Planning for the Cap

How to avoid the $1 million compensation cap in IPOs and spinoffs.
BY JOSEPH R. OLIVER AND ROSELYN E. MORRIS

  

EXECUTIVE SUMMARY
  • FOR FEDERAL TAX PURPOSES, PUBLIC COMPANIES can deduct no more than $1 million of annual compensation for the CEO and each of four other highly paid officers. For a newly public company, disallowed deductions could create a severe cash crunch. Effective planning includes postponing the limit and structuring compensation packages that avoid it.
  • PERFORMANCE-BASED COMPENSATION , COMMISSIONS and certain other benefits sidestep the $1 million cap. Performance-based compensation is tied to one or more preestablished, objective performance goals set by a compensation committee of the board and approved by shareholders. Before making payment, the compensation committee must certify that the goals have been satisfied.
  • THE COMPENSATION LIMIT MAY BE DELAYED MORE THAN three years for a company that becomes public through an IPO. Material modification or expiration of a compensation plan or agreement, or issuance of all stock or other compensation, shortens the postponement period.
  • A CORPORATION SPUN OFF BY ITS PARENT may establish compensation agreements for its officers either before or during a transition period without consulting the subsidiary’s new shareholders. The parent’s compensation committee and shareholders can set up and approve agreements before the spinoff; the subsidiary’s committee can do so afterward.
  • BEFORE A COMPANY GOES PUBLIC IT SHOULD renegotiate any compensation agreements with golden parachute provisions. The $1 million limit is reduced by any deduction disallowed under the section 280G parachute payment rules.
JOSEPH R. OLIVER, CPA, PhD, is professor of accounting at Southwest Texas State University in San Marcos. His e-mail address is jo06@business.swt.edu . ROSELYN E. MORRIS, CPA, PhD, is associate professor of accounting at Southwest Texas State University. Her e-mail address is rm13@business.swt.edu .

he vigorous U.S. economy of the last few years, spurred by Internet start-ups and new technology, has seen a record number of initial public offerings (IPOs) and corporate restructurings. As a company goes from private to public, management must be aware of the implications of compensation limits for key executives under IRC section 162(m). With careful planning, companies undergoing an IPO or a spinoff can postpone the cap or structure compensation packages that avoid the limit.

OVERVIEW OF THE CAP

Under section 162(m), a publicly held company can deduct for federal tax purposes no more than $1 million of annual compensation paid to its CEO and each of four other highly paid officers. The limit applies to corporations required to register any class of their common stock under section 12 of the Securities Exchange Act of 1934 by the last day of their tax year. Although privately held companies are not subject to the cap, the IRS may still contest the reasonableness of owner–employees’ compensation, arguing that a portion is actually a nondeductible dividend. As a result, CPAs might consider the same compensation strategies for both types of corporations.

The $1 million cap only applies to certain “covered” employees, generally the CEO and the four other highest paid officers on the last day of the tax year. If the IPO or restructuring make it difficult to identify the CEO or the four highest paid officers, the tax law relies on the executive compensation disclosure rules in the act.

In three private letter rulings (199910011, 199928014 and 199928015), the IRS exempted from the cap all compensation paid during the year to officers who resigned before yearend—even though the individuals might continue or return to work for the company as employees, consultants or directors. In each of the cases, those resigning had no intention to resume their duties as company officers at any time in the foreseeable future.

The section 162(m) restriction applies to salary, bonuses and other compensation not directly tied to performance. It does not apply to

  • Performance-based compensation.

  • Commissions generated directly by the employee’s performance.

  • Retirement plan contributions.

  • Contributions under deferred compensation or salary reduction agreements.

  • Excludable items such as tax-free fringe benefits.

PERFORMANCE-BASED COMPENSATION

When Congress passed the compensation limit into law, some corporations initially continued to pay salaries above the cap, forgoing the benefit of tax deductions on the excess amounts. The typical IPO or spinoff cannot afford to do so, however. Forgoing federal tax deductions on, for example, $2 million of excess compensation to top executives would cost a profitable company up to $700,000 in unnecessary federal taxes annually. Even if a corporation currently reports losses, deductible compensation increases the net operating loss (NOL) carrybacks and carryovers that may yield tax savings in other years.

Structuring a Compensation Committee

A carefully selected compensation committee is an integral part of any company’s strategy to avoid the $1 million compensation cap. This committee of the board of directors must establish the performance goals under which executive compensation is computed and later certify—in writing—that the goals are met before payment is made. Under Treasury regulations section 1.162-27(e)(3), the committee is comprised solely of two or more “outside” directors who

  • Are not current employees of the corporation.
  • Have not been officers (administrative executives in regular and continued service) of the corporation.
  • Are not former employees who are compensated for prior services during the tax year.
  • Do not receive direct or indirect remuneration from the company in any capacity other than as directors.

Although the law permits certain de minimis exceptions, directors may be disqualified by receiving payments for goods or services directly from the corporation or by ownership in an entity that receives such payments. For more details, see the examples in regulations section 1.162-27(e)(3)(ix).

Perhaps the most widely applicable exception to the $1 million limit is performance-based compensation that meets four requirements:

  1. The compensation is paid solely because the employee or company attain one or more preestablished, objective performance goals.

  2. A compensation committee made up solely of two or more outside directors (see the sidebar above) establishes the performance goals.

  3. Before the company pays the compensation, the material terms of the performance goals are disclosed to and approved by shareholders.

  4. Before payment, the committee certifies in writing (for example, in the corporate minutes) that the employee satisfied the performance goals and any other material terms. This step is not required for compensation attributable solely to the increase in value of corporate stock; however, stock-based compensation frequently is subject to additional rules. (See the sidebar below).

Stock-Based Compensation

Stock-based compensation must meet additional requirements under Treasury regulations sections 1.162-27(e)(2) and 1.162-27(e)(4)(iv) to avoid the $1 million cap.

  • The plan under which an option or right is granted must state the maximum number of shares with respect to which options or rights may be granted to any employee during a specified period.
  • Possible compensation under the terms of an option or right is based solely on an increase in stock value after the date of the grant or award, unless vesting or exercise is otherwise contingent on a qualified performance goal.
  • The number of options actually granted may not exceed the maximum number of shares stated in the compensation plan.
  • n Disclosure to shareholders of stock-based compensation generally must include enough information to allow computing the maximum compensation attributable to exercise of options based on shareholders’ assumptions about future stock performance. This might constitute the maximum number of shares for which options are granted to any employee and the price at which the options could be exercised.
  • Whether or not a stock option grant is performance-based compensation is determined by examining the particular grant. The terms of other grants made to the same or other employees generally are not relevant in making this determination.

Changes in a grant or award of stock options, stock appreciation rights or other stock-based compensation generally may reflect changes in corporate capitalization. Thus, planning should include amending compensation agreements after stock splits or dividends, spinoffs and other transactions that change the number and type of shares outstanding.

A preestablished goal is one the compensation committee sets in writing in the first 90 days of the period of service to which the goal relates or in the first 25% of the period, if less. The outcome must be substantially uncertain when the goal is fixed. For example, a company cannot base a bonus on a simple percentage of total sales, because every profit-oriented enterprise expects some sales and the outcome would not be substantially uncertain. Basing a bonus on a percentage of total profits would qualify, however, because year-to-year profits are substantially uncertain. In fact, many companies with sales report no profits at all.

The goal must be objective so a third party could examine the relevant facts and determine whether or not it was met. Often the goal is based on one or more criteria that apply to the employee, a business unit or the entire company. Examples include stock price, market share, sales growth, earnings per share, return on equity or cost control. The goal need not be based on increases or positive results but could be geared to the company or employee maintaining the status quo or limiting losses.

A goal must include a clearly stated formula or standard for computing compensation if it is attained. A third party must be able to calculate the amount payable to the employee on the basis of performance results. The formula or standard generally cannot permit discretionary increases in compensation beyond that provided.

Example 1. Corporation A establishes a plan that will pay its CEO a $500,000 cash bonus if sales increase 5% over the prior year. The company sets the goal during the first 90 days of its fiscal year and the outcome is substantially uncertain. The compensation committee retains the right to reduce the bonus if it decides certain subjective factors warrant a reduction, even though the company meets the sales goal. The bonus satisfies the requirements for a preestablished objective goal.

The information the company discloses to shareholders generally must include

  • Titles or classes of employees eligible to receive compensation under the goal.

  • A description of the business criteria on which each performance goal is based, but not necessarily specific targets or confidential information that cannot be disclosed to competitors.

  • The maximum amount of compensation that the company could pay to any employee or the formula used to compute the compensation if the goal is attained.

IPO INSIGHTS

The $1 million cap may not immediately apply to a company that goes public through an IPO and could be delayed for more than three years. The company’s prospectus must provide information about compensation plans and agreements that satisfies all securities laws in effect on that date. Under Treasury regulations section 1.162-27(f)(1) and (2), the deferral for a compensation plan or agreement lasts until the earliest of these events:

  • The company materially modifies the plan or agreement, generally increasing the amount of compensation payable or accelerating payment without reducing the amount to reflect the time value of money.

  • All employer stock or other compensation under the plan is issued.

  • The plan or agreement expires.

  • Shareholders have their first meeting to elect directors after the close of the third calendar year following the year the IPO took place.

A company must grant stock-based compensation on or before the earliest of these events in order for the exercise of options or rights or the substantial vesting of restricted property to later qualify under section 162(m).

Example 2. Corporation X has an IPO in 2001. When it offers its stock to the public, compensation agreements for the CEO and the four other highest paid employees are already in place. The prospectus discloses information about the agreements that satisfies all relevant securities laws. None of the agreements is scheduled to expire during 2001, 2002, 2003 or 2004, and each was drawn so no material modifications are required during this period. During these years, the company issues less than the full amount of stock and other compensation allocated to the agreements. The CEO and the other four executives continue to work for corporation X during the entire period; the company does not arrange any compensation agreements with replacement employees. As a result, it need not comply with section 162(m) until the first shareholders’ meeting after the end of 2004.

WHAT ABOUT SPINOFFS?

The $1 million cap applies separately to the top executives of a publicly held parent company and any subsidiaries that also are publicly held. However, the law treats a publicly held parent and its privately held subsidiaries as a single entity for this purpose. Members of the group must combine compensation they pay to each of the covered employees and prorate any disallowed amount among themselves. If a subsidiary becomes publicly held, perhaps through a spinoff, it is not eligible for the deferral accorded IPOs. However, a company may establish compensation agreements either before or after the spinoff without consulting the subsidiary’s new shareholders, according to Treasury regulations section 1.162-27(f)(4).

Compensation agreements for the subsidiary’s CEO and top four executives must meet the objectivity and other criteria for performance-based compensation required of any public company. If the agreements are drawn up before the subsidiary becomes a separate public entity, however, the law treats the parent’s outside directors as the subsidiary’s outside directors and the parent’s shareholders as the subsidiary’s shareholders. The parent’s outside directors establish the compensation agreements and the parent’s shareholders approve them before the subsidiary is spun off.

Before the subsidiary’s executives receive compensation under their agreements, outside directors must certify in writing that the performance goals and any other material terms were satisfied. If the goals are attained before the subsidiary separates from its parent, the parent’s compensation committee may perform the certification. Afterward, the subsidiary must establish its own compensation committee to do so.

Example 3. Corporation P is publicly held and has a 100%-owned subsidiary, corporation S, which it plans to spin off. As part of the preparation, corporation P’s compensation committee establishes a plan for the top executives of corporation S to receive bonuses after the spinoff. The plan satisfies the criteria for performance-based compensation and corporation P’s shareholders approve it before the subsidiary goes public. The goals are attained after the spinoff and corporation S’s compensation committee certifies that they have been met before the bonuses are paid. The bonuses qualify as performance-based compensation.

The shareholder approval requirement may be omitted for compensation paid and for stock options, stock appreciation rights and restricted property granted before a specific date under Treasury regulations section 1.162-27(f)(4)(iii). This is the day of the first regularly scheduled meeting of the subsidiary’s new shareholders that occurs more than 12 months after the subsidiary becomes a separate public company. While the outside directors of either the parent or the subsidiary may establish and administer the performance goals, the subsidiary’s outside directors must certify that the goals are met.

Example 4. Assume corporation P does not establish compensation goals or agreements for corporation S’s top employees before the spinoff takes place on June 30, 2001. The former subsidiary may put together a compensation committee of outside directors and establish its own compensation plans without shareholder approval. The exception applies only to compensation paid before the first regularly scheduled meeting of corporation S’s new shareholders after June 30, 2002, and to stock options, stock appreciation rights and restricted property granted before the meeting. Corporation S’s outside directors must certify that the established goals are met before the company pays the compensation.

A CAUTION ON PARACHUTE PAYMENTS

Compensation agreements for executives of a corporation that will undergo an IPO or spinoff may not qualify as performance-based but may be well under $1 million each. Even so, CPAs should examine the agreements for golden parachute provisions. These generally are payments that amount to at least triple an executive’s base compensation and are triggered by changes in ownership or control of a corporation or a substantial portion of its assets. The $1 million limit is reduced by any deduction disallowed by the parachute payment rules of IRC section 280G.

Example 5. The president of corporation S receives a $900,000 salary, none of which is based on performance. In addition, under a compensation agreement, she could receive a parachute payment, $700,000 of which would be an excess payment for which no deduction would be allowed. The excess parachute payment would reduce the $1 million limit for the president’s compensation to $300,000. For the $900,000 salary the president earns, corporation S could deduct only $300,000. The remaining $600,000 could cost the company more than $200,000 in additional federal income tax. If possible, corporation S should try to renegotiate the president’s compensation agreement to avoid the parachute payment.

ENTERING A NEW PHASE

Businesses may overlook planning for the $1 million compensation cap in the complex and often hectic process of arranging an IPO or spinoff. The damage to cash flow from lost deductions could come at a time when the company can ill afford it. Fortunately, the law provides delays and exceptions that CPAs can use to a company’s advantage as it gains access to new sources of capital and enters a new phase of its life.

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