New IRS Guidance on Dividends and Dividend Equivalents as Performance-Based Compensation Under 162(m)
Wolff & Samson Employee Benefits and Executive Compensation Alert
The Internal Revenue Service recently issued a new Ruling providing guidance for public companies regarding the treatment of dividends and dividend equivalents under Section 162(m) of the Internal Revenue Code. Revenue Ruling 2012-19 reiterates the IRS’ long-held view that dividends declared on restricted stock (“RS”) and dividend equivalents declared on restricted stock units (“RSUs”) will not qualify as “qualified performance-based compensation” unless such dividends and dividend equivalents separately satisfy the requirements for such treatment under Section 162(m).
Section 162(m) limits a public company’s deduction of compensation paid to a “covered employee” to $1 million per year. A “covered employee” includes a public company’s Chief Executive Officer and the three highest paid other officers, other than the Chief Financial Officer.
The $1 million deduction limit does not apply, however, to the extent that the compensation paid to the covered employee constitutes “qualified performance-based compensation,” which is compensation payable solely on account of the attainment of one or more pre-established, objective performance goals, provided that the following requirements are satisfied:
- the performance goals are determined by the board of directors or a compensation committee comprised solely of two or more “outside” (independent) directors;
- the material terms under which the compensation is to be paid, including the performance goals, are disclosed to the shareholders and approved by a majority vote prior to payment of any such compensation; and
- the compensation committee certifies, prior to payment of any such compensation, that the performance goals and other material terms were in fact satisfied.
Detailed IRS rules apply to each of these requirements. A performance goal generally is considered “pre-established” if it is established by the compensation committee no later than 90 days into the performance period. In no event, however, is a performance goal considered “pre-established” if it is established by the compensation committee after 25% of the performance period has expired. A performance goal generally is considered “objective” if it is based upon one or more business criteria that apply to the individual, a business unit or the corporation as a whole.
The determination of whether the requirements listed above are satisfied is made on a grant-by-grant basis.
Restricted Stock vs. Restricted Stock Units
RS differs from an RSU in that the former represents the grant of a share of actual stock of the company subject to a vesting schedule, whereas the latter represents the grant of the right to receive a share of fully vested stock at some future date. Accordingly, the recipient of a share of RS receives a certificate for such stock (or such certificate is held in escrow by the company) and, unless the RS agreement provides otherwise, generally is entitled to all voting rights available, and dividends declared, on such stock. In contrast, the recipient of an RSU does not receive a certificate, generally is not entitled to any voting rights and generally receives dividends, if any, in the form of “dividend equivalents” (usually cash or deemed shares of stock based upon dividends declared on a share of restricted stock). Other differences exist, including, most notably, the tax treatment of RS and RSUs.
For purposes of Section 162(m), both RS and RSUs can qualify as qualified performance-based compensation.
Dividends and Dividend Equivalents
In Revenue Ruling 2012-19, the IRS notes that:
- if the dividends or dividend equivalents vest and become payable only if the related performance goals with respect to the RS and RSUs, respectively, are satisfied, and such performance goals satisfy the requirements for qualified performance-based compensation, then the dividends or dividend equivalents will qualify as qualified performance-based compensation; and
- if the dividends or dividend equivalents with respect to the RS or RSUs are payable irrespective of whether the performance goals with respect to such RS and RSUs are satisfied, then the dividends or dividend equivalents will qualify as qualified performance-based compensation only if they separately satisfy the requirements of this exemption.
Public Company Action Items
A public company should review all of its equity compensation plans and agreements (including those embedded in employment, retention, severance and change in control agreements) to determine the following:
- Does the plan or any agreement provide for the grant of RS or RSUs?
- If so, is the grant intended to qualify as qualified performance-based compensation?
- If so, does the grant provide for dividends or dividend equivalents?
- If so, are these dividends and dividend equivalents subject to the same performance goals as the underlying RS and RSUs, respectively?
- If the performance goals are not the same, have such goals separately satisfied the requirements for qualified performance-based compensation?
Answering each of these questions can present numerous difficulties for a public company. Further complicating matters, if the dividends and dividend equivalents are not subject to the same performance goals as the underlying RS and RSUs, respectively, a public company runs the very real risk of making an inconsistent determination of performance and confusing shareholders when it comes time for shareholder approval of the dividends and dividend equivalents.
In any event, the threshold question for any public company with respect to equity or equity-based compensation should be what vehicle best promotes the objectives of the company. Aligning pay with performance clearly matters, but so does providing key officers with a tax-efficient compensation package that reflects such officers’ own objectives (e.g., as a shareholder). These are complex issues to navigate.
Please contact your Wolff & Samson attorney or Adam Cantor, Chair of the firm’s Employee Benefits and Executive Compensation Group, for assistance in complying with the complex requirements of Section 162(m) and other executive compensation rules.