162(M) Deduction Limitation and Post-IPO or S-1 Grants of RSUs and Phantom Stock
On March 31, 2015, the IRS issued final regulations under Section 162(m) of the Internal Revenue Code of 1986, as amended ("Code"). Section 162(m) denies a deduction to a public company of compensation paid to a "covered employee" (the CEO and the three most highly compensated "named executive officers" on the proxy statement, excluding the CFO) that exceeds $1 million, unless such excess compensation qualifies for an exemption.
One such exemption applies in the case of a private company that becomes public (e.g., through an initial public offering ("IPO") or the filing of an S-1 registration statement with the Securities and Exchange Commission). In this situation, the $1 million deduction does not apply, during a specified transition period, to compensation paid pursuant to a plan (e.g., an equity compensation plan) or agreement (e.g., an employment, change in control or severance agreement) that existed during the period in which the company was private.
The transition period begins on the date the company becomes a public company and ends on the earliest to occur of:
1. the expiration of the plan or agreement;
2. a material modification of the plan or agreement;
3. the issuance of all employer stock and other compensation that has been allocated under the plan or agreement; or
4. the first meeting of the 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 IPO occurs (or if the company becomes public other than through an IPO, the first calendar year in which the company becomes public).
The final regulations differentiate between the grant of a stock option, stock appreciation right ("SAR") or a share of restricted stock and the grant of a restricted stock unit ("RSU") (the right to receive a fully vested share of stock in the future) or a share of phantom stock (the right to receive the cash value of a fully vested share of stock in the future):
1. Stock Option, SAR and Restricted Stock - transition relief applies to income recognized on exercise (stock option or SAR) or vesting (restricted stock), as applicable, provided that the grant occurs within the transition period; and
2. RSU or Phantom Stock - for any grant made on or after April 1, 2015, transition relief applies only if the vested RSU stock is distributed or the phantom stock cash is paid, as applicable, to the covered employee within the transition period.
Business Next Steps: A company needs to take particular care in granting RSUs and phantom stock in the transition period after becoming public. For any grant made on or after April 1, 2015, pursuant to a plan or agreement in effect while the company was private, unless the RSU or phantom stock vests and is distributed or paid during the transition period, the transition relief will not apply. Instead, the company will need to avail itself of another exemption, most likely the exemption for qualified performance-based compensation. This exemption has numerous requirements, so a company that goes public and wishes to grant RSUs or phantom stock should do some careful planning and consider enlisting competent legal counsel to guide it through the regulatory maze of opportunities and pitfalls.
If you would like more information, please contact your Chiesa Shahinian & Giantomasi PC attorney.