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Navigating the treacherous waters of regulatory reform and ensuring compliance with the countless rules and regulations imposed under the current administration places significant constraints on a company’s time and resources. Therefore, keeping up-to-date on current regulations becomes even more imperative. Staying knowledgeable and aware of the details of the regulations, as well as recent changes, is the only way to ensure your company will steer clear of the recent surge of lawsuits as well as meet 162(m) deductibility guidelines.

Yes, that’s right — lawsuits. Since one of 162(m)’s rules is that the material terms of the performance-based compensation plan must be disclosed to and approved by shareholders, it is incumbent upon the Company to ensure all aspects of the plan meet this requirement. Plaintiff’s lawyers have recently begun filing shareholder derivative lawsuits challenging executive compensation under 162(m) guidelines. Among those lawsuits, the most prevalent allegations include:

• Payments made by the compensation committee were substantially certain to occur.
• The disclosure of the performance goals was too vague/misleading or false.
• The company did not attempt to limit nonperformance-based compensation to less than $1M.
• The Compensation Committee maintained too much discretion.
• The company will pay regardless of whether the shareholders approve the performance goals.

While the merits of these cases have yet to be determined, one disturbing thing is certain, courts are not automatically dismissing 162(m) related cases. What can you do to mitigate the risk of a 162(m) lawsuit? First, gain a full understanding of the law. Second, use this knowledge to ensure the proper steps are taken to ensure compliance with 162(m).

Understanding 162(m) deductibility rules is imperative to taking initiatives to comply with and receive the deduction each year. IRS 162(m) applies to publicly held corporations (listed on a major US exchange or with more than $500M in assets and 500 holders of securities), and deems that no corporate tax deduction is allowed for applicable or “covered” employee (CEO and other named executive officers, except the CFO) compensation to the extent that the compensation to said employee exceeds $1 million. However, compensation that is considered “performance-based” is disregarded in applying to the $1 million limit. The following outlines the qualifications that must be met for compensation to be considered performance-based:

• Compensation is contingent upon the achievement of one or more pre-determined performance goals.
• Goals must be established by a Committee comprised of at least two independent outside directors.
• Goals must be disclosed in writing no later than 90 days following the commencement of the performance period. In no event can performance goals be established after 25% of the performance period has occurred. These performance goals must be objective and nondiscretionary.
• The attainment of performance goals must be “substantially uncertain” at the time the performance goal is established.
• The Committee must certify that performance goals were achieved prior to payment, and payments must be made within 75 days of the close of the performance period.
• Positive discretion is not allowable; however, the Committee can retain the ability to adjust the awards downward.
• The terms of the plan must be disclosed to and approved by shareholders. Plans are generally approved once every five years.
• SAR’s and stock options are considered performance-based if the other requirements are met. Restricted stock does not qualify unless the vesting is contingent upon achievement of performance goals.

Many times it is assumed that all types of compensation must meet performance-based guidelines, as described above, in order to be exempt from the 162(m) rule. But of course there are always exceptions to the rule, and the following types of compensation receive exemptions from the 162(m) tax deductibility limitations:

• Commission-based compensation;
• Payments related to a tax-qualified retirement plan;
• Compensation excludable from gross income; and
• Compensation payable under preexisting binding contracts.

With this information in mind, what should you do to ensure you are maximizing your company’s 162(m) deduction? Take action early. The following actions should be considered before the end of the first quarter:

• Bonuses payable in 2013 for 2012 performance. The Committee must certify in writing that performance goals have been achieved prior to bonuses or other performance-based compensation being paid, and payments must be made within 75 days of the close of the performance period. It is important to note that the executive must be employed upon the date of the bonus being paid for the company to receive the deduction. NOTE: This is a change from prior years when an employee was required to be employed on the last day of the performance period to be eligible for payment.
• Setting 2013 performance goals. The Committee must set the performance goals for 2012 no later than March 31, 2012 to maintain deductibility of performance-based compensation. The performance goal or goals must be disclosed in the form of an objective formula, which means a third-party could calculate the amount of the award with the necessary information. While the ability to exercise negative discretion is allowable, deductibility is lost if positive discretion is permitted.
• Check shareholder approval requirements. Incentive plans must be approved by shareholders every five years. The items which must be included in this approval are eligibility, performance metrics, and maximum awards payable under the plan.

The taxation rules imposed by the IRS can be cumbersome (it is by design); however, remaining on top of changes to the regulations and preparing accordingly can save a company significant tax burdens. So, as you prepare and work diligently through this proxy season, do not forget about 162(m).