that the exercise of the grants is the FMV at grant.
Newly Public Companies
For a limited “transition” period, Section 162(m) doesn’t apply to arrangements that were in effect while a company was privately held (provided that the arrangements are disclosed in the IPO prospectus, if applicable). This transition period ends with the first shareholders’ meeting at which directors are elected after the end of the third calendar year (first calendar year, for companies that didn’t complete an IPO) following the year the company first became public (unless the plan expires, is materially modified, or runs out of shares or the arrangement is materially modified before then).
For stock options, SARs, and restricted stock, the current regs are even more generous–any awards granted during this transition period are not subject to 162(m), even if settled after the transition period ends. The proposed regs don’t change this, but they do make it clear that RSUs and phantom stock are not covered by this exemption. My understanding from some of the memos we’ve posted in our alert on this is that this reverses a couple of private letter rulings on this issue (see the Morrison & Foerster, Morgan Lewis, and Edwards Angell Palmer & Dodge memos). The current regs specifically state that the exemption applies to stock options, SARs, and restricted stock, but are silent as to the treatment of RSUs and phantom stock–providing the IRS/Treasury with the leeway to exclude them now.
Subtle Changes
Several of the changes are pretty subtle–so subtle that when comparing the proposed regs to the current regs, I couldn’t figure out what had changed. So I used the handy-dandy document compare feature in Word to create a redline version of the new regs, which I’ve posted for the convenience of NASPP members.
Chickens, Stock Plan Administrators, and Whiskey The author of the joke that appeared in last week’s blog entry is John Hammond of AST Equity Plan Solutions (and poet laureate of the NASPP blog). Ten points to Erin Madison of Broadcom, who was the only person to email me the correct the answer. I can’t believe no one else figured it out!