Should Shareholders Re-approve Performance Goals at the Upcoming Annual Meeting?

As publicly held companies prepare for their annual meetings, consideration should be given to whether or not performance goals within certain incentive compensation arrangements should be re-approved by their shareholders.  This is a worthwhile endeavor because failure to comply with Section 162(m) of the Internal Revenue Code of 1986, as amended, could result in a loss of deduction associated with certain executive officer pay.

As background, Section 162(m) generally provides that compensation paid by a public company to a covered employee is not deductible to the extent it exceeds $1,000,000 ("$1mm"); however, an exemption to the $1mm limit applies for performance-based compensation that satisfies certain conditions (the "Exemption").  One such condition is that the material terms of the performance goals must be disclosed and approved by the company's shareholders before the underlying compensation is paid.

However, if the compensation committee has the authority to change the targets under a performance goal after shareholders approved the goals (which is often the case), then ". . . the 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."  See Treas. Reg. 1.162-27(e)(4)(vi).  In other words, approximately every five years the shareholders would have to re-approve the performance goals in order for the Exemption to apply (i.e., to protect the deductibility of compensation paid to covered employees that exceeds $1mm).  

Shareholder approved performance goals are typically contained within equity incentive plans, long-term incentive plans (LTIPs), annual bonus programs/plans, and in rare instances, employment agreements.  So don't forget to at least consider the issue! 

Deductibility of Executive Compensation: Amendments Required Due to Revenue Ruling 2008-13

Compensation committee members (and the officers of the companies to which they serve) generally put forth a lot of effort to ensure compensation paid to their covered employees are deductible under Section 162(m) of the Internal Revenue Code of 1986, as amended.  The purpose of this blog entry is to highlight that certain compensation arrangements may need to be amended prior to January 1, 2010 to comply with Revenue Ruling 2008-13 (PDF).

As background, Section 162(m) generally provides that compensation paid by a public company to a covered employee is not deductible to the extent it exceeds $1,000,000 ("$1mm"); however, an exemption to the $1mm limit applies for performance-based compensation that satisfies certain conditions (the "Exemption").

To highlight the application of the Exemption, consider a simple example: In a given year assume a public company pays one of its covered employees $1.7mm in cash to which $300,000 is covered by the Exemption. Under this example, the public company would be able to deduct $1.3mm (representing the $1mm limit plus $300,000 covered by the Exemption) and the remaining $400,000 would not be deductible. 

In 2008 the IRS released Rev. Rul. 2008-13, which provides that the Exemption is not applicable for compensation tied to performance conditions that are wholly or partially waived when a covered employee terminates employment without cause, resigns for good reason or retires.  This caught many in the tax community off guard because Rev. Rul. 2008-13 appeared to represent a fundamental shift in IRS policy (prior to Rev. Rul. 2008-13 the tax community generally believed that such waivers were appropriate due to previous IRS private letter rulings addressing the subject). 

Therefore, to ensure the deductibility of compensation paid to covered employees under the Exemption, the following arrangements (and possibly more) should be reviewed to determine whether they should be amended to comply with Rev. Rul. 2008-13: employment agreements, performance-based bonus arrangements, and restricted stock and restricted stock unit award agreements.  With some exceptions, compliance is required prior to January 1, 2010.