[Federal Register Volume 60, Number 244 (Wednesday, December 20, 1995)]
[Rules and Regulations]
[Pages 65534-65547]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30869]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 8650]
RIN 1545-AS23
Disallowance of Deductions for Employee Remuneration in Excess of
$1,000,000
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulations.
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SUMMARY: This document contains final regulations relating to the
disallowance of deductions for employee remuneration in excess of
$1,000,000. The regulations provide guidance to taxpayers that are
subject to section 162(m), which was added to the Code by the Omnibus
Budget Reconciliation Act of 1993.
DATES: These regulations are effective January 1, 1994.
For dates of applicability, see Sec. 1.162-27(j).
FOR FURTHER INFORMATION CONTACT: Robert Misner or Charles T. Deliee at
(202)622-6060 (not a toll free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in these final regulations
have been reviewed and approved by the Office of Management and Budget
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under
control number 1545-1466. Responses to these collections of information
are required to obtain a tax deduction for performance-based
compensation in excess of $1 million.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid control number.
The estimated average annual burden per respondent is 50 hours.
Comments concerning the accuracy of this burden estimate and
suggestions for reducing this burden should be sent to the Internal
Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,
DC 20224, and to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information and
Regulatory Affairs, Washington, DC 20503.
Books or records relating to this collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
Under section 162(m) of the Internal Revenue Code, a publicly held
corporation is denied a deduction for compensation paid to its
``covered employees'' to the extent the compensation exceeds $1,000,000
if the compensation would otherwise be deductible in a taxable year
beginning on or after January 1, 1994.
On December 20, 1993, proposed regulations under section 162(m)
(the 1993 proposed regulations) were published in the Federal Register
(58
[[Page 65535]]
FR 66310). Amendments to the proposed regulations (the 1994 amendments)
were published in the Federal Register on December 2, 1994 (59 FR
61844). Public hearings were held on May 9, 1994, and August 11, 1995.
After consideration of the comments that were received in response to
the notices of proposed rulemaking and at the hearings, the IRS and
Treasury adopt the proposed regulations as amended and revised by this
Treasury decision.
Explanation of Provisions
A. Overview of Provisions
As noted above, section 162(m) provides that a publicly held
corporation is denied a deduction for compensation paid to a ``covered
employee'' to the extent the compensation exceeds $1,000,000. A
``covered employee'' includes the chief executive officer (CEO), as
well as any other individual whose compensation is required to be
reported to the Securities and Exchange Commission by reason of that
individual being among the four highest compensated officers for the
taxable year (other than the CEO), as of the end of the corporation's
taxable year.
``Performance-based compensation'' and certain other compensation
is not subject to the deduction limitation of section 162(m).
Performance-based compensation is remuneration payable solely on
account of the attainment of one or more performance goals, but only
if: (1) the goals are determined by a compensation committee of the
board of directors consisting solely of two or more outside directors;
(2) the material terms under which the compensation is to be paid are
disclosed to the shareholders and approved by a majority in a separate
vote before payment is made; and (3) before any payment is made, the
compensation committee certifies that the performance goals and any
other material terms have been satisfied.
Compensation is also excluded from the deduction limitation of
section 162(m) if it is paid under a binding written contract that was
in existence on February 17, 1993. In addition, in accordance with the
legislative history, the proposed regulations exempt from the
limitation compensation that is paid under an arrangement that existed
before the corporation became publicly held, to the extent that the
arrangement is disclosed in the initial public offering.
B. Discussion of Comments
Comments that relate to the application of the proposed regulations
and the responses to the comments, including an explanation of the
revisions reflected in the final regulations, are summarized below.
Dividend Equivalents Paid on Stock Options
Under the proposed regulations, the performance-based exception to
the deduction limitation generally is applied on a grant-by-grant
basis. If the facts and circumstances indicate, however, that the
employee would receive all or part of the compensation regardless of
whether the performance goal is attained, the compensation is not
performance based. For example, where payment under a nonperformance
based bonus is contingent upon the failure to attain the performance
goals under an otherwise performance-based bonus, neither bonus
arrangement will be considered performance based. The proposed
regulations provide that whether dividends (which generally are not
performance based) on restricted stock are payable before attainment of
the performance goal, will not affect the determination of whether the
restricted stock is performance based. The proposed regulations also
provide, however, that if the amount of any compensation the employee
will receive under a stock option is not based solely on an increase in
the value of the stock after the date of grant (for example, an option
granted with an exercise price that is less than the fair market value
of the stock as of the date of grant), none of the compensation
attributable to the grant will be performance based.
Commentators raised the question of whether nonperformance-based
dividend equivalents that are paid with respect to a granted but
unexercised stock option irrespective of whether the option is
exercised will cause the compensation paid upon the exercise of the
option to be nonperformance based. Section 1.162-27(e)(2)(vi) of the
final regulations provides that such dividend equivalents will not
cause the compensation paid upon the exercise of the option to be
nonperformance based, provided that the payment of the dividend
equivalents is not conditioned upon the employee exercising the option.
If the payment of the dividend equivalent is conditioned upon the
employee exercising the option, the dividend effectively reduces the
exercise price of the option, thereby causing the option to be
nonperformance based upon its exercise.
Bonus Pools
Section 1.162-27(e)(2)(ii) of the proposed regulations provides
that a preestablished performance goal must state, in terms of an
objective formula or standard, the method for computing the amount of
compensation payable to the employee if the goal is attained. A formula
or standard is objective if a third party having knowledge of the
relevant performance results could calculate the amount to be paid to
the employee.
Section 1.162-27(e)(2)(iii) prohibits discretion to increase the
amount of compensation to be paid under the preestablished performance
goal, but permits the compensation committee to reduce or eliminate the
compensation that is due upon attainment of the goal.
Examples 7 and 8 under Sec. 1.162-27(e)(2)(vii) of the proposed
regulations illustrated the application of these rules to bonus pools.
In Example 7, the amount of the bonus pool was determined under an
objective formula. However, because the compensation committee retained
the discretion to determine the fraction of the bonus pool that each
covered employee would receive, the compensation that any individual
could receive was not determined under an objective formula and,
therefore, the bonus plan did not satisfy the requirements of paragraph
(e)(2). In Example 8, the compensation for any individual was
determined under an objective formula because each employee's share of
the bonus pool was specified and because, notwithstanding the
compensation committee's ability to reduce the compensation payable to
each individual employee, a reduction in one employee's bonus would not
result in an increase in the amount of any other employee's bonus.
Several commentators have indicated that, in some cases where
compensation committees have stated the amount payable to each
individual under a bonus pool plan as a percentage of the bonus pool,
the total of these percentages has exceeded 100 percent of the pool.
The use of such overlapping percentages is inconsistent with
Sec. 1.162-27(e)(2), as illustrated by both Example 7 and Example 8. As
noted, Example 8 states that negative discretion will not cause the
bonus plan to fail to satisfy the requirements of paragraph (e)(2),
``provided that a reduction in the amount of one employee's bonus does
not result in an increase in the amount of any other employee's
bonus.'' Where the total of the percentages payable under a bonus pool
plan exceeds 100 percent, it is impossible to award each individual the
[[Page 65536]]
stated percentage, and this necessary exercise of negative discretion
with respect to one or more employees means that it is impossible for a
third party, with knowledge of the relevant performance results, to
calculate the amount to be paid to each employee. Further, a reduction
in at least some employees' bonuses will result in an increase in the
amount available to pay other employees' bonuses.
Accordingly, Sec. 1.162-27(e)(2)(iii) is amended to state more
clearly that, when the compensation to be paid to each employee is
stated in terms of a percentage of a bonus pool, the sum of the
individual percentages for all participants in the pool cannot exceed
100 percent. In addition, the principle stated in Example 8, that the
exercise of negative discretion with respect to one employee cannot
increase the amount payable to another employee, is incorporated in
paragraph (e)(2)(iii). Example 8 is also revised to more clearly
illustrate this rule.
Although the IRS and Treasury believe that the changes made merely
clarify the proposed regulations, it is recognized that others have
interpreted the language of the proposed regulations differently.
Therefore, under Sec. 1.162-27(j)(2)(iv), this clarified rule will not
be applied to any compensation paid before January 1, 2001, under a
bonus pool based on performance in any period that began before
December 20, 1995.
Outside Directors
Section 1.162-27(e)(3)(vi) provides that a director is not
precluded from being an outside director solely because he or she is a
former officer of a corporation that previously was an affiliated
corporation of the publicly held corporation. The regulation is revised
to clarify that a former officer of either a spun off or liquidated
corporation, that formerly was a member of the affiliated group, is not
precluded from serving on the compensation committee of the publicly
held member of the affiliated group.
Companies that Become Publicly Held Without an Initial Public Offering
Under Sec. 1.162-27(f), the $1 million deduction limit does not
apply to any compensation plan or agreement that existed before the
corporation became publicly held to the extent that the plan or
agreement was disclosed in the prospectus accompanying the initial
public offering (IPO). This exception may be relied on until the
earliest of: (1) the expiration of the plan or agreement, (2) the
material modification of the plan or agreement, (3) the issuance of all
stock and other compensation that has been allocated under the plan, or
(4) the first shareholder meeting at which directors will be elected
that occurs after the close of the third calendar year following the
calendar year in which the IPO occurs.
Commentators have asked whether this rule applies to corporations
that become publicly held without an IPO.
As indicated in the legislative history accompanying Code section
162(m), the prospectus that accompanies the IPO provides an opportunity
to disclose the terms of the plan or agreement to the potential
shareholders, and the subsequent purchase of the stock with that
knowledge may be viewed as tantamount to a favorable vote on the
compensation arrangement. When a corporation becomes publicly held
without an IPO, there is no comparable alternative means of satisfying
the requirements of section 162(m)(4)(C)(ii). On the other hand,
because there is no requirement for privately held corporations to
comply with section 162(m), the IRS and Treasury recognize the need for
a transition rule for plans and agreements that are in existence when a
privately held corporation becomes publicly held without an IPO.
Accordingly, Sec. 1.162-27(f)(1) is revised to provide relief for
privately held corporations that become publicly held without an IPO.
Under the transition rule for these corporations, the reliance period
in Sec. 1.162-27(f)(2) lapses upon the first meeting of shareholders at
which directors are to be elected that occurs after the close of the
first calendar year following the calendar year in which the
corporation becomes publicly held.
Written Binding Contracts
Section 1.162-27(h)(1) provides the transition rules for
compensation payable under a written binding contract that was in
effect on February 17, 1993. Under those rules, a written binding
contract that is terminable or cancelable by the corporation after
February 17, 1993, without the employee's consent is treated as a new
contract as of the date that any such termination or cancelation, if
made, would be effective. The proposed regulations further provide
that, if the terms of a contract provide that the contract will be
terminated or canceled as of a certain date unless either the
corporation or the employee elects to renew within 30 days of that
date, the contract is treated as renewed by the corporation as of that
date.
Commentators have suggested that these regulations clarify the
outcome where a corporation will remain bound by the terms of a
contract beyond a certain date at the sole discretion of the employee.
For example, if a contract that is in effect on February 17, 1993,
provides that the employee has the sole discretion to extend or renew
the terms beyond its stated expiration, without the consent of the
corporation, a question arises whether the contract will be considered
a pre-February 17, 1993 written binding contract after the employee
chooses to extend.
Generally, the question of whether the terms of a contract are
binding is determined under state law. The IRS and Treasury believe
that the rules for determining whether a contract is binding should be
applied based on whether the corporation is bound by the terms of the
contract. Thus, if a contract provides the employee with the right to
extend or renew its terms without the consent of the corporation, and
the corporation is legally obligated to pay the agreed-upon
compensation to the employee if the employee chooses to extend or renew
the contract, the contract will be considered binding on the
corporation. Accordingly, a new sentence has been added to Sec. 1.162-
27(h)(1)(i) to clarify that, if the corporation will remain legally
obligated by the terms of a contract beyond a certain date at the sole
discretion of the employee, the contract will not be treated as a new
contract as of that date if the employee exercises the discretion.
Awards Based on a Percentage of Salary
The 1994 amendments modified Sec. 1.162-27(e)(2)(iii) to provide
that, if the terms of an objective formula or standard fail to preclude
discretion merely because the amount of compensation to be paid upon
attainment of the performance goal is based, in whole or in part, on a
percentage of salary or base pay, the objective formula or standard
will not be considered discretionary (and thus Sec. 1.162-27(e)(2)(iii)
will not be violated) if the maximum dollar amount to be paid is fixed
at the time the performance goal is established. The final regulations
clarify that a maximum dollar amount need not be specified under this
provision if, at the time the performance goal is established, the
dollar amount of salary or base pay is fixed. In such a case, the use
of salary or base pay does not cause the formula to fail to preclude
discretion to increase compensation.
The 1994 amendments made a corresponding amendment with respect to
salary-based formulas to the shareholder disclosure rules in
Sec. 1.162-27(e)(4)(i). However, the shareholder disclosure amendment
was not
[[Page 65537]]
explicitly limited to formulas that would otherwise be discretionary.
The final regulations clarify that the shareholder disclosure rule
relating to salary-based formulas applies only to those formulas that
would otherwise be discretionary.
In addition, the final regulations provide transition relief with
respect to the 1994 amendment of the shareholder disclosure requirement
relating to salary-based formulas. New Sec. 1.162-27(j)(2)(v) provides
that this disclosure requirement applies only to plans approved by
shareholders after April 30, 1995.
In the case of a preestablished performance goal that was
established prior to the publication of the 1994 amendments, a
corporation could, of course, rely upon a reasonable good faith
interpretation of the statutory provisions to determine that the
performance goal was stated in terms of an objective formula, to the
extent the issue to which the interpretation relates was not covered by
the 1993 regulations. An award made pursuant to such a performance goal
would not fail to be performance based merely because the award was
made after the publication of the 1994 amendments.
Stock-Based Compensation
The 1993 proposed regulations provided transition relief for
previously approved plans and agreements that did not satisfy the
written binding contract requirement as of February 17, 1993, but that
were approved by shareholders before December 20, 1993. See Sec. 1.162-
27(h)(3)(iii). The transition relief applied to compensation paid prior
to the expiration of a reliance period. In response to comments on the
1993 proposed regulations, the 1994 amendments expanded this relief to
encompass compensation paid after the reliance period with respect to
the exercise of stock options and stock appreciation rights, and the
substantial vesting of restricted property, provided that the stock
option, stock appreciation right, or restricted property was granted
during the reliance period. Similar relief provisions were also
included in new transition rules added by the 1994 amendments. (See
Secs. 1.162-27(f)(3), (f)(4), (j)(2)(ii), and (j)(2)(iii) of the final
regulations.)
Commentators have asked that the relief provided in the 1994
amendments for stock options, stock appreciation rights, and restricted
property be extended even further to cover other stock-based
compensation and deferred compensation in general. After careful
consideration of the comments received, the IRS and Treasury have
concluded that there is not adequate justification for a further
expansion of the 1994 expansion of the prior regulatory transition
relief for previously approved plans and agreements, or the other
similar relief provisions added in 1994.
Subsidiaries That Become Separate Publicly Held Corporations
Section 1.162-27(f)(4) of the proposed regulations contains special
rules for subsidiaries that become separate publicly held corporations.
A transition rule set forth in Sec. 1.162-27(i)(2)(iii) of the proposed
regulations specified delayed effective dates for these special rules.
However, commentators indicated that the regulations were not explicit
as to which rules applied prior to the delayed effective dates.
The final regulations clarify that compensation paid prior to the
delayed effective dates by a subsidiary that becomes a separate
publicly held corporation will not be subject to the $1 million
deduction limit if the conditions of the transition rule are satisfied.
(This transition rule and all other effective date provisions have been
moved from paragraph (i) to paragraph (j) of the final regulations.
Paragraph (i) is reserved.)
Special Analysis
It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It also has been determined that
section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)
and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to
these regulations, and, therefore, a Regulatory Flexibility Analysis is
not required. Pursuant to section 7805(f) of the Internal Revenue Code,
the notice of proposed rulemaking preceding these regulations was
submitted to the Small Business Administration for comment on its
impact on small business.
Drafting Information
The principal authors of these regulations are Charles T. Deliee
and Robert Misner, Office of the Associate Chief Counsel (Employee
Benefits and Exempt Organizations), Internal Revenue Service. However,
other personnel from IRS and the Treasury Department participated in
their development.
List of Subjects
26 CFR Part 1
Income taxes, reporting and recordkeeping requirements.
26 CFR Part 602
Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602 are amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority for part 1 continues to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.162-27 is added to read as follows:
Sec. 1.162-27 Certain employee remuneration in excess of $1,000,000.
(a) Scope. This section provides rules for the application of the
$1 million deduction limit under section 162(m) of the Internal Revenue
Code. Paragraph (b) of this section provides the general rule limiting
deductions under section 162(m). Paragraph (c) of this section provides
definitions of generally applicable terms. Paragraph (d) of this
section provides an exception from the deduction limit for compensation
payable on a commission basis. Paragraph (e) of this section provides
an exception for qualified performance-based compensation. Paragraphs
(f) and (g) of this section provide special rules for corporations that
become publicly held corporations and payments that are subject to
section 280G, respectively. Paragraph (h) of this section provides
transition rules, including the rules for contracts that are
grandfathered and not subject to section 162(m). Paragraph (j) of this
section contains the effective date provisions. For rules concerning
the deductibility of compensation for services that are not covered by
section 162(m) and this section, see section 162(a)(1) and Sec. 1.162-
7. This section is not determinative as to whether compensation meets
the requirements of section 162(a)(1).
(b) Limitation on deduction. Section 162(m) precludes a deduction
under chapter 1 of the Internal Revenue Code by any publicly held
corporation for compensation paid to any covered employee to the extent
that the compensation for the taxable year exceeds $1,000,000.
(c) Definitions--(1) Publicly held corporation--(i) General rule. A
publicly held corporation means any corporation issuing any class of
common equity securities required to be registered under section 12 of
the Exchange Act. A corporation is not considered publicly held if the
registration of its equity securities is voluntary. For purposes of
this section, whether a corporation is
[[Page 65538]]
publicly held is determined based solely on whether, as of the last day
of its taxable year, the corporation is subject to the reporting
obligations of section 12 of the Exchange Act.
(ii) Affiliated groups. A publicly held corporation includes an
affiliated group of corporations, as defined in section 1504
(determined without regard to section 1504(b)). For purposes of this
section, however, an affiliated group of corporations does not include
any subsidiary that is itself a publicly held corporation. Such a
publicly held subsidiary, and its subsidiaries (if any), are separately
subject to this section. If a covered employee is paid compensation in
a taxable year by more than one member of an affiliated group,
compensation paid by each member of the affiliated group is aggregated
with compensation paid to the covered employee by all other members of
the group. Any amount disallowed as a deduction by this section must be
prorated among the payor corporations in proportion to the amount of
compensation paid to the covered employee by each such corporation in
the taxable year.
(2) Covered employee--(i) General rule. A covered employee means
any individual who, on the last day of the taxable year, is--
(A) The chief executive officer of the corporation or is acting in
such capacity; or
(B) Among the four highest compensated officers (other than the
chief executive officer).
(ii) Application of rules of the Securities and Exchange
Commission. Whether an individual is the chief executive officer
described in paragraph (c)(2)(i)(A) of this section or an officer
described in paragraph (c)(2)(i)(B) of this section is determined
pursuant to the executive compensation disclosure rules under the
Exchange Act.
(3) Compensation--(i) In general. For purposes of the deduction
limitation described in paragraph (b) of this section, compensation
means the aggregate amount allowable as a deduction under chapter 1 of
the Internal Revenue Code for the taxable year (determined without
regard to section 162(m)) for remuneration for services performed by a
covered employee, whether or not the services were performed during the
taxable year.
(ii) Exceptions. Compensation does not include--
(A) Remuneration covered in section 3121(a)(1) through section
3121(a)(5)(D) (concerning remuneration that is not treated as wages for
purposes of the Federal Insurance Contributions Act); and
(B) Remuneration consisting of any benefit provided to or on behalf
of an employee if, at the time the benefit is provided, it is
reasonable to believe that the employee will be able to exclude it from
gross income. In addition, compensation does not include salary
reduction contributions described in section 3121(v)(1).
(4) Compensation Committee. The compensation committee means the
committee of directors (including any subcommittee of directors) of the
publicly held corporation that has the authority to establish and
administer performance goals described in paragraph (e)(2) of this
section, and to certify that performance goals are attained, as
described in paragraph (e)(5) of this section. A committee of directors
is not treated as failing to have the authority to establish
performance goals merely because the goals are ratified by the board of
directors of the publicly held corporation or, if applicable, any other
committee of the board of directors. See paragraph (e)(3) of this
section for rules concerning the composition of the compensation
committee.
(5) Exchange Act. The Exchange Act means the Securities Exchange
Act of 1934.
(6) Examples. This paragraph (c) may be illustrated by the
following examples:
Example 1. Corporation X is a publicly held corporation with a
July 1 to June 30 fiscal year. For Corporation X's taxable year
ending on June 30, 1995, Corporation X pays compensation of
$2,000,000 to A, an employee. However, A's compensation is not
required to be reported to shareholders under the executive
compensation disclosure rules of the Exchange Act because A is
neither the chief executive officer nor one of the four highest
compensated officers employed on the last day of the taxable year.
A's compensation is not subject to the deduction limitation of
paragraph (b) of this section.
Example 2. C, a covered employee, performs services and receives
compensation from Corporations X, Y, and Z, members of an affiliated
group of corporations. Corporation X, the parent corporation, is a
publicly held corporation. The total compensation paid to C from all
affiliated group members is $3,000,000 for the taxable year, of
which Corporation X pays $1,500,000; Corporation Y pays $900,000;
and Corporation Z pays $600,000. Because the compensation paid by
all affiliated group members is aggregated for purposes of section
162(m), $2,000,000 of the aggregate compensation paid is
nondeductible. Corporations X, Y, and Z each are treated as paying a
ratable portion of the nondeductible compensation. Thus, two thirds
of each corporation's payment will be nondeductible. Corporation X
has a nondeductible compensation expense of $1,000,000
($1,500,000 x $2,000,000/$3,000,000). Corporation Y has a
nondeductible compensation expense of $600,000
($900,000 x $2,000,000/$3,000,000). Corporation Z has a
nondeductible compensation expense of $400,000
($600,000 x $2,000,000/$3,000,000).
Example 3. Corporation W, a calendar year taxpayer, has total
assets equal to or exceeding $5 million and a class of equity
security held of record by 500 or more persons on December 31, 1994.
However, under the Exchange Act, Corporation W is not required to
file a registration statement with respect to that security until
April 30, 1995. Thus, Corporation W is not a publicly held
corporation on December 31, 1994, but is a publicly held corporation
on December 31, 1995.
Example 4. The facts are the same as in Example 3, except that
on December 15, 1996, Corporation W files with the Securities and
Exchange Commission to disclose that Corporation W is no longer
required to be registered under section 12 of the Exchange Act and
to terminate its registration of securities under that provision.
Because Corporation W is no longer subject to Exchange Act reporting
obligations as of December 31, 1996, Corporation W is not a publicly
held corporation for taxable year 1996, even though the registration
of Corporation W's securities does not terminate until 90 days after
Corporation W files with the Securities and Exchange Commission.
(d) Exception for compensation paid on a commission basis. The
deduction limit in paragraph (b) of this section shall not apply to any
compensation paid on a commission basis. For this purpose, compensation
is paid on a commission basis if the facts and circumstances show that
it is paid solely on account of income generated directly by the
individual performance of the individual to whom the compensation is
paid. Compensation does not fail to be attributable directly to the
individual merely because support services, such as secretarial or
research services, are utilized in generating the income. However, if
compensation is paid on account of broader performance standards, such
as income produced by a business unit of the corporation, the
compensation does not qualify for the exception provided under this
paragraph (d).
(e) Exception for qualified performance-based compensation--
(1) In general. The deduction limit in paragraph (b) of this
section does not apply to qualified performance-based compensation.
Qualified performance-based compensation is compensation that meets all
of the requirements of paragraphs (e)(2) through (e)(5) of this
section.
(2) Performance goal requirement--(i) Preestablished goal.
Qualified performance-based compensation must be paid solely on account
of the attainment of one or more
[[Page 65539]]
preestablished, objective performance goals. A performance goal is
considered preestablished if it is established in writing by the
compensation committee not later than 90 days after the commencement of
the period of service to which the performance goal relates, provided
that the outcome is substantially uncertain at the time the
compensation committee actually establishes the goal. However, in no
event will a performance goal be considered to be preestablished if it
is established after 25 percent of the period of service (as scheduled
in good faith at the time the goal is established) has elapsed. A
performance goal is objective if a third party having knowledge of the
relevant facts could determine whether the goal is met. Performance
goals can be based on one or more business criteria that apply to the
individual, a business unit, or the corporation as a whole. Such
business criteria could include, for example, stock price, market
share, sales, earnings per share, return on equity, or costs. A
performance goal need not, however, be based upon an increase or
positive result under a business criterion and could include, for
example, maintaining the status quo or limiting economic losses
(measured, in each case, by reference to a specific business
criterion). A performance goal does not include the mere continued
employment of the covered employee. Thus, a vesting provision based
solely on continued employment would not constitute a performance goal.
See paragraph (e)(2)(vi) of this section for rules on compensation that
is based on an increase in the price of stock.
(ii) Objective compensation formula. A preestablished performance
goal must state, in terms of an objective formula or standard, the
method for computing the amount of compensation payable to the employee
if the goal is attained. A formula or standard is objective if a third
party having knowledge of the relevant performance results could
calculate the amount to be paid to the employee. In addition, a formula
or standard must specify the individual employees or class of employees
to which it applies.
(iii) Discretion.
(A) The terms of an objective formula or standard must preclude
discretion to increase the amount of compensation payable that would
otherwise be due upon attainment of the goal. A performance goal is not
discretionary for purposes of this paragraph (e)(2)(iii) merely because
the compensation committee reduces or eliminates the compensation or
other economic benefit that was due upon attainment of the goal.
However, the exercise of negative discretion with respect to one
employee is not permitted to result in an increase in the amount
payable to another employee. Thus, for example, in the case of a bonus
pool, if the amount payable to each employee is stated in terms of a
percentage of the pool, the sum of these individual percentages of the
pool is not permitted to exceed 100 percent. If the terms of an
objective formula or standard fail to preclude discretion to increase
the amount of compensation merely because the amount of compensation to
be paid upon attainment of the performance goal is based, in whole or
in part, on a percentage of salary or base pay and the dollar amount of
the salary or base pay is not fixed at the time the performance goal is
established, then the objective formula or standard will not be
considered discretionary for purposes of this paragraph (e)(2)(iii) if
the maximum dollar amount to be paid is fixed at that time.
(B) If compensation is payable upon or after the attainment of a
performance goal, and a change is made to accelerate the payment of
compensation to an earlier date after the attainment of the goal, the
change will be treated as an increase in the amount of compensation,
unless the amount of compensation paid is discounted to reasonably
reflect the time value of money. If compensation is payable upon or
after the attainment of a performance goal, and a change is made to
defer the payment of compensation to a later date, any amount paid in
excess of the amount that was originally owed to the employee will not
be treated as an increase in the amount of compensation if the
additional amount is based either on a reasonable rate of interest or
on one or more predetermined actual investments (whether or not assets
associated with the amount originally owed are actually invested
therein) such that the amount payable by the employer at the later date
will be based on the actual rate of return of a specific investment
(including any decrease as well as any increase in the value of an
investment). If compensation is payable in the form of property, a
change in the timing of the transfer of that property after the
attainment of the goal will not be treated as an increase in the amount
of compensation for purposes of this paragraph (e)(2)(iii). Thus, for
example, if the terms of a stock grant provide for stock to be
transferred after the attainment of a performance goal and the transfer
of the stock also is subject to a vesting schedule, a change in the
vesting schedule that either accelerates or defers the transfer of
stock will not be treated as an increase in the amount of compensation
payable under the performance goal.
(C) Compensation attributable to a stock option, stock appreciation
right, or other stock-based compensation does not fail to satisfy the
requirements of this paragraph (e)(2) to the extent that a change in
the grant or award is made to reflect a change in corporate
capitalization, such as a stock split or dividend, or a corporate
transaction, such as any merger of a corporation into another
corporation, any consolidation of two or more corporations into another
corporation, any separation of a corporation (including a spinoff or
other distribution of stock or property by a corporation), any
reorganization of a corporation (whether or not such reorganization
comes within the definition of such term in section 368), or any
partial or complete liquidation by a corporation.
(iv) Grant-by-grant determination. The determination of whether
compensation satisfies the requirements of this paragraph (e)(2)
generally shall be made on a grant-by-grant basis. Thus, for example,
whether compensation attributable to a stock option grant satisfies the
requirements of this paragraph (e)(2) generally is determined on the
basis of the particular grant made and without regard to the terms of
any other option grant, or other grant of compensation, to the same or
another employee. As a further example, except as provided in paragraph
(e)(2)(vi), whether a grant of restricted stock or other stock-based
compensation satisfies the requirements of this paragraph (e)(2) is
determined without regard to whether dividends, dividend equivalents,
or other similar distributions with respect to stock, on such stock-
based compensation are payable prior to the attainment of the
performance goal. Dividends, dividend equivalents, or other similar
distributions with respect to stock that are treated as separate grants
under this paragraph (e)(2)(iv) are not performance-based compensation
unless they separately satisfy the requirements of this paragraph
(e)(2).
(v) Compensation contingent upon attainment of performance goal.
Compensation does not satisfy the requirements of this paragraph (e)(2)
if the facts and circumstances indicate that the employee would receive
all or part of the compensation regardless of whether the performance
goal is attained. Thus, if the payment of compensation under a grant or
award is only nominally or partially contingent on attaining a
performance goal, none of the compensation payable under the
[[Page 65540]]
grant or award will be considered performance-based. For example, if an
employee is entitled to a bonus under either of two arrangements, where
payment under a nonperformance-based arrangement is contingent upon the
failure to attain the performance goals under an otherwise performance-
based arrangement, then neither arrangement provides for compensation
that satisfies the requirements of this paragraph (e)(2). Compensation
does not fail to be qualified performance-based compensation merely
because the plan allows the compensation to be payable upon death,
disability, or change of ownership or control, although compensation
actually paid on account of those events prior to the attainment of the
performance goal would not satisfy the requirements of this paragraph
(e)(2). As an exception to the general rule set forth in the first
sentence of paragraph (e)(2)(iv) of this section, the facts-and-
circumstances determination referred to in the first sentence of this
paragraph (e)(2)(v) is made taking into account all plans,
arrangements, and agreements that provide for compensation to the
employee.
(vi) Application of requirements to stock options and stock
appreciation rights--(A) In general. Compensation attributable to a
stock option or a stock appreciation right is deemed to satisfy the
requirements of this paragraph (e)(2) if the grant or award is made by
the compensation committee; the plan under which the option or right is
granted states the maximum number of shares with respect to which
options or rights may be granted during a specified period to any
employee; and, under the terms of the option or right, the amount of
compensation the employee could receive is based solely on an increase
in the value of the stock after the date of the grant or award.
Conversely, if the amount of compensation the employee will receive
under the grant or award is not based solely on an increase in the
value of the stock after the date of grant or award (e.g., in the case
of restricted stock, or an option that is granted with an exercise
price that is less than the fair market value of the stock as of the
date of grant), none of the compensation attributable to the grant or
award is qualified performance-based compensation because it does not
satisfy the requirement of this paragraph (e)(2)(vi)(A). Whether a
stock option grant is based solely on an increase in the value of the
stock after the date of grant is determined without regard to any
dividend equivalent that may be payable, provided that payment of the
dividend equivalent is not made contingent on the exercise of the
option. The rule that the compensation attributable to a stock option
or stock appreciation right must be based solely on an increase in the
value of the stock after the date of grant or award does not apply if
the grant or award is made on account of, or if the vesting or
exercisability of the grant or award is contingent on, the attainment
of a performance goal that satisfies the requirements of this paragraph
(e)(2).
(B) Cancellation and repricing. Compensation attributable to a
stock option or stock appreciation right does not satisfy the
requirements of this paragraph (e)(2) to the extent that the number of
options granted exceeds the maximum number of shares for which options
may be granted to the employee as specified in the plan. If an option
is canceled, the canceled option continues to be counted against the
maximum number of shares for which options may be granted to the
employee under the plan. If, after grant, the exercise price of an
option is reduced, the transaction is treated as a cancellation of the
option and a grant of a new option. In such case, both the option that
is deemed to be canceled and the option that is deemed to be granted
reduce the maximum number of shares for which options may be granted to
the employee under the plan. This paragraph (e)(2)(vi)(B) also applies
in the case of a stock appreciation right where, after the award is
made, the base amount on which stock appreciation is calculated is
reduced to reflect a reduction in the fair market value of stock.
(vii) Examples. This paragraph (e)(2) may be illustrated by the
following examples:
Example 1. No later than 90 days after the start of a fiscal
year, but while the outcome is substantially uncertain, Corporation
S establishes a bonus plan under which A, the chief executive
officer, will receive a cash bonus of $500,000, if year-end
corporate sales are increased by at least 5 percent. The
compensation committee retains the right, if the performance goal is
met, to reduce the bonus payment to A if, in its judgment, other
subjective factors warrant a reduction. The bonus will meet the
requirements of this paragraph (e)(2).
Example 2. The facts are the same as in Example 1, except that
the bonus is based on a percentage of Corporation S's total sales
for the fiscal year. Because Corporation S is virtually certain to
have some sales for the fiscal year, the outcome of the performance
goal is not substantially uncertain, and therefore the bonus does
not meet the requirements of this paragraph (e)(2).
Example 3. The facts are the same as in Example 1, except that
the bonus is based on a percentage of Corporation S's total profits
for the fiscal year. Although some sales are virtually certain for
virtually all public companies, it is substantially uncertain
whether a company will have profits for a specified future period
even if the company has a history of profitability. Therefore, the
bonus will meet the requirements of this paragraph (e)(2).
Example 4. B is the general counsel of Corporation R, which is
engaged in patent litigation with Corporation S. Representatives of
Corporation S have informally indicated to Corporation R a
willingness to settle the litigation for $50,000,000. Subsequently,
the compensation committee of Corporation R agrees to pay B a bonus
if B obtains a formal settlement for at least $50,000,000. The bonus
to B does not meet the requirement of this paragraph (e)(2) because
the performance goal was not established at a time when the outcome
was substantially uncertain.
Example 5. Corporation S, a public utility, adopts a bonus plan
for selected salaried employees that will pay a bonus at the end of
a 3-year period of $750,000 each if, at the end of the 3 years, the
price of S stock has increased by 10 percent. The plan also provides
that the 10-percent goal will automatically adjust upward or
downward by the percentage change in a published utilities index.
Thus, for example, if the published utilities index shows a net
increase of 5 percent over a 3-year period, then the salaried
employees would receive a bonus only if Corporation S stock has
increased by 15 percent. Conversely, if the published utilities
index shows a net decrease of 5 percent over a 3-year period, then
the salaried employees would receive a bonus if Corporation S stock
has increased by 5 percent. Because these automatic adjustments in
the performance goal are preestablished, the bonus meets the
requirement of this paragraph (e)(2), notwithstanding the potential
changes in the performance goal.
Example 6. The facts are the same as in Example 5, except that
the bonus plan provides that, at the end of the 3-year period, a
bonus of $750,000 will be paid to each salaried employee if either
the price of Corporation S stock has increased by 10 percent or the
earnings per share on Corporation S stock have increased by 5
percent. If both the earnings-per-share goal and the stock-price
goal are preestablished, the compensation committee's discretion to
choose to pay a bonus under either of the two goals does not cause
any bonus paid under the plan to fail to meet the requirement of
this paragraph (e)(2) because each goal independently meets the
requirements of this paragraph (e)(2). The choice to pay under
either of the two goals is tantamount to the discretion to choose
not to pay under one of the goals, as provided in paragraph
(e)(2)(iii) of this section.
Example 7. Corporation U establishes a bonus plan under which a
specified class of employees will participate in a bonus pool if
certain preestablished performance goals are attained. The amount of
the bonus pool is determined under an objective formula. Under the
terms of the bonus plan, the compensation committee retains the
discretion to determine the fraction of the bonus pool that each
employee may receive.
[[Page 65541]]
The bonus plan does not satisfy the requirements of this paragraph
(e)(2). Although the aggregate amount of the bonus plan is
determined under an objective formula, a third party could not
determine the amount that any individual could receive under the
plan.
Example 8. The facts are the same as in Example 7, except that
the bonus plan provides that a specified share of the bonus pool is
payable to each employee, and the total of these shares does not
exceed 100% of the pool. The bonus plan satisfies the requirements
of this paragraph (e)(2). In addition, the bonus plan will satisfy
the requirements of this paragraph (e)(2) even if the compensation
committee retains the discretion to reduce the compensation payable
to any individual employee, provided that a reduction in the amount
of one employee's bonus does not result in an increase in the amount
of any other employee's bonus.
Example 9. Corporation V establishes a stock option plan for
salaried employees. The terms of the stock option plan specify that
no salaried employee shall receive options for more than 100,000
shares over any 3-year period. The compensation committee grants
options for 50,000 shares to each of several salaried employees. The
exercise price of each option is equal to or greater than the fair
market value at the time of each grant. Compensation attributable to
the exercise of the options satisfies the requirements of this
paragraph (e)(2). If, however, the terms of the options provide that
the exercise price is less than fair market value at the date of
grant, no compensation attributable to the exercise of those options
satisfies the requirements of this paragraph (e)(2) unless issuance
or exercise of the options was contingent upon the attainment of a
preestablished performance goal that satisfies this paragraph
(e)(2).
Example 10. The facts are the same as in Example 9, except that,
within the same 3-year grant period, the fair market value of
Corporation V stock is significantly less than the exercise price of
the options. The compensation committee reprices those options to
that lower current fair market value of Corporation V stock. The
repricing of the options for 50,000 shares held by each salaried
employee is treated as the grant of new options for an additional
50,000 shares to each employee. Thus, each of the salaried employees
is treated as having received grants for 100,000 shares.
Consequently, if any additional options are granted to those
employees during the 3-year period, compensation attributable to the
exercise of those additional options would not satisfy the
requirements of this paragraph (e)(2). The results would be the same
if the compensation committee canceled the outstanding options and
issued new options to the same employees that were exercisable at
the fair market value of Corporation V stock on the date of reissue.
Example 11. Corporation W maintains a plan under which each
participating employee may receive incentive stock options,
nonqualified stock options, stock appreciation rights, or grants of
restricted Corporation W stock. The plan specifies that each
participating employee may receive options, stock appreciation
rights, restricted stock, or any combination of each, for no more
than 20,000 shares over the life of the plan. The plan provides that
stock options may be granted with an exercise price of less than,
equal to, or greater than fair market value on the date of grant.
Options granted with an exercise price equal to, or greater than,
fair market value on the date of grant do not fail to meet the
requirements of this paragraph (e)(2) merely because the
compensation committee has the discretion to determine the types of
awards (i.e., options, rights, or restricted stock) to be granted to
each employee or the discretion to issue options or make other
compensation awards under the plan that would not meet the
requirements of this paragraph (e)(2). Whether an option granted
under the plan satisfies the requirements of this paragraph (e)(2)
is determined on the basis of the specific terms of the option and
without regard to other options or awards under the plan.
Example 12. Corporation X maintains a plan under which stock
appreciation rights may be awarded to key employees. The plan
permits the compensation committee to make awards under which the
amount of compensation payable to the employee is equal to the
increase in the stock price plus a percentage ``gross up'' intended
to offset the tax liability of the employee. In addition, the plan
permits the compensation committee to make awards under which the
amount of compensation payable to the employee is equal to the
increase in the stock price, based on the highest price, which is
defined as the highest price paid for Corporation X stock (or
offered in a tender offer or other arms-length offer) during the 90
days preceding exercise. Compensation attributable to awards under
the plan satisfies the requirements of paragraph (e)(2)(vi) of this
section, provided that the terms of the plan specify the maximum
number of shares for which awards may be made.
Example 13. Corporation W adopts a plan under which a bonus will
be paid to the CEO only if there is a 10% increase in earnings per
share during the performance period. The plan provides that earnings
per share will be calculated without regard to any change in
accounting standards that may be required by the Financial
Accounting Standards Board after the goal is established. After the
goal is established, such a change in accounting standards occurs.
Corporation W's reported earnings, for purposes of determining
earnings per share under the plan, are adjusted pursuant to this
plan provision to factor out this change in standards. This
adjustment will not be considered an exercise of impermissible
discretion because it is made pursuant to the plan provision.
Example 14. Corporation X adopts a performance-based incentive
pay plan with a four-year performance period. Bonuses under the plan
are scheduled to be paid in the first year after the end of the
performance period (year 5). However, in the second year of the
performance period, the compensation committee determines that any
bonuses payable in year 5 will instead, for bona fide business
reasons, be paid in year 10. The compensation committee also
determines that any compensation that would have been payable in
year 5 will be adjusted to reflect the delay in payment. The
adjustment will be based on the greater of the future rate of return
of a specified mutual fund that invests in blue chip stocks or of a
specified venture capital investment over the five-year deferral
period. Each of these investments, considered by itself, is a
predetermined actual investment because it is based on the future
rate of return of an actual investment. However, the adjustment in
this case is not based on predetermined actual investments within
the meaning of paragraph (e)(2)(iii)(B) of this section because the
amount payable by Corporation X in year 10 will be based on the
greater of the two investment returns and, thus, will not be based
on the actual rate of return on either specific investment.
Example 15. The facts are the same as in Example 14, except that
the increase will be based on Moody's Average Corporate Bond Yield
over the five-year deferral period. Because this index reflects a
reasonable rate of interest, the increase in the compensation
payable that is based on the index's rate of return is not
considered an impermissible increase in the amount of compensation
payable under the formula.
Example 16. The facts are the same as in Example 14, except that
the increase will be based on the rate of return for the Standard &
Poor's 500 Index. This index does not measure interest rates and
thus does not represent a reasonable rate of interest. In addition,
this index does not represent an actual investment. Therefore, any
additional compensation payable based on the rate of return of this
index will result in an impermissible increase in the amount payable
under the formula. If, in contrast, the increase were based on the
rate of return of an existing mutual fund that is invested in a
manner that seeks to approximate the Standard & Poor's 500 Index,
the increase would be based on a predetermined actual investment
within the meaning of paragraph (e)(2)(iii)(B) of this section and
thus would not result in an impermissible increase in the amount
payable under the formula.
(3) Outside directors--(i) General rule. The performance goal under
which compensation is paid must be established by a compensation
committee comprised solely of two or more outside directors. A director
is an outside director if the director--
(A) Is not a current employee of the publicly held corporation;
(B) Is not a former employee of the publicly held corporation who
receives compensation for prior services (other than benefits under a
tax-qualified retirement plan) during the taxable year;
(C) Has not been an officer of the publicly held corporation; and
(D) Does not receive remuneration from the publicly held
corporation, either directly or indirectly, in any capacity other than
as a director. For this purpose, remuneration includes any payment in
exchange for goods or services.
[[Page 65542]]
(ii) Remuneration received. For purposes of this paragraph (e)(3),
remuneration is received, directly or indirectly, by a director in each
of the following circumstances:
(A) If remuneration is paid, directly or indirectly, to the
director personally or to an entity in which the director has a
beneficial ownership interest of greater than 50 percent. For this
purpose, remuneration is considered paid when actually paid (and
throughout the remainder of that taxable year of the corporation) and,
if earlier, throughout the period when a contract or agreement to pay
remuneration is outstanding.
(B) If remuneration, other than de minimis remuneration, was paid
by the publicly held corporation in its preceding taxable year to an
entity in which the director has a beneficial ownership interest of at
least 5 percent but not more than 50 percent. For this purpose,
remuneration is considered paid when actually paid or, if earlier, when
the publicly held corporation becomes liable to pay it.
(C) If remuneration, other than de minimis remuneration, was paid
by the publicly held corporation in its preceding taxable year to an
entity by which the director is employed or self-employed other than as
a director. For this purpose, remuneration is considered paid when
actually paid or, if earlier, when the publicly held corporation
becomes liable to pay it.
(iii) De minimis remuneration--(A) In general. For purposes of
paragraphs (e)(3)(ii)(B) and (C) of this section, remuneration that was
paid by the publicly held corporation in its preceding taxable year to
an entity is de minimis if payments to the entity did not exceed 5
percent of the gross revenue of the entity for its taxable year ending
with or within that preceding taxable year of the publicly held
corporation.
(B) Remuneration for personal services and substantial owners.
Notwithstanding paragraph (e)(3)(iii)(A) of this section, remuneration
in excess of $60,000 is not de minimis if the remuneration is paid to
an entity described in paragraph (e)(3)(ii)(B) of this section, or is
paid for personal services to an entity described in paragraph
(e)(3)(ii)(C) of this section.
(iv) Remuneration for personal services. For purposes of paragraph
(e)(3)(iii)(B) of this section, remuneration from a publicly held
corporation is for personal services if--
(A) The remuneration is paid to an entity for personal or
professional services, consisting of legal, accounting, investment
banking, and management consulting services (and other similar services
that may be specified by the Commissioner in revenue rulings, notices,
or other guidance published in the Internal Revenue Bulletin),
performed for the publicly held corporation, and the remuneration is
not for services that are incidental to the purchase of goods or to the
purchase of services that are not personal services; and
(B) The director performs significant services (whether or not as
an employee) for the corporation, division, or similar organization
(within the entity) that actually provides the services described in
paragraph (e)(3)(iv)(A) of this section to the publicly held
corporation, or more than 50 percent of the entity's gross revenues
(for the entity's preceding taxable year) are derived from that
corporation, subsidiary, or similar organization.
(v) Entity defined. For purposes of this paragraph (e)(3), entity
means an organization that is a sole proprietorship, trust, estate,
partnership, or corporation. The term also includes an affiliated group
of corporations as defined in section 1504 (determined without regard
to section 1504(b)) and a group of organizations that would be an
affiliated group but for the fact that one or more of the organizations
are not incorporated. However, the aggregation rules referred to in the
preceding sentence do not apply for purposes of determining whether a
director has a beneficial ownership interest of at least 5 percent or
greater than 50 percent.
(vi) Employees and former officers. Whether a director is an
employee or a former officer is determined on the basis of the facts at
the time that the individual is serving as a director on the
compensation committee. Thus, a director is not precluded from being an
outside director solely because the director is a former officer of a
corporation that previously was an affiliated corporation of the
publicly held corporation. For example, a director of a parent
corporation of an affiliated group is not precluded from being an
outside director solely because that director is a former officer of an
affiliated subsidiary that was spun off or liquidated. However, an
outside director would no longer be an outside director if a
corporation in which the director was previously an officer became an
affiliated corporation of the publicly held corporation.
(vii) Officer. Solely for purposes of this paragraph (e)(3),
officer means an administrative executive who is or was in regular and
continued service. The term implies continuity of service and excludes
those employed for a special and single transaction. An individual who
merely has (or had) the title of officer but not the authority of an
officer is not considered an officer. The determination of whether an
individual is or was an officer is based on all of the facts and
circumstances in the particular case, including without limitation the
source of the individual's authority, the term for which the individual
is elected or appointed, and the nature and extent of the individual's
duties.
(viii) Members of affiliated groups. For purposes of this paragraph
(e)(3), the outside directors of the publicly held member of an
affiliated group are treated as the outside directors of all members of
the affiliated group.
(ix) Examples. This paragraph (e)(3) may be illustrated by the
following examples:
Example 1. Corporations X and Y are members of an affiliated
group of corporations as defined in section 1504, until July 1,
1994, when Y is sold to another group. Prior to the sale, A served
as an officer of Corporation Y. After July 1, 1994, A is not treated
as a former officer of Corporation X by reason of having been an
officer of Y.
Example 2. Corporation Z, a calendar-year taxpayer, uses the
services of a law firm by which B is employed, but in which B has a
less-than-5-percent ownership interest. The law firm reports income
on a July 1 to June 30 basis. Corporation Z appoints B to serve on
its compensation committee for calendar year 1998 after determining
that, in calendar year 1997, it did not become liable to the law
firm for remuneration exceeding the lesser of $60,000 or five
percent of the law firm's gross revenue (calculated for the year
ending June 30, 1997). On October 1, 1998, Corporation Z becomes
liable to pay remuneration of $50,000 to the law firm on June 30,
1999. For the year ending June 30, 1998, the law firm's gross
revenue was less than $1 million. Thus, in calendar year 1999, B is
not an outside director. However, B may satisfy the requirements for
an outside director in calendar year 2000, if, in calendar year
1999, Corporation Z does not become liable to the law firm for
additional remuneration. This is because the remuneration actually
paid on June 30, 1999 was considered paid on October 1, 1998 under
paragraph (e)(3)(ii)(C) of this section.
Example 3. Corporation Z, a publicly held corporation, purchases
goods from Corporation A. D, an executive and less- than-5-percent
owner of Corporation A, sits on the board of directors of
Corporation Z and on its compensation committee. For 1997,
Corporation Z obtains representations to the effect that D is not
eligible for any commission for D's sales to Corporation Z and that,
for purposes of determining D's compensation for 1997, Corporation
A's sales to Corporation Z are not otherwise treated differently
than sales to other customers of Corporation A (including its
affiliates, if any) or are irrelevant. In addition, Corporation Z
has no reason to believe that these representations are inaccurate
or that it is otherwise paying remuneration indirectly to D
personally. Thus, in 1997, no remuneration
[[Page 65543]]
is considered paid by Corporation Z indirectly to D personally under
paragraph (e)(3)(ii)(A) of this section.
Example 4. (i) Corporation W, a publicly held corporation,
purchases goods from Corporation T. C, an executive and less- than-
5-percent owner of Corporation T, sits on the board of directors of
Corporation W and on its compensation committee. Corporation T
develops a new product and agrees on January 1, 1998 to pay C a
bonus of $500,000 if Corporation W contracts to purchase the
product. Even if Corporation W purchases the new product, sales to
Corporation W will represent less than 5 percent of Corporation T's
gross revenues. In 1999, Corporation W contracts to purchase the new
product and, in 2000, C receives the $500,000 bonus from Corporation
T. In 1998, 1999, and 2000, Corporation W does not obtain any
representations relating to indirect remuneration to C personally
(such as the representations described in Example 3).
(ii) Thus, in 1998, 1999, and 2000, remuneration is considered
paid by Corporation W indirectly to C personally under paragraph
(e)(3)(ii)(A) of this section. Accordingly, in 1998, 1999, and 2000,
C is not an outside director of Corporation W. The result would have
been the same if Corporation W had obtained appropriate
representations but nevertheless had reason to believe that it was
paying remuneration indirectly to C personally.
Example 5. Corporation R, a publicly held corporation, purchases
utility service from Corporation Q, a public utility. The chief
executive officer, and less-than-5-percent owner, of Corporation Q
is a director of Corporation R. Corporation R pays Corporation Q
more than $60,000 per year for the utility service, but less than 5
percent of Corporation Q's gross revenues. Because utility services
are not personal services, the fees paid are not subject to the
$60,000 de minimis rule for remuneration for personal services
within the meaning of paragraph (e)(3)(iii)(B) of this section.
Thus, the chief executive officer qualifies as an outside director
of Corporation R, unless disqualified on some other basis.
Example 6. Corporation A, a publicly held corporation, purchases
management consulting services from Division S of Conglomerate P.
The chief financial officer of Division S is a director of
Corporation A. Corporation A pays more than $60,000 per year for the
management consulting services, but less than 5 percent of
Conglomerate P's gross revenues. Because management consulting
services are personal services within the meaning of paragraph
(e)(3)(iv)(A) of this section, and the chief financial officer
performs significant services for Division S, the fees paid are
subject to the $60,000 de minimis rule as remuneration for personal
services. Thus, the chief financial officer does not qualify as an
outside director of Corporation A.
Example 7. The facts are the same as in Example 6, except that
the chief executive officer, and less-than-5-percent owner, of the
parent company of Conglomerate P is a director of Corporation A and
does not perform significant services for Division S. If the gross
revenues of Division S do not constitute more than 50 percent of the
gross revenues of Conglomerate P for P's preceding taxable year, the
chief executive officer will qualify as an outside director of
Corporation A, unless disqualified on some other basis.
(4) Shareholder approval requirement--(i) General rule. The
material terms of the performance goal under which the compensation is
to be paid must be disclosed to and subsequently approved by the
shareholders of the publicly held corporation before the compensation
is paid. The requirements of this paragraph (e)(4) are not satisfied if
the compensation would be paid regardless of whether the material terms
are approved by shareholders. The material terms include the employees
eligible to receive compensation; a description of the business
criteria on which the performance goal is based; and either the maximum
amount of compensation that could be paid to any employee or the
formula used to calculate the amount of compensation to be paid to the
employee if the performance goal is attained (except that, in the case
of a formula that fails to preclude discretion to increase the amount
of compensation (as described in paragraph (e)(2)(iii)(A) of this
section) merely because the amount of compensation to be paid is based,
in whole or in part, on a percentage of salary or base pay and the
dollar amount of the salary or base pay is not fixed at the time the
performance goal is established, the maximum dollar amount of
compensation that could be paid to the employee must be disclosed).
(ii) Eligible employees. Disclosure of the employees eligible to
receive compensation need not be so specific as to identify the
particular individuals by name. A general description of the class of
eligible employees by title or class is sufficient, such as the chief
executive officer and vice presidents, or all salaried employees, all
executive officers, or all key employees.
(iii) Description of business criteria--(A) In general. Disclosure
of the business criteria on which the performance goal is based need
not include the specific targets that must be satisfied under the
performance goal. For example, if a bonus plan provides that a bonus
will be paid if earnings per share increase by 10 percent, the 10-
percent figure is a target that need not be disclosed to shareholders.
However, in that case, disclosure must be made that the bonus plan is
based on an earnings-per-share business criterion. In the case of a
plan under which employees may be granted stock options or stock
appreciation rights, no specific description of the business criteria
is required if the grants or awards are based on a stock price that is
no less than current fair market value.
(B) Disclosure of confidential information. The requirements of
this paragraph (e)(4) may be satisfied even though information that
otherwise would be a material term of a performance goal is not
disclosed to shareholders, provided that the compensation committee
determines that the information is confidential commercial or business
information, the disclosure of which would have an adverse effect on
the publicly held corporation. Whether disclosure would adversely
affect the corporation is determined on the basis of the facts and
circumstances. If the compensation committee makes such a
determination, the disclosure to shareholders must state the
compensation committee's belief that the information is confidential
commercial or business information, the disclosure of which would
adversely affect the company. In addition, the ability not to disclose
confidential information does not eliminate the requirement that
disclosure be made of the maximum amount of compensation that is
payable to an individual under a performance goal. Confidential
information does not include the identity of an executive or the class
of executives to which a performance goal applies or the amount of
compensation that is payable if the goal is satisfied.
(iv) Description of compensation. Disclosure as to the compensation
payable under a performance goal must be specific enough so that
shareholders can determine the maximum amount of compensation that
could be paid to any employee during a specified period. If the terms
of the performance goal do not provide for a maximum dollar amount, the
disclosure must include the formula under which the compensation would
be calculated. Thus, for example, if compensation attributable to the
exercise of stock options is equal to the difference in the exercise
price and the current value of the stock, disclosure would be required
of the maximum number of shares for which grants may be made to any
employee and the exercise price of those options (e.g., fair market
value on date of grant). In that case, shareholders could calculate the
maximum amount of compensation that would be attributable to the
exercise of options on the basis of their assumptions as to the future
stock price.
(v) Disclosure requirements of the Securities and Exchange
Commission. To the extent not otherwise specifically provided in this
paragraph (e)(4), whether the material terms of a
[[Page 65544]]
performance goal are adequately disclosed to shareholders is determined
under the same standards as apply under the Exchange Act.
(vi) Frequency of disclosure. Once the material terms of a
performance goal are disclosed to and approved by shareholders, no
additional disclosure or approval is required unless the compensation
committee changes the material terms of the performance goal. If,
however, the compensation committee has authority to change the targets
under a performance goal after shareholder approval of the goal,
material terms of the performance goal must be disclosed to and
reapproved by shareholders no later than the first shareholder meeting
that occurs in the fifth year following the year in which shareholders
previously approved the performance goal.
(vii) Shareholder vote. For purposes of this paragraph (e)(4), the
material terms of a performance goal are approved by shareholders if,
in a separate vote, a majority of the votes cast on the issue
(including abstentions to the extent abstentions are counted as voting
under applicable state law) are cast in favor of approval.
(viii) Members of affiliated group. For purposes of this paragraph
(e)(4), the shareholders of the publicly held member of the affiliated
group are treated as the shareholders of all members of the affiliated
group.
(ix) Examples. This paragraph (e)(4) may be illustrated by the
following examples:
Example 1. Corporation X adopts a plan that will pay a specified
class of its executives an annual cash bonus based on the overall
increase in corporate sales during the year. Under the terms of the
plan, the cash bonus of each executive equals $100,000 multiplied by
the number of percentage points by which sales increase in the
current year when compared to the prior year. Corporation X
discloses to its shareholders prior to the vote both the class of
executives eligible to receive awards and the annual formula of
$100,000 multiplied by the percentage increase in sales. This
disclosure meets the requirements of this paragraph (e)(4). Because
the compensation committee does not have the authority to establish
a different target under the plan, Corporation X need not redisclose
to its shareholders and obtain their reapproval of the material
terms of the plan until those material terms are changed.
Example 2. The facts are the same as in Example 1 except that
Corporation X discloses only that bonuses will be paid on the basis
of the annual increase in sales. This disclosure does not meet the
requirements of this paragraph (e)(4) because it does not include
the formula for calculating the compensation or a maximum amount of
compensation to be paid if the performance goal is satisfied.
Example 3. Corporation Y adopts an incentive compensation plan
in 1995 that will pay a specified class of its executives a bonus
every 3 years based on the following 3 factors: increases in
earnings per share, reduction in costs for specified divisions, and
increases in sales by specified divisions. The bonus is payable in
cash or in Corporation Y stock, at the option of the executive.
Under the terms of the plan, prior to the beginning of each 3-year
period, the compensation committee determines the specific targets
under each of the three factors (i.e., the amount of the increase in
earnings per share, the reduction in costs, and the amount of sales)
that must be met in order for the executives to receive a bonus.
Under the terms of the plan, the compensation committee retains the
discretion to determine whether a bonus will be paid under any one
of the goals. The terms of the plan also specify that no executive
may receive a bonus in excess of $1,500,000 for any 3-year period.
To satisfy the requirements of this paragraph (e)(4), Corporation Y
obtains shareholder approval of the plan at its 1995 annual
shareholder meeting. In the proxy statement issued to shareholders,
Corporation Y need not disclose to shareholders the specific targets
that are set by the compensation committee. However, Corporation Y
must disclose that bonuses are paid on the basis of earnings per
share, reductions in costs, and increases in sales of specified
divisions. Corporation Y also must disclose the maximum amount of
compensation that any executive may receive under the plan is
$1,500,000 per 3-year period. Unless changes in the material terms
of the plan are made earlier, Corporation Y need not disclose the
material terms of the plan to the shareholders and obtain their
reapproval until the first shareholders' meeting held in 2000.
Example 4. The same facts as in Example 3, except that prior to
the beginning of the second 3-year period, the compensation
committee determines that different targets will be set under the
plan for that period with regard to all three of the performance
criteria (i.e., earnings per share, reductions in costs, and
increases in sales). In addition, the compensation committee raises
the maximum dollar amount that can be paid under the plan for a 3-
year period to $2,000,000. The increase in the maximum dollar amount
of compensation under the plan is a changed material term. Thus, to
satisfy the requirements of this paragraph (e)(4), Corporation Y
must disclose to and obtain approval by the shareholders of the plan
as amended.
Example 5. In 1998, Corporation Z establishes a plan under which
a specified group of executives will receive a cash bonus not to
exceed $750,000 each if a new product that has been in development
is completed and ready for sale to customers by January 1, 2000.
Although the completion of the new product is a material term of the
performance goal under this paragraph (e)(4), the compensation
committee determines that the disclosure to shareholders of the
performance goal would adversely affect Corporation Z because its
competitors would be made aware of the existence and timing of its
new product. In this case, the requirements of this paragraph (e)(4)
are satisfied if all other material terms, including the maximum
amount of compensation, are disclosed and the disclosure
affirmatively states that the terms of the performance goal are not
being disclosed because the compensation committee has determined
that those terms include confidential information, the disclosure of
which would adversely affect Corporation Z.
(5) Compensation committee certification. The compensation
committee must certify in writing prior to payment of the compensation
that the performance goals and any other material terms were in fact
satisfied. For this purpose, approved minutes of the compensation
committee meeting in which the certification is made are treated as a
written certification. Certification by the compensation committee is
not required for compensation that is attributable solely to the
increase in the stock of the publicly held corporation.
(f) Companies that become publicly held, spinoffs, and similar
transactions--(1) In general. In the case of a corporation that was not
a publicly held corporation and then becomes a publicly held
corporation, the deduction limit of paragraph (b) of this section does
not apply to any remuneration paid pursuant to a compensation plan or
agreement that existed during the period in which the corporation was
not publicly held. However, in the case of such a corporation that
becomes publicly held in connection with an initial public offering,
this relief applies only to the extent that the prospectus accompanying
the initial public offering disclosed information concerning those
plans or agreements that satisfied all applicable securities laws then
in effect. In accordance with paragraph (c)(1)(ii) of this section, a
corporation that is a member of an affiliated group that includes a
publicly held corporation is considered publicly held and, therefore,
cannot rely on this paragraph (f)(1).
(2) Reliance period. Paragraph (f)(1) of this section may be relied
upon until the earliest of--
(i) The expiration of the plan or agreement;
(ii) The material modification of the plan or agreement, within the
meaning of paragraph (h)(1)(iii) of this section;
(iii) The issuance of all employer stock and other compensation
that has been allocated under the plan; or
(iv) The first meeting of shareholders at which directors are to be
elected that occurs after the close of the third calendar year
following the calendar year in which the initial public offering
[[Page 65545]]
occurs or, in the case of a privately held corporation that becomes
publicly held without an initial public offering, the first calendar
year following the calendar year in which the corporation becomes
publicly held.
(3) Stock-based compensation. Paragraph (f)(1) of this section will
apply to any compensation received pursuant to the exercise of a stock
option or stock appreciation right, or the substantial vesting of
restricted property, granted under a plan or agreement described in
paragraph (f)(1) of this section if the grant occurs on or before the
earliest of the events specified in paragraph (f)(2) of this section.
(4) Subsidiaries that become separate publicly held corporations--
(i) In general. If a subsidiary that is a member of the affiliated
group described in paragraph (c)(1)(ii) of this section becomes a
separate publicly held corporation (whether by spinoff or otherwise),
any remuneration paid to covered employees of the new publicly held
corporation will satisfy the exception for performance-based
compensation described in paragraph (e) of this section if the
conditions in either paragraph (f)(4)(ii) or (f)(4)(iii) of this
section are satisfied.
(ii) Prior establishment and approval. Remuneration satisfies the
requirements of this paragraph (f)(4)(ii) if the remuneration satisfies
the requirements for performance-based compensation set forth in
paragraphs (e)(2), (e)(3), and (e)(4) of this section (by application
of paragraphs (e)(3)(viii) and (e)(4)(viii) of this section) before the
corporation becomes a separate publicly held corporation, and the
certification required by paragraph (e)(5) of this section is made by
the compensation committee of the new publicly held corporation (but if
the performance goals are attained before the corporation becomes a
separate publicly held corporation, the certification may be made by
the compensation committee referred to in paragraph (e)(3)(viii) of
this section before it becomes a separate publicly held corporation).
Thus, this paragraph (f)(4)(ii) requires that the outside directors and
shareholders (within the meaning of paragraphs (e)(3)(viii) and
(e)(4)(viii) of this section) of the corporation before it becomes a
separate publicly held corporation establish and approve, respectively,
the performance-based compensation for the covered employees of the new
publicly held corporation in accordance with paragraphs (e)(3) and
(e)(4) of this section.
(iii) Transition period. Remuneration satisfies the requirements of
this paragraph (f)(4)(iii) if the remuneration satisfies all of the
requirements of paragraphs (e)(2), (e)(3), and (e)(5) of this section.
The outside directors (within the meaning of paragraph (e)(3)(viii) of
this section) of the corporation before it becomes a separate publicly
held corporation, or the outside directors of the new publicly held
corporation, may establish and administer the performance goals for the
covered employees of the new publicly held corporation for purposes of
satisfying the requirements of paragraphs (e)(2) and (e)(3) of this
section. The certification required by paragraph (e)(5) of this section
must be made by the compensation committee of the new publicly held
corporation. However, a taxpayer may rely on this paragraph (f)(4)(iii)
to satisfy the requirements of paragraph (e) of this section only for
compensation paid, or stock options, stock appreciation rights, or
restricted property granted, prior to the first regularly scheduled
meeting of the shareholders of the new publicly held corporation that
occurs more than 12 months after the date the corporation becomes a
separate publicly held corporation. Compensation paid, or stock
options, stock appreciation rights, or restricted property granted, on
or after the date of that meeting of shareholders must satisfy all
requirements of paragraph (e) of this section, including the
shareholder approval requirement of paragraph (e)(4) of this section,
in order to satisfy the requirements for performance-based
compensation.
(5) Example. The following example illustrates the application of
paragraph (f)(4)(ii) of this section:
Example. Corporation P, which is publicly held, decides to spin
off Corporation S, a wholly owned subsidiary of Corporation P. After
the spinoff, Corporation S will be a separate publicly held
corporation. Before the spinoff, the compensation committee of
Corporation P, pursuant to paragraph (e)(3)(viii) of this section,
establishes a bonus plan for the executives of Corporation S that
provides for bonuses payable after the spinoff and that satisfies
the requirements of paragraph (e)(2) of this section. If, pursuant
to paragraph (e)(4)(viii) of this section, the shareholders of
Corporation P approve the plan prior to the spinoff, that approval
will satisfy the requirements of paragraph (e)(4) of this section
with respect to compensation paid pursuant to the bonus plan after
the spinoff. However, the compensation committee of Corporation S
will be required to certify that the goals are satisfied prior to
the payment of the bonuses in order for the bonuses to be considered
performance-based compensation.
(g) Coordination with disallowed excess parachute payments. The
$1,000,000 limitation in paragraph (b) of this section is reduced (but
not below zero) by the amount (if any) that would have been included in
the compensation of the covered employee for the taxable year but for
being disallowed by reason of section 280G. For example, assume that
during a taxable year a corporation pays $1,500,000 to a covered
employee and no portion satisfies the exception in paragraph (d) of
this section for commissions or paragraph (e) of this section for
qualified performance-based compensation. Of the $1,500,000, $600,000
is an excess parachute payment, as defined in section 280G(b)(1) and is
disallowed by reason of that section. Because the excess parachute
payment reduces the limitation of paragraph (b) of this section, the
corporation can deduct $400,000, and $500,000 of the otherwise
deductible amount is nondeductible by reason of section 162(m).
(h) Transition rules--(1) Compensation payable under a written
binding contract which was in effect on February 17, 1993--(i) General
rule. The deduction limit of paragraph (b) of this section does not
apply to any compensation payable under a written binding contract that
was in effect on February 17, 1993. The preceding sentence does not
apply unless, under applicable state law, the corporation is obligated
to pay the compensation if the employee performs services. However, the
deduction limit of paragraph (b) of this section does apply to a
contract that is renewed after February 17, 1993. A written binding
contract that is terminable or cancelable by the corporation after
February 17, 1993, without the employee's consent is treated as a new
contract as of the date that any such termination or cancellation, if
made, would be effective. Thus, for example, if the terms of a contract
provide that it will be automatically renewed as of a certain date
unless either the corporation or the employee gives notice of
termination of the contract at least 30 days before that date, the
contract is treated as a new contract as of the date that termination
would be effective if that notice were given. Similarly, for example,
if the terms of a contract provide that the contract will be terminated
or canceled as of a certain date unless either the corporation or the
employee elects to renew within 30 days of that date, the contract is
treated as renewed by the corporation as of that date. Alternatively,
if the corporation will remain legally obligated by the terms of a
contract beyond a certain date at the sole discretion of the employee,
the
[[Page 65546]]
contract will not be treated as a new contract as of that date if the
employee exercises the discretion to keep the corporation bound to the
contract. A contract is not treated as terminable or cancelable if it
can be terminated or canceled only by terminating the employment
relationship of the employee.
(ii) Compensation payable under a plan or arrangement. If a
compensation plan or arrangement meets the requirements of paragraph
(h)(1)(i) of this section, the compensation paid to an employee
pursuant to the plan or arrangement will not be subject to the
deduction limit of paragraph (b) of this section even though the
employee was not eligible to participate in the plan as of February 17,
1993. However, the preceding sentence does not apply unless the
employee was employed on February 17, 1993, by the corporation that
maintained the plan or arrangement, or the employee had the right to
participate in the plan or arrangement under a written binding contract
as of that date.
(iii) Material modifications.
(A) Paragraph (h)(1)(i) of this section will not apply to any
written binding contract that is materially modified. A material
modification occurs when the contract is amended to increase the amount
of compensation payable to the employee. If a binding written contract
is materially modified, it is treated as a new contract entered into as
of the date of the material modification. Thus, amounts received by an
employee under the contract prior to a material modification are not
affected, but amounts received subsequent to the material modification
are not treated as paid under a binding, written contract described in
paragraph (h)(1)(i) of this section.
(B) A modification of the contract that accelerates the payment of
compensation will be treated as a material modification unless the
amount of compensation paid is discounted to reasonably reflect the
time value of money. If the contract is modified to defer the payment
of compensation, any compensation paid in excess of the amount that was
originally payable to the employee under the contract will not be
treated as a material modification if the additional amount is based on
either a reasonable rate of interest or one or more predetermined
actual investments (whether or not assets associated with the amount
originally owed are actually invested therein) such that the amount
payable by the employer at the later date will be based on the actual
rate of return of the specific investment (including any decrease as
well as any increase in the value of the investment).
(C) The adoption of a supplemental contract or agreement that
provides for increased compensation, or the payment of additional
compensation, is a material modification of a binding, written contract
where the facts and circumstances show that the additional compensation
is paid on the basis of substantially the same elements or conditions
as the compensation that is otherwise paid under the written binding
contract. However, a material modification of a written binding
contract does not include a supplemental payment that is equal to or
less than a reasonable cost-of-living increase over the payment made in
the preceding year under that written binding contract. In addition, a
supplemental payment of compensation that satisfies the requirements of
qualified performance-based compensation in paragraph (e) of this
section will not be treated as a material modification.
(iv) Examples. The following examples illustrate the exception of
this paragraph (h)(1):
Example 1. Corporation X executed a 3-year compensation
arrangement with C on February 15, 1993, that constitutes a written
binding contract under applicable state law. The terms of the
arrangement provide for automatic extension after the 3-year term
for additional 1-year periods, unless the corporation exercises its
option to terminate the arrangement within 30 days of the end of the
3-year term or, thereafter, within 30 days before each anniversary
date. Termination of the compensation arrangement does not require
the termination of C's employment relationship with Corporation X.
Unless terminated, the arrangement is treated as renewed on February
15, 1996, and the deduction limit of paragraph (b) of this section
applies to payments under the arrangement after that date.
Example 2. Corporation Y executed a 5-year employment agreement
with B on January 1, 1992, providing for a salary of $900,000 per
year. Assume that this agreement constitutes a written binding
contract under applicable state law. In 1992 and 1993, B receives
the salary of $900,000 per year. In 1994, Corporation Y increases
B's salary with a payment of $20,000. The $20,000 supplemental
payment does not constitute a material modification of the written
binding contract because the $20,000 payment is less than or equal
to a reasonable cost-of-living increase from 1993. However, the
$20,000 supplemental payment is subject to the limitation in
paragraph (b) of this section. On January 1, 1995, Corporation Y
increases B's salary to $1,200,000. The $280,000 supplemental
payment is a material modification of the written binding contract
because the additional compensation is paid on the basis of
substantially the same elements or conditions as the compensation
that is otherwise paid under the written binding contract and it is
greater than a reasonable, annual cost-of-living increase. Because
the written binding contract is materially modified as of January 1,
1995, all compensation paid to B in 1995 and thereafter is subject
to the deduction limitation of section 162(m).
Example 3. Assume the same facts as in Example 2, except that
instead of an increase in salary, B receives a restricted stock
grant subject to B's continued employment for the balance of the
contract. The restricted stock grant is not a material modification
of the binding written contract because any additional compensation
paid to B under the grant is not paid on the basis of substantially
the same elements and conditions as B's salary because it is based
both on the stock price and B's continued service. However,
compensation attributable to the restricted stock grant is subject
to the deduction limitation of section 162(m).
(2) Special transition rule for outside directors. A director who
is a disinterested director is treated as satisfying the requirements
of an outside director under paragraph (e)(3) of this section until the
first meeting of shareholders at which directors are to be elected that
occurs on or after January 1, 1996. For purposes of this paragraph
(h)(2) and paragraph (h)(3) of this section, a director is a
disinterested director if the director is disinterested within the
meaning of Rule 16b-3(c)(2)(i), 17 CFR 240.16b-3(c)(2)(i), under the
Exchange Act (including the provisions of Rule 16b-3(d)(3), as in
effect on April 30, 1991).
(3) Special transition rule for previously-approved plans--(i) In
general. Any compensation paid under a plan or agreement approved by
shareholders before December 20, 1993, is treated as satisfying the
requirements of paragraphs (e)(3) and (e)(4) of this section, provided
that the directors administering the plan or agreement are
disinterested directors and the plan was approved by shareholders in a
manner consistent with Rule 16b-3(b), 17 CFR 240.16b-3(b), under the
Exchange Act or Rule 16b-3(a), 17 CFR 240.16b-3(a) (as contained in 17
CFR part 240 revised April 1, 1990). In addition, for purposes of
satisfying the requirements of paragraph (e)(2)(vi) of this section, a
plan or agreement is treated as stating a maximum number of shares with
respect to which an option or right may be granted to any employee if
the plan or agreement that was approved by the shareholders provided
for an aggregate limit, consistent with Rule 16b-3(b), 17 CFR 250.16b-
3(b), on the shares of employer stock with respect to which awards may
be made under the plan or agreement.
(ii) Reliance period. The transition rule provided in this
paragraph (h)(3)
[[Page 65547]]
shall continue and may be relied upon until the earliest of--
(A) The expiration or material modification of the plan or
agreement;
(B) The issuance of all employer stock and other compensation that
has been allocated under the plan; or
(C) The first meeting of shareholders at which directors are to be
elected that occurs after December 31, 1996.
(iii) Stock-based compensation. This paragraph (h)(3) will apply to
any compensation received pursuant to the exercise of a stock option or
stock appreciation right, or the substantial vesting of restricted
property, granted under a plan or agreement described in paragraph
(h)(3)(i) of this section if the grant occurs on or before the earliest
of the events specified in paragraph (h)(3)(ii) of this section.
(iv) Example. The following example illustrates the application of
this paragraph (h)(3):
Example. Corporation Z adopted a stock option plan in 1991.
Pursuant to Rule 16b-3 under the Exchange Act, the stock option plan
has been administered by disinterested directors and was approved by
Corporation Z shareholders. Under the terms of the plan, shareholder
approval is not required again until 2001. In addition, the terms of
the stock option plan include an aggregate limit on the number of
shares available under the plan. Option grants under the Corporation
Z plan are made with an exercise price equal to or greater than the
fair market value of Corporation Z stock. Compensation attributable
to the exercise of options that are granted under the plan before
the earliest of the dates specified in paragraph (h)(3)(ii) of this
section will be treated as satisfying the requirements of paragraph
(e) of this section for qualified performance-based compensation,
regardless of when the options are exercised.
(i) (Reserved)
(j) Effective date--(1) In general. Section 162(m) and this section
apply to compensation that is otherwise deductible by the corporation
in a taxable year beginning on or after January 1, 1994.
(2) Delayed effective date for certain provisions--(i) Date on
which remuneration is considered paid. Notwithstanding paragraph (j)(1)
of this section, the rules in the second sentence of each of paragraphs
(e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of this section for
determining the date or dates on which remuneration is considered paid
to a director are effective for taxable years beginning on or after
January 1, 1995. Prior to those taxable years, taxpayers must follow
the rules in paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C)
of this section or another reasonable, good faith interpretation of
section 162(m) with respect to the date or dates on which remuneration
is considered paid to a director.
(ii) Separate treatment of publicly held subsidiaries.
Notwithstanding paragraph (j)(1) of this section, the rule in paragraph
(c)(1)(ii) of this section that treats publicly held subsidiaries as
separately subject to section 162(m) is effective as of the first
regularly scheduled meeting of the shareholders of the publicly held
subsidiary that occurs more than 12 months after December 2, 1994. The
rule for stock-based compensation set forth in paragraph (f)(3) of this
section will apply for this purpose, except that the grant must occur
before the shareholder meeting specified in this paragraph (j)(2)(ii).
Taxpayers may choose to rely on the rule referred to in the first
sentence of this paragraph (j)(2)(ii) for the period prior to the
effective date of the rule.
(iii) Subsidiaries that become separate publicly held corporations.
Notwithstanding paragraph (j)(1) of this section, if a subsidiary of a
publicly held corporation becomes a separate publicly held corporation
as described in paragraph (f)(4)(i) of this section, then, for the
duration of the reliance period described in paragraph (f)(2) of this
section, the rules of paragraph (f)(1) of this section are treated as
applying (and the rules of paragraph (f)(4) of this section do not
apply) to remuneration paid to covered employees of that new publicly
held corporation pursuant to a plan or agreement that existed prior to
December 2, 1994, provided that the treatment of that remuneration as
performance-based is in accordance with a reasonable, good faith
interpretation of section 162(m). However, if remuneration is paid to
covered employees of that new publicly held corporation pursuant to a
plan or agreement that existed prior to December 2, 1994, but that
remuneration is not performance-based under a reasonable, good faith
interpretation of section 162(m), the rules of paragraph (f)(1) of this
section will be treated as applying only until the first regularly
scheduled meeting of shareholders that occurs more than 12 months after
December 2, 1994. The rules of paragraph (f)(4) of this section will
apply as of that first regularly scheduled meeting. The rule for stock-
based compensation set forth in paragraph (f)(3) of this section will
apply for purposes of this paragraph (j)(2)(iii), except that the grant
must occur before the shareholder meeting specified in the preceding
sentence if the remuneration is not performance-based under a
reasonable, good faith interpretation of section 162(m). Taxpayers may
choose to rely on the rules of paragraph (f)(4) of this section for the
period prior to the applicable effective date referred to in the first
or second sentence of this paragraph (j)(2)(iii).
(iv) Bonus pools. Notwithstanding paragraph (j)(1) of this section,
the rules in paragraph (e)(2)(iii)(A) that limit the sum of individual
percentages of a bonus pool to 100 percent will not apply to
remuneration paid before January 1, 2001, based on performance in any
performance period that began prior to December 20, 1995.
(v) Compensation based on a percentage of salary or base pay.
Notwithstanding paragraph (j)(1) of this section, the requirement in
paragraph (e)(4)(i) of this section that, in the case of certain
formulas based on a percentage of salary or base pay, a corporation
disclose to shareholders the maximum dollar amount of compensation that
could be paid to the employee, will apply only to plans approved by
shareholders after April 30, 1995.
PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT
Par. 3. The authority citation for part 602 continues to read as
follows:
Authority: 26 U.S.C. 7805.
Sec. 602.101 [Amended]
Par. 4. In Sec. 602.101, paragraph (c) is amended by adding the
entry ``1.162-27. . . . 1545-1466'' in numerical order to the table.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
Approved: December 12, 1995.
Leslie Samuels,
Assistant Secretary of the Treasury.
[FR Doc. 95-30869 Filed 12-19-95; 8:45 am]
BILLING CODE 4830-01-U
