Articles Posted in Executive Compensation

In Press Release 2015-160 (Washington D.C., Aug. 5, 2015), the Securities and Exchange Commission (the “SEC”) says that it has adopted a final rule that requires a public company to disclose the ratio of the compensation of its chief executive officer (the “CEO”) to the median compensation of its employees. According to the Press Release, the new rule, which is mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, provides companies with flexibility in calculating this pay ratio, and helps inform shareholders when voting on “say on pay.”

The Press Release includes a Fact Sheet, which explains the new rule.

In an IRS Memorandum, the IRS dealt with the following issue: Does the correction of a failure to comply with section 409A(a) of the Internal Revenue Code, which correction applies only to compensation subject to a substantial risk of forfeiture, avoid income inclusion under section 409A if the correction is made before the compensation vests but during the service provider’s taxable year in which it vests? And the IRS concluded that income inclusion is NOT avoided. Why?

The IRS said in the Memorandum that section 409A(a)(1)(A)(i) provides that, if a nonqualified deferred compensation plan fails to comply, or fails to be operated in accordance, with section 409A(a)(2), (3) and (4) “at any time during a taxable year,” compensation deferred under the plan that is not subject to a substantial risk of forfeiture and that has not previously been included in income is includible in the service provider’s gross income for the taxable year. Deferred compensation, which is subject to a substantial risk of forfeiture, is subject to the requirements of section 409A(a)(2), (3), and (4) at all times during a taxable year, though a deferred amount is not includible in income under section 409A if it is subject to a substantial risk of forfeiture at all times during the taxable year.

In contrast, if the amount is not subject to a substantial risk of forfeiture at all times during the taxable year (generally meaning the amount is vested as of the end of the taxable year), the amount is includible in income. The correction of a failure to comply with section 409A(a) during a taxable year indicates that a failure existed during the taxable year in which the correction is made. In accordance with section 409A(a)(1)(A)(i), a failure applicable to deferred compensation subject to a substantial risk of forfeiture that lapses during the taxable year results in income inclusion of the deferred amount under section 409A, regardless of whether the failure is corrected during the same taxable year but before the substantial risk of forfeiture lapses.

BACKGROUND

On June 24, 2011, the Treasury Department and the IRS published a notice of proposed rulemaking (the “Proposed Regulations”) under section 162(m) of the Internal Revenue Code (the “Code”). The existing regulations for section 162(m) are found in Treas. Reg. § 1.162-27. The Treasury Department and the IRS have now adopted the Proposed Regulations, with modifications, as final regulations (the “Final Regulations”).

PROVISIONS OF THE FINAL REGULATIONS

In Weiss v. DHL Express, Inc., Nos. 12-1853, 12-1864 (1st Cir. 2013), the defendant, DHL Express, Inc. (“DHL”), was contesting a jury verdict in the district court in favor of the plaintiff, Jeremy Weiss (“Weiss”).

In this case, Weiss’s employment at DHL had been terminated, ostensibly for his failure to properly investigate, document, and ameliorate the misconduct of an employee under his supervision. The termination occurred just months before Weiss was to receive a $60,000 bonus. Weiss filed suit to recover the bonus on the grounds that he was terminated without good cause, which under the terms of the bonus plan (the “Plan”) entitled him to a full payout. Thus, Weiss had brought a breach of contract claim. The district court allowed the claim to go to a jury, which found for Weiss. DHL appeals the jury verdict.

In analyzing the case, the First Circuit Court of Appeals (the “Court”) noted that, under the terms of the Plan, if Weiss was terminated for good cause, he would not be entitled to the bonus. Further, the plain language of the Plan designates DHL’s Employee Benefits Committee (the “Committee”) as the sole arbiter of whether a Plan participant is terminated for good cause. As a result, whether Weiss was terminated for good cause and thus lost his right to the bonus was a decision within the ambit of the Committee’s sole and final decision-making authority. Here, the Committee did in fact determine that Weiss was terminated for good cause. As such, the Court overturned the jury verdict in Weiss’ favor.

In K & K Veterinary Supply, Inc. v. Commissioner of Internal Revenue, T.C. Memo. 2013-84, the Tax Court faced the question, among others, of whether amounts paid as compensation to officers and certain employees were reasonable, within the meaning of IRC section 162(a)(1), and therefore tax deductible.

In this case, the corporation in question, K & K Veterinary Supply, Inc. (the “Company”), claimed the following tax deductions for salary, which the Commissioner challenged:

2006 2007

In Sutardja v. United States, No. 11-724T (Court of Federal Claims 2013), the Internal Revenue Service (the “IRS”) had determined that the exercise by Dr. Sehat Sutardja (” Dr. Sutardja”) of nonqualified stock options granted by his company, Marvell Technology Group Limited, was subject to an additional tax and interest under IRC section 409A. Section 409A provides for a 20 percent surtax plus interest on amounts received under a nonqualified deferred compensation plan, if certain conditions exist. The IRS sought to apply the additional tax and interest on the grounds that stock option arrangement did not comply with section 409A.

In analyzing the case, the Court noted that, at the date of grant, the stock options did not have a readily ascertainable market value. As such, the stock options were not taxable at grant or upon vesting. Further, if the option exercise price was set at or above fair market value at the time of the grant, section 409A taxation would be inappropriate even upon exercise. But does section 409A apply to discounted stock options when exercised (the “discount” being an exercise price set below the fair market value on date of grant)? The Court concluded that the answer is yes, since:

–a nonqualified stock option constitutes deferred compensation, which is subject to section 409A (the FICA rules for defining deferred compensation do not apply);

The Internal Revenue Service (the “IRS”) has issued proposed regulations on the $500,000 limit under IRC section 162(m)(6) on the annual deduction for compensation paid to an individual by a covered health insurance provider. A “covered health insurance provider” is, generally, an insurance company for which at least 25% of its gross premiums are for minimum essential health care coverage. An employer may rely on the proposed regulations until final regulations are issued. The proposed regulations are over 100 pages long. In sum, the proposed regulations provide the following:

In General. For taxable years beginning after 2012, section 162(m)(6) limits to $500,000 the allowable deduction for the aggregate individual remuneration and deferred deduction remuneration attributable to services performed by an individual for a covered health insurance provider in a taxable year beginning after 2012 which (but for section 162(m)(6)) is otherwise deductible for federal income tax purposes. “Individual remuneration” is pay for services that is not deferred deduction remuneration . “Deferred deduction remuneration” is pay for services that is deductible in a future taxable year.

Tax Years Starting Before 2013. Deferred deduction remuneration attributable to services performed in a taxable year beginning after 2009 and before 2013, which otherwise becomes deductible in a taxable year beginning after 2012, is also subject to the $500,000 deduction limit, determined as if the deduction limit applied to taxable years beginning after 2009.

In Revenue Ruling 2012-19, the Internal Revenue Service (the “IRS”) examined the question of whether dividends and dividend equivalents relating to restricted stock and restricted stock units (“RSUs”), which are qualified performance-based compensation under § 162(m)(4)(C) of the Internal Revenue Code (the “Code”), must separately satisfy the requirements under § 162(m)(4)(C) to be treated as qualified performance-based compensation (and therefore to be excluded from applicable remuneration for purposes of applying the Code § 162(m)(1) $1,000,000 limit on deductions).

The IRS posited the following facts. Corporation X and Corporation Y are publicly held corporations within the meaning of § 162(m)(2) of the Code. Both corporations maintain plans under which participating employees may be granted restricted common stock of the respective corporation or RSUs based upon the common stock of the respective corporation. The restricted stock and RSUs are qualified performance-based compensation.

The IRS then provided two situations. In Situation 1, Corporation X’s plan provides that dividends and dividend equivalents otherwise payable to an employee, during the period from grant to vesting with respect to restricted stock and RSU awards granted to the employee, are accumulated and become vested and payable only if the related performance goals with respect to the restricted stock and RSUs are satisfied. All other requirements of Treas. Reg. § 1.162-27(e) are met with respect to the grant of rights to dividends and dividend equivalents. In Situation 2, Corporation Y’s plan provides for payment to an employee, during the period from grant to vesting with respect to restricted stock and RSU awards granted to the employee, of dividends and dividend equivalents on the restricted stock and RSUs at the same time dividends are paid on common stock of Corporation Y, regardless of whether the performance goals established with respect to the restricted stock and RSUs are satisfied.

In Revenue Procedure 2012-29, the Internal Revenue Service (the “IRS”) provides sample language that may be used (but is not required to be used) for making an election under section 83(b) of the Internal Revenue Code (the “Code”). Also, the Revenue Procedure provides examples of the income tax consequences of making such an election.

Section 83(a) of the Code provides, generally, that if in connection with the performance of services, property is transferred to the service provider, then the fair market value (the “FMV”) of the property is included in his/her gross income as of the first time that the service provider’s rights in the property are transferable to another person or are not subject to a substantial risk of forfeiture, whichever occurs earlier. Section 83(b) of the Code, and Treas. Reg. Sec. 1.83-2(a), generally permit the service provider to elect to include in gross income the FMV of the property at the time of transfer to him/her (e.g., instead of waiting until a substantial risk of forfeiture no longer exists). Why would you make the election? The FMV of the property is likely to be less at the time of transfer than later on when the property value would otherwise be included in gross income under section 83(a), so income taxes can be saved by making the section 83(b) election.

Under section 83(b)(2), an election made under section 83(b) must be made in accordance with the regulations thereunder, and must be filed with the IRS no later than 30 days after the date that the property is transferred to the service provider. Under Treas. Reg. Sec.1.83-2(c), an election under section 83(b) is made by filing a copy of a written statement with the IRS office with which the service provider files his/her return. In addition, the service provider is required to submit a copy of such statement with his or her income tax return for the taxable year in which such property was transferred. Treas. Reg. Sec. 1.83-2(d) requires the service provider to submit a copy of the section 83(b) election to the service recipient. Under Treas. Reg. Sec. 1.83-2(e), the election must be signed by the service provider, indicate that an election is being made under section 83(b) and contain certain information specified in the regulation. The sample language in the Revenue Procedure (modified as needed since this language specifically relates to transferred common stock) can be used to make a section 83(b) election.

The Internal Revenue Service (“IRS”) has provided new guidance, in the form of proposed regulations, on the timing of income inclusion under section 83 when property has been transferred in connection with the provision of services.

By way of background, in general under section 83(a), if property is transferred in connection with the provision of services, the fair market value of the property is included in the recipient’s gross income on the first date on which either the recipient’s rights in the property are transferable or are not subject to a substantial risk of forfeiture. Under section 83(c)(1), the rights of a person in property is subject to a substantial risk of forfeiture, if such person’s rights to the full enjoyment of the property are conditioned on the future performance of substantial services by any individual. Treas. Reg. Sec. 1.83-3(c)(1) elaborates on this rule.

The IRS’s proposed regulations would amend sec. 1.83-3(c)(1) to clarify whether a substantial risk of forfeiture exists. Under the proposed regulations: