Performance-based compensation.

Million dollar limit for corporate executives.

An employer may deduct the entire amount of reasonable compensation that is paid to its employees--usually. The determination of whether compensation is "reasonable" is highly subjective, however; in addition, that determination is dependent on the facts of a particular situation.

Several years ago, Congress perceived that corporate executives were receiving nondeductible dividends disguised as deductible salaries and bonuses. To address this problem, it passed IRC section 162(m), which limits to $1 million per year the allowable deduction for compensation paid or accrued to certain executives of publicly held corporations.

DETERMINE WHAT'S ALLOWED

Section 162(m) applies to corporations required to register their stock with the SEC if the stock is listed on a national exchange or if the entities each have at least $5 million in assets and 500 shareholders.

The deduction limit applies to the CEO or any of the four other highest paid officers for whom compensation must be reported under SEC rules.

Although section 162(m) covers all otherwise deductible remuneration, "performance-based compensation" is an exception to the deduction limit.

THE REQUIREMENTS

Qualified performance-based compensation must meet the following requirements:

* It is paid solely as remuneration for attaining one or more preestablished, objective performance goals.

* Performance goals are established by the compensation committee--a committee of two or more outside directors (including any subcommittee) of a publicly held entity with the authority to establish and administer performance goals and to certify that such goals were attained. An outside director is one who (1) is not a current corporate employee, (2) is not a former employee currently receiving compensation for prior services other than benefits under a qualified retirement plan, (3) has not been an officer of the corporation and (4) does not receive remuneration, directly or indirectly, in any capacity other than as a director.

* The material terms of the performance goal under which the compensation is to be paid are disclosed to and approved by the corporation's shareholders by vote before the payment is made.

* Prior to payment, the compensation committee certifies that all aspects of the performance goals were satisfied.

STOCK OPTIONS

Compensation from the exercise of stock options or stock appreciation rights meets these requirements if

* The grant of options or rights is made by the compensation committee.

* The plan states the maximum number of shares to which options or rights may be granted to any employee during a specified period.

* The amount of compensation received by an employee is based solely on an increase in the value of the stock after the date of grant.

RECENT DEVELOPMENTS

A recent IRS letter ruling involved a publicly held corporation with a shareholder-approved stock option plan. The entity's compensation committee consisted of at least two outside directors, plus several other individuals who did not qualify. To comply with the qualified performance-based compensation requirements and to ease the administrative burdens and costs of maintaining separate committees, all the directors who did not meet the outside director definition abstained or recused themselves from these determinations. In this situation, the IRS ruled that such a committee constituted a valid compensation committee.

For a discussion of this ruling and other current developments concerning employee benefits, see "Current Developments (Part II)," by Peter Elinsky, Terrance Richardson and Eugene Holmes, in the December 1998 issue of The Tax Adviser.

Nicholas Fiore, editor The Tax Adviser