View From Sidley: ‘A Million Here, a Million There, Pretty Soon You’re Talking Real Money’ **

Like other business expenses, Section 162 of the Internal Revenue Code of 1986, as amended (the “Code”), generally entitles employers to a tax deduction for compensation paid to their employees. It is important for employers to consider how the design of their incentive compensation plans affects their right to a tax deduction and the timing of that deduction. Are they taking full advantage of the tax deductibility of compensation payments? Or are they leaving money on the table?

Section 162(m)—Public Companies

First, most public companies are very familiar with Section 162(m) of the Code, which imposes a $1 million cap on the tax deduction that a public company can take on compensation paid to each of its four highest paid executive officers (other than the chief financial officer), and with the exemption under Section 162(m) for qualifying “performance-based compensation,” which is fully deductible even if it exceeds $1 million. Code §162(m)(3)(C); Treas. Reg. §1.162-27(e). To qualify as performance-based compensation, companies must satisfy a number of conditions that lead many to conclude that Section 162(m) is, in large part, form over substance. If the proper procedural steps are taken, the company can maximize its tax deduction with relatively little substantive effect on how bonuses are actually determined. But many companies overlook some of these procedural requirements and put millions of dollars of tax deductions at risk.

Just as threatening as IRS scrutiny, flaws in plan design can also draw the unwanted attention of class action lawyers who might allege that the company misled investors in its proxy statement when it claimed that its compensation qualified as performance-based compensation under Section 162(m) of the Code. Savvy lawyers will carefully review publicly filed proxy statements looking for alleged flaws in the qualification of a plan under Section 162(m), and then either send a demand letter to the board of directors or file a lawsuit against the board seeking a correction of the company’s proxy disclosure plus legal fees to reward them for their noble policing of the company’s proxy disclosure on behalf of the company’s shareholders.

Whether seeking to immunize a compensation plan from challenges by the IRS or the plaintiffs’ bar, public companies and their compensation counsel should be aware of certain Section 162(m) defects that seem to recur with some regularity.

Outside Directors.

Section 162(m) requires a plan to designate a committee of outside directors (typically the compensation committee) to grant and administer performance-based awards. Code §162(m)(3)(C)(i). Occasionally, certain members of a compensation committee fail to qualify as outside directors, for example due to a relationship with a third party that provides services to the company. The qualification of a director as an outside director can be especially vulnerable following a corporate spin-off or an IPO, when many companies rely on transitional accounting, legal or other professional services provided by a third party with which a director might be employed or otherwise have a relationship. See Treas. Reg. §1.162-27(e)(3). Companies should carefully review the outside director status of each member of the compensation committee, and if any member does not qualify, that member should be recused from any actions involving performance-based compensation granted to senior executives.

Shareholder-Approved Plan.

Section 162(m) requires the shareholders of the corporation to approve the material performance measures on which the compensation is based. Code §162(m)(3)(C)(ii); Treas. Reg. §1.162-27(e)(4). Shareholders need not approve the specific performance measures used each year, but instead may approve a menu of permissible performance measures to be selected by the compensation committee, as long as the shareholders re-approve the performance measures every five years. Treas. Reg. §1.162-27(e)(4)(vi). Companies should include on their annual proxy statement checklists a reminder to determine whether five-year re-approval of their equity or cash bonus plans is necessary. In addition to their approval of the list of permissible performance measures, shareholders also must approve a per-person limit on the amount that can be paid in any specified performance period. Plaintiffs’ lawyers review proxies carefully to determine if any of the covered employees who are subject to Section 162(m) received compensation in excess of this shareholder-approved limit. It is important to review proposed awards—such as larger grants made in connection with the hiring of a new CEO—to confirm that the grants are within the shareholder-approved limit. No CEO likes to be told that an equity award has to be rescinded because it exceeded a shareholder-approved plan limit. Some shareholder-approved plans allow for a larger per person limit in the year an executive is hired to accommodate special sign-on grants. Finally, it is important to understand that Section 162(m) requires the plan to be conditioned on shareholder approval. The shareholders are approving the plan, not merely the tax deduction. When companies or their counsel draft plan proposals to include in their proxy statement, they occasionally suggest that the shareholders are approving the tax deduction, and that if the shareholders do not approve the plan, the plan will still take effect but simply will not qualify for a full tax deduction. Plaintiffs’ lawyers will quickly view this as a Section 162(m) defect.

Objective Performance Measures.

During the first 90 days of the performance period (or, for performance periods shorter than one year, within the first 25% of the performance period), the compensation committee must approve objective performance goals that must be satisfied as a condition to the payment or vesting of performance-based compensation. Treas. Reg. §1.162-27(e)(2). When the committee approves the performance goals, the committee minutes should specify clearly how performance is to be measured. For example, if the committee approves a non-GAAP performance measure, such as “adjusted EBITDA,” the minutes should be clear which adjustments will be made to EBITDA. It is unclear whether it is sufficient to simply state that the performance measure will be consistent with the company’s audited financial statements. If the performance measure leaves too much discretion, the compensation will not qualify as performance-based compensation under Section 162(m).

Guaranteed Payments.

In order for compensation to qualify as “performance-based compensation” under Section 162(m), it must be contingent on the attainment of the pre-established performance goals, such that the compensation cannot be paid if the performance goals are not achieved. Treas. Reg. §1.162-27(e)(2)(v). An exception exists if payments are made without regard to performance (e.g., performance is deemed satisfied at the target or some other level) upon the employee’s death, disability or a change in control (although the Section 162(m) exemption is lost if one of these events actually occurs), but many employers provide for guaranteed payouts in the event of other types of employment termination, such as retirement or an involuntary termination without cause. The mere possibility of these contingent payout events unrelated to performance can cause the compensation to be nondeductible even in years when those events do not occur. See Rev. Rul. 2008-113. It is important to understand the consequences under Section 162(m) when negotiating executive employment agreements or equity award agreements that may provide for specified payments in certain events.

Adjustment of Performance Measures.

It is common for unanticipated circumstances to arise during a performance period that are out of the control of the executives (especially in the case of longer-term performance periods), and for compensation committees to desire some flexibility to adjust the company’s performance results to disregard these circumstances. Because Section 162(m) allows for “negative discretion,” the committee can always adjust the performance in way that reduces the payment amount. Treas. Reg. §1.162-27(e)(2)(iii). The greater challenge arises when the adjustment results in an increase in compensation. There are two procedural approaches that companies often take to preserve the ability to adjust for unforeseen circumstances, and it is important that each approach be implemented carefully.

First, when the compensation committee approves the performance measures at the beginning of the performance period, the committee should specify, either in the committee minutes approving the performance conditions or in the program document or award agreement for the particular grant, if applicable, the objectively determined adjustments that will be made to actual performance results. It is unclear how much detail must be included when specifying adjustments. Clearly, adjustments for specific events, such as changes in accounting standards, expenses incurred in connection with corporate transactions and changes in foreign exchange rates, should be permissible. See Treas. Reg. §1.162-27(e)(2)(vii), Example 13. It is unclear whether more nebulous adjustment events, such as “unanticipated, extraordinary events,” are permitted, or whether they would jeopardize the pre-established nature of the performance criteria. The compensation committee minutes or other documentation evidencing the pre-established performance conditions should specify the adjustments as objectively as possible, such as by reference to items in the company’s audited financial statements.

An alternative approach taken by companies to maximize flexibility in the payout of awards is the use of a two-tiered performance goal structure, which is often referred to as a “plan within a plan,” or an “umbrella plan.” The first tier goal is considered the qualifying section 162(m) goal, and would be fairly rigid. The first tier goal can either be a binary goal—an “on-off” switch—which provides for an initial “funding” of the maximum payout amount if the goal is satisfied and for no payment if the goal is not satisfied, or, alternatively, it can provide for an aggregate pool that is measured as a percentage of earnings or some other performance metric. Of course, in either case the goal must be substantially uncertain of attainment at the time it is set and not be subject to any discretionary adjustment after the first 90 days of the performance period. Treasury regulations under Section 162(m) suggest that a pool based on the amount of the company’s sales or revenue would not be substantially uncertain, but a pool based on the company’s profits would be substantially uncertain, even if the company has a history of profitability. Treas. Reg. §1.162-27(e)(vii), Examples 2 and 3. Once the 162(m) performance-based amount is considered “funded,” based on the first tier goal, the committee uses a second tier of performance goals to determine the final payout amount, which will always be less than the maximum amount determined using the first tier Section 162(m) goal. The second tier goals allow for maximum flexibility, and may include objective or subjective goals, corporate or individual goals, and can be adjusted upward or downward as long as the payout never exceeds the amount earned based on achievement of the first tier Section 162(m) goal. This approach has become prevalent over the years, and gives companies maximum flexibility to adjust payments for unanticipated circumstances, while staying within the contours of Section 162(m).

Timing of Deductions—Public and Private Companies

Separate from the deduction cap under section 162(m), all employers—both public and private—will find that the design of their cash bonus programs can affect the timing of their tax deduction. Will bonuses be deductible in the year they are earned or the year they are paid? Employers should consider how they can design their bonus programs in a way that ensures that their tax deductions are timed properly.

Generally, under Section 461 of the Code, bonuses paid by a corporation that has adopted the accrual method of accounting are deductible by the corporation in the taxable year in which:

• all of the events have occurred that establish the fact of the liability,

• the amount of the liability can be determined with reasonable accuracy and

• economic performance has occurred with respect to the liability.

Over the past several years, the IRS has published guidance bringing into question whether bonuses are properly deductible in the year accrued, rather than the year in which they are paid. See, e.g., Chief Counsel Advice Memorandum 200949040 and Chief Counsel Advice Memorandum 201246029. For example, if bonuses are contingent on continued employment through the date they are paid or if bonuses are subject to discretion until the date they are paid, then the requirements described above that would allow the company to take a deduction in the performance year may not have been satisfied.

However, courts have long allowed for bonuses to be deductible in the performance year, rather than the year of payment, if an aggregate bonus pool has been fixed by the end of the performance year, and any forfeited bonuses are required to be allocated among other employees. See, e.g., Washington Post v. U.S., 405 F.2d 1279 (Ct. Cl. 1969); Produce Reporter Co. v. Commr., 18 TC 69 (1952) and Willoughby Camera Stores v. Commr., 125 F.2d 607 (2d Cir. 1941). In Revenue Ruling 2011-29, the IRS concurred with the analysis taken by the courts. Whether a bonus liability is fixed depends on whether the corporation makes an irrevocable commitment to the employees as a group, even if the commitment to each individual employee is not fixed.

As a result, to be able to take the position that bonuses are deductible in the year of performance rather than the year of payment, many employers have begun adopting resolutions prior to the end of the performance year approving a minimum bonus pool that in all events will be allocated among all employees as a group. This requires the company to estimate the aggregate bonus pool that will be earned for the year, and to approve a percentage of that estimated amount (e.g., 80%) that will be paid regardless of final performance results or employment status. Of course, the resolutions should clarify that any bonuses payable to executives who are subject to Section 162(m) of the Code remain conditioned on the applicable performance conditions, such that if the performance conditions are not satisfied the bonuses will be reallocated among other employees.

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Of course, despite the tax deduction considerations described above, it is important to remember that these considerations sometimes are outweighed by the incentive and retention objectives of the company. But being aware of how a company’s procedures affect the deductibility of its compensation payments or awards may allow the company to save millions of dollars in taxes.