The $1 million cap on compensation deductions.

Under the Revenue Reconciliation Act of 1993, publicly held corporations cannot deduct annually more than $1 million of compensation paid or accrued to their chief executive officer (CEO) and certain other highly compensated officers for tax purposes. Although this limitation deals with corporate governance principles that have traditionally been part of the nation's securities laws, the $1 million cap is found in Sec. 162(m) of the Code.

This article will discuss the newly issued proposed regulations on the requirements of Sec. 162(m) for any payment that would be deductible in a tax year beginning after Dec. 31, 1993. It is unclear how much reliance can be placed on these proposed regulations since neither the proposed regulations nor the accompanying preamble contains any statement indicating that taxpayers who rely on the proposed regulations will be afforded any protection from a subsequent IRS challenge. Despite this silence, many taxpayers are likely to place considerable reliance on the proposed regulations since they address a large number of important issues not answered in the statute or legislative history.

General Rule

The concept set out in Sec. 162(m) is straightforward: A "publicly held corporation" cannot deduct for regular and alternative minimum tax purposes more than $1 million for compensation paid to any "covered employee" during the employer's tax year. In order to be deductible up to the $1 million cap, the compensation must still meet the reasonableness requirement of Sec. 162(a)(1).(1) It is important to realize that it does not matter when the compensation is earned; the limitation applies for the employer's tax year in which the compensation would otherwise be deductible. There are two major exceptions to the $1 million limitation: compensation paid on a commission basis and qualified performance-based compensation. Of these two exceptions, the more important is the performance-based exception. There are several transition and grandfather rules that are also important.

(1)Prop. Regs. Sec. 1.162-27(a).

* Publicly held corporations

A publicly held corporation is any corporation issuing common equity securities required to be registered under Section 12 of the Securities Exchange Act of 1934 (the Act). This determination is made solely on the basis of whether, as of the last day of its tax year, the corporation is subject to the reporting obligations of Section 12 of the Act.(2) A corporation is not considered publicly held if the registration of its equity securities is voluntary.(3) The proposed regulations provide that a publicly held corporation includes an affiliated group of corporations, as defined in Sec. 1504 (determined without regard to Sec. 1504(b)).(4) Sec. 1504(a)(2) generally requires direct or indirect ownership of 80% or more of another corporation's voting power and value. The proposed regulation seems to go beyond the literal wording of the statute, although its effect seems to comply with the intent of the legislation. This means, for example, that deductions can be limited for compensation paid to executives of wholly owned subsidiaries (domestic and foreign) whose stock is not registered under the Act, so long as the executive is a covered employee of the registered parent corporation. The proposed regulations also provide that if a covered employee is paid compensation by more than one member of an affiliated group, then the compensation paid by each member of the affiliated group is aggregated and the amount disallowed is prorated among the payor corporations in proportion to the compensation paid by each of the affiliated corporations.(5)

(2)Prop. Regs. Sec. 1.162-27(c)(1)(i).

(3)Id.

(4)Prop. Regs. Sec. 1.162-27(c)(1)(ii).

(5)Id.

* Covered employees

An individual is a covered employee if on the last day of the employer's tax year, the individual is the CEO of the corporation (or is acting as the CEO) or among the four highest compensated officers, other than the CEO.(6) The proposed regulations refer to the Act to determine whether someone is described in either of the two categories. It is important to note that the definition of covered employees for purposes of Sec. 162(m) varies from the Securities and Exchange Commission (SEC) guidelines for determining "named executive officers" whose compensation is disclosed in the company's annual proxy statement. As a result of recent amendments, it is possible for more than five individuals to be reported in a company's proxy statement. However, the Code limits the number of covered employees to five. The most significant area of difference is that, under the proposed regulations, only individuals who are employed on the last day of the tax year can be covered employees. For example, someone who retires as a CEO before the last day of the company's tax year will not be taken into account for purposes of the deduction disallowance rules, although their compensation would still have to be disclosed under the new SEC proxy guidelines. Similarly, other individuals who would have been among the four most highly compensated employees will not be taken into account if they are not employed on the last day of the tax year. This provides a significant planning opportunity for certain taxpayers. By terminating employment before the last day of the company's tax year, any compensation paid to such a terminated employee will not be subject to the new deduction disallowance rules in the termination year.

(6)Prop. Regs. Sec. 1.162-27(c)(2)(i).

Finally, any compensation paid after the year in which an individual retires will also not be subject to the deduction disallowance rules since the individual is no longer a covered employee. This will mean that many employers affected by these rules will want to consider deferral agreements, elective or mandatory, to defer the payment of compensation in excess of $1 million that is not commission or performance-based until after the executive has terminated employment.

* Compensation

For purposes of Sec. 162(m), compensation means the aggregate amount allowable as a deduction for the tax year (determined without regard to Sec. 162(m)) for remuneration for services performed by a covered employee, whether or not the services were performed during the tax year.(7) There are seven types of compensation that are not taken into account for purposes of this calculation: (1) payments made to or from a qualified trust described in Sec. 401(a); (2) payments made to or under an annuity plan described in Sec. 403(a); (3) payments made under a simplified employee pension described in Sec. 408(k)(1) (except contributions described in Sec. 408(k)(6)); (4) contributions to or under an annuity contract described in Sec. 403(b) unless the payment for the purchase of the contract is made by reason of a salary reduction agreement;(8) (5) remuneration consisting of any benefit provided to or on behalf of an employee if, at the time the benefit is provided, it is reasonable to believe that the employee will be able to exclude it from gross income; (6) salary reduction contributions to a Sec. 401(k) plan; and (7) amounts treated as employer contributions to governmental plans under Sec. 414(h)(2).(9)

(7)Sec. 162(m)(4)(A); Prop. Regs. Sec. 1.162-27(c)(3).

(8)Prop. Regs. Sec. 1.162-27(c)(3)(ii)(A).

(9)Prop. Regs. Sec. 1.162-27(c)(3)(ii)(B).

Exception for Compensation Paid on a Commission Basis

Any compensation paid on a commission basis is not subject to the deduction disallowance rules of Sec. 162(m). Compensation is considered paid on a commission basis if the facts and circumstances show that it is paid solely on account of income generated directly by the individual performance of the person to whom the compensation is paid. If the compensation is paid on account of broader performance standards, such as income produced by a business unit, the compensation will not qualify for this exception.(10) This exception appears to have limited applicability and, while helpful in certain circumstances, will not be used by many taxpayers.

(10)Prop. Regs. Sec. 1.162-27(d).

Exception for Qualified Performance-Based Compensation

The major exception to the $1 million limitation is "performance-based compensation." This exception will be the centerpiece of discussion in most affected corporations in the short and long term as they attempt to avoid the loss of a corporate deduction for compensation paid to a covered employee.

In general, compensation must meet the following four requirements in order to be considered performance-based: (1) it must be paid solely on account of the attainment of one or more preestablished objective performance goals; (2) the performance goal(s) must be established by a compensation committee comprised solely of two or more outside directors; (3) the material terms of the performance goal(s) must be disclosed to and subsequently approved by the shareholders; and (4) the compensation committee must certify in writing before payment that the performance goals have, in fact, been satisfied.

* Preestablished objective performance goal requirement

The proposed regulations contain two sets of rules for determining whether compensation is being paid pursuant to a preestablished objective performance goal. One set of rules deals with stock options and stock appreciation rights (SARs), the other deals with all other compensation.

General rule--compensation other than stock options or SARs: Within the context of the proposed regulations, each of the words in the phrase "preestablished objective performance goal" has a distinct and significant meaning to which the regulations devote significant attention.

In order to be "preestablished," the goal must be established in writing by the compensation committee before the commencement of services to which the performance goal relates and while the outcome is substantially uncertain.(11) Although it is unclear from the proposed regulations, the requirement of establishing the goal "prior to the commencement of services" is likely to be determined in a manner similar to that used by the IRS for determining whether compensation has been deferred before the performance of services as set out in Rev. Proc. 71-19.(12) This would mean, for example, that goals based on an employer's fiscal year beginning July 1, 1994 would have to be established in writing by the compensation committee before July 1, 1994. For 1994, the IRS has given certain employers until Mar. 31, 1994 to set goals for the 1994 year.(13) The requirement that the goal be established before the commencement of services could cause many taxpayers to change their current manner of setting performance goals. Many companies do not establish the current year performance goals until the results of the prior year are known. The IRS has received a great many comments asking that the proposed regulations be modified to allow performance goals to be established within some reasonable period of time after the beginning of the performance period.

(11)Prop. Regs. Sec. 1.162-27(e)(2)(i).

(12)Rev. Proc. 71-19, 1971-1 CB 698.

(13)Notice 94-2, IRB 1994-2, 25. In order to take advantage of this relief, at the time the compensation committee actually establishes the goal, the outcome must be substantially uncertain, the period of services to which the goal relates cannot begin before Jan. 1, 1994, and the performance period must be scheduled to continue at least nine months.

A performance goal is "objective" if it meets two "third party" tests: (1) a third party having knowledge of the relevant facts could determine whether the goal is met and (2) a third party having knowledge of the relevant performance results could calculate the amount to be paid to the employee if the goal is attained.(14)

(14)Prop. Regs. Sec. 1.162-27(e)(2)(ii).

The first of these two tests is relatively straightforward and requires objectivity in establishing the goal, e.g., an increase in earnings per share of 5%. The second test is more involved and requires objectivity in determining the amount to be paid if the goal is attained. This requires precision in establishing the formula or amount. In addition, the proposed regulations provide that this standard is not met unless the formula or standard also specifies the individual employees or class of employees to which it applies.

Under the proposed regulations, in order to meet the "objective formula or standard" test, there can be no discretion to increase the amount of compensation payable on the goal's attainment. However, a performance goal is not discretionary merely because the compensation committee has the power to reduce or eliminate the compensation due on the goal's attainment.(15) If a change is made to accelerate the payment of compensation to an earlier date after a goal's attainment, the change will be treated as a discretionary increase in the amount of compensation, unless the amount of compensation paid is discounted to reasonably reflect the time value of money.(16) If a change is made to defer the compensation payment to a later date, any amount paid in excess of the original amount owed will not be treated as an increase in the compensation amount if the additional amount is based on a reasonable interest rate. In the case of property, however, a change in the timing of the property's transfer after a goal's attainment will not be treated as an increase in the compensation amount. For example, if a stock grant is contingent on both the attainment of a performance goal and a period of service, eliminating the service requirement following the attainment of the performance goal will not be treated as an increase in the amount of compensation payable under the performance goal. This position appears to be based on the theory that the time value of money is implicit in the current value of property.

(15)Prop. Regs. Sec. 1.162-27(e)(2)(iii)(A).

(16)Prop. Regs. Sec. 1.162-27(e)(2)(iii)(B).

A "performance goal" is a goal based on one or more business criteria that apply to the individual, a business unit or the corporation as a whole. Business criteria such as stock price, market share, sales, earnings per share, return on equity or costs are all considered acceptable standards. The performance goal need not be based on an increase or positive result and could include, for example, maintaining the status quo or limiting economic losses.(17) Although at first glance it appears that this would allow employers to establish easily attainable goals to ensure the payment of contingent performance-based compensation, the requirement that the outcome of a goal be substantially uncertain at the time it is set should prevent any abuse in this area. The proposed regulations also make clear that a performance goal does not include the mere continuance of employment.

(17)Prop. Regs. Sec. 1.162-27(e)(2)(i).

The determination of whether compensation satisfies these requirements is made on a grant-by-grant basis. In other words, a discretionary payment of compensation under a plan will not prevent other payments under that plan that meet the requirements from qualifying as performance-based compensation.

Finally, compensation does not meet the preestablished objective performance goal requirement if the facts and circumstances indicate that the employee would receive all or part of the compensation regardless of whether the performance goal is attained. All plans and arrangements are taken into account for this purpose.(18) In other words, if the facts and circumstances indicate that a payment is only partially contingent on attaining a performance goal, then none of the compensation paid on attainment of the goal will be considered performance-based. Therefore, whenever an employer maintains both an objective plan and a discretionary plan, the qualification of the objective plan as performance-based compensation will be subject to some risk. To minimize this risk, it appears advisable to condition payments under the objective plan on different performance criteria from those used in the discretionary plan.

(18)Prop. Regs. Sec. 1.162-27(e)(2)(iv).

Stock options and SARs: Compensation attributable to stock options and SARs will be deemed to meet the preestablished objective performance goal requirement if it meets three different tests from those set out above. First, the grant must be made by a compensation committee comprised solely of two or more outside directors. Second, the plan under which the option or SAR is granted must state the maximum number of shares or SARs that may be granted during a specified period to any employee. The proposed regulations do not specify the length of the period and it appears that the period could cover several years, including the full life of the plan. This provides compensation committees with considerable discretion in establishing a pattern for granting options or SARs over the specified period. Third, the amount of compensation the employee could receive must be based solely on an increase in the value of stock after the date of the grant or award. Therefore, if the SAR or stock option is granted with an exercise price or grant amount less than the fair market value (FMV) of the company stock on date of grant, the award cannot qualify for this special rule. In such cases, however, if the granting, vesting or exercisability of the option or award is contingent on the attainment of a performance goal described above in the "general rule," the amount paid can still qualify as performance-based compensation.(19)

(19)Prop. Regs. Sec. 1.162-27(e)(2)(vi)(A).

Under the proposed regulations, compensation attributable to a stock option or SAR does not qualify for this special rule to the extent the number of options or SARs exceeds the maximum number of options or SARs stated under the plan (see the second requirement in the preceding paragraph). A cancelled option or SAR continues to be counted against the maximum number of shares for which options may be granted to the employee.(20) This position in the proposed regulations is reminiscent of the so-called "shadow" rule, which was used by the IRS in the incentive stock option area with respect to the requirement that stock options be exercised in the order granted, which was in effect before 1987.(21) Similarly, if an option's exercise price is reduced, the transaction is treated as a cancellation of the option and a grant of a new option. The effect of this rule is to use up the maximum amount allowed for the individual under the plan more rapidly. It is unclear in the proposed regulations whether, if the maximum limit is exceeded, all options or SARs granted under the plan are ineligible for treatment under this special rule or just those in excess of the limit. The better answer appears to be just those in excess of the maximum limit.

(20)Prop. Regs. Sec. 1.162-27(e)(2)(vi)(B).

(21)Prop. Regs. Sec. 1.422A-2(f)(3). Under the "shadow rule," options were considered to be outstanding until they either expired or were exercised under their original terms.

Finally, to the extent that a change in the terms of a stock option or SAR is made to reflect a change in corporate capitalization, such a change will not disqualify the compensation from eligibility under this special rule and, apparently, will not be treated as the grant of a new option or SAR.(22)

(22)Prop. Regs. Sec. 1.162-27(e)(2)(vi)(C).

* Compensation committee comprised solely of two or more outside directors

In general, in order to be performance-based compensation, the performance goal must be established by a compensation committee comprised solely of two or more outside directors. One of the most controversial aspects of the proposed regulations involves the definition of "outside director."

A director is an outside director if the director (1) is not a current employee of the publicly held corporation, (2) is not a former employee of the publicly held corporation receiving compensation for prior services during the tax year (other than benefits under a qualified retirement plan), (3) has never been an officer of the publicly held corporation and (4) does not receive remuneration, either directly or indirectly, from the corporation other than as a director.(23) It is the last requirement that is the most controversial.

(23)Prop. Regs. Sec. 1.162-27(e)(3)(i).

Remuneration is deemed to be paid to a director if it is paid in exchange for goods and services directly to an entity in which the director has a more-than-50% beneficial ownership interest. If the director's beneficial ownership interest is less than 50%, then "de minimis remuneration" may be paid to an entity in which the director has a beneficial ownership interest of at least 5% but not more than 50%. Finally, any remuneration paid to the director's employer is taken into account for this purpose (regardless of any ownership interest by the director in the employer) unless that remuneration is de minimis.(24) De minimis remuneration is determined by looking backward to the prior year of the publicly held corporation. Specifically, remuneration paid to an entity is considered de minimis if, during the publicly held corporation's preceding tax year, payments to the entity did not exceed the lesser of $60,000 or 5% of the gross income of the entity for its tax year ending with or within the publicly held corporation's tax year.(25) Therefore,

if an individual works for an organization that receives more than $60,000 for services or goods provided to a publicly held corporation, any individual employed by that organization will not be considered an outside director in the subsequent year. This is the case even though the employee has no ownership interest in the employer. This is likely to mean that some publicly held corporations will not be able to form a compensation committee of outside directors from their current board of directors.

(24)Prop. Regs. Sec. 1.162-27(e)(3)(ii).

(25)Prop. Regs. Sec. 1.162-27(e)(3)(iii).

The proposed regulations provide that the determination of whether a director is an employee or a former officer of the publicly held corporation is made on the basis of facts at the time the individual is serving as a director on the compensation committee. Thus, a director is not precluded from being an outside director solely because that individual is a former officer of a corporation previously affiliated with the publicly held corporation. An officer means an administrative executive who is or was in regular and continued service. An individual who merely has (or had) the title of officer but not the authority of an officer is not considered an officer. Similarly, an officer will not include those individuals employed for a special or single transaction.(26)

(26)Prop. Regs. Sec. 1.162-27(e)(3)(iv) and (v).

Finally, the proposed regulations contain an important transition rule under which a disinterested director within the meaning of SEC Rule 16b-3(c)(2)(i) will be treated as an outside director until the first shareholder meeting after July 1, 1994 at which directors are elected.(27)

(27)Prop. Regs. Sec. 1.162-27(h)(2).

* Disclosure to and approval by shareholders

In order to qualify as performance-based compensation, the material terms of the performance goal under which the compensation is to be paid must be disclosed to and subsequently approved by shareholders of the publicly held corporation.(28) If the compensation would be paid regardless of whether the material terms are approved by shareholders, the shareholder approval requirements will not be met. It is important to realize that what must be disclosed to shareholders, i.e., the "material terms" of the performance goal, is substantially less specific than the "preestablished objective performance goal" that must be agreed on by the outside directors. Also, unlike the establishment of the performance goal itself, there is no apparent requirement that the shareholder vote occur before the commencement of services or even before the time the attainment of the goal becomes substantially certain.

(28)Prop. Regs. Sec. 1.162-27(e)(4)(i).

There are three aspects of a compensation arrangement that are considered to constitute its material terms. First, the material terms include the individuals eligible to receive compensation. Particular individuals do not have to be identified by name; a general description of the class of eligible employees is sufficient, e.g., the chief executive officer and vice presidents, all salaried employees, all executive officers.(29)

(29)Prop. Regs. Sec. 1.162-27(e)(4)(ii).

The second material term that must be disclosed to and approved by shareholders is a description of the business criteria on which the performance goal is based. The proposed regulations provide that disclosure of the business criteria need not include the specific targets that must be satisfied under the performance goal.(30) For example, if a bonus will be paid only if profits increase by 10%, the 10% figure need not be disclosed to shareholders. However, disclosure must be made that the bonus is contingent based on a profits criterion. The proposed regulations provide that if the compensation committee determines that the information is confidential commercial or business information, the disclosure of which would have an adverse effect on the publicly held corporation, the information need not be disclosed to shareholders.(31) This is a determination to be made on the basis of facts and circumstances. The ability not to disclose confidential information does not eliminate the requirement (discussed in the following paragraph) that the maximum amount of compensation payable to an individual under a performance goal be disclosed. It also does not eliminate the requirement (in the preceding paragraph) that the identity of an executive or the class of executives to which the performance goal applies must be disclosed. Finally, the proposed regulations provide that in the case of stock options and SARs, no specific description of the business criteria is required if the options or SARs are based on a stock price that is no less than the current FMV at time of grant.

(30)Prop. Regs. Sec. 1.162-27(e)(4)(iii)(A).

(31)Prop. Regs. Sec. 1.162-27(e)(4)(iii)(B).

The third material term that must be disclosed to and approved by shareholders is either the maximum amount of compensation to be paid or the formula used to calculate the amount of compensation to be paid if the performance goal is attained.(32) If the formula is disclosed, the disclosure must be specific enough so that shareholders can determine the maximum amount of compensation that could be paid to any employee during a specified period.

(32)Prop. Regs. Sec. 1.162-27(e)(4)(iv).

The proposed regulations also provide that to the extent not specifically covered in the regulations, the standard for determining whether adequate disclosure has occurred is determined under the same standards that apply for purposes of the Securities Exchange Act. Once the material terms of the performance goal(s) are disclosed to and approved by shareholders, no additional disclosure or approval is required unless the compensation committee changes the material terms of the performance goal. However, if the compensation committee has the authority to change the targets after shareholder approval, the material terms of the goal must be disclosed to and reapproved by shareholders no later than the first shareholder meeting occurring in the fifth year following the year in which the shareholders previously approved the performance goal.(33)

(33)Prop. Regs. Sec. 1.162-27(e)(4)(vi).

Finally, the shareholder vote requirement is met if the material terms of the performance goal are approved by a majority of the voting shares in a separate vote. Abstentions are not counted as voting unless applicable state law provides otherwise.(34)

(34)Prop. Regs. Sec. 1.162-27(e)(4)(vii).

* Compensation committee certification

The final requirement for compensation to qualify as performance-based is that the compensation committee must certify in writing before the payment is made that the performance goals and any other material terms were in fact attained. Approved minutes of the compensation committee in which the certification is made are treated as written certification.(35) Certification is not required for compensation attributable solely to an increase in the stock of the publicly held corporation. In the case of compensation other than stock options or SARs, compensation committees may want to retain outside advisers to verify that the performance goals have been attained.

(35)Prop. Regs. Sec. 1.162-27(e)(5).

Privately Held Companies That Become Public

The proposed regulations provide that in the case of a corporation that was not publicly held for the entire year, the deduction disallowance rules do not apply to any compensation plan or agreement that existed while the corporation was not publicly held, as long as the prospectus accompanying the initial public offering disclosed information concerning the plan or agreement that satisfied all applicable securities laws then in effect. This grandfather treatment will not apply if the plan is materially amended.(36) It is unclear from the proposed regulations whether this grandfather treatment applies to subsequent tax years of the previously privately held corporation or just the year in which it becomes publicly held. It is also unclear whether it applies to incentive programs that were adopted before the initial public offering and become effective on a successful public issuance or later.

(36)Prop. Regs. Sec. 1.162-27(f).

Coordination With Golden Parachute Rules

The proposed regulations follow the statute by providing that the $1 million limitation is reduced by the amount that would have been included as part of the compensation deduction for the covered employee but for the fact that it is disallowed by Sec. 280G.(37)

(37)Prop. Regs. Sec. 1.162-27(g).

Example: During a tax year, corporation P pays $1,500,000 to a covered employee and none of the compensation qualifies for either the performance-based or commission exceptions described above. If $600,000 of that amount is an excess parachute payment, the $1,000,000 limitation is reduced to $400,000. Therefore, $500,000 is not deductible by reason of Sec. 162(m).

Transition Rules

* Written binding contract in effect on Feb. 17, 1993

One of the most significant transition rules provided by the statute exempts from the $1 million compensation limitation any compensation payable under a written binding contract that was in effect on Feb. 17, 1993.(38) In order to qualify for this exception, the contract had to be binding under applicable state law. Therefore, in a discretionary stock option plan, only those stock options granted on or before Feb. 17, 1993 appear to qualify for this transition rule. The written binding contract exception does not apply to a contract that is renewed after Feb. 17, 1993. A written binding contract that is terminable or cancellable by the corporation after Feb. 17, 1993 without the employee's consent is treated as a new contract as of the date that any such termination or cancellation would be effective. Individuals employed on Feb. 17, 1993, but not yet eligible to participate in a binding plan or arrangement, will be covered by the transition rule if the employee had the right to participate in the plan under a written binding contract as of Feb. 17, 1993.

This transition rule does not apply to any written binding contract that is materially modified. A material modification is defined as occurring "when the contract is amended to increase the amount of compensation payable to the employee."(39) This appears to be the exclusive test for determining whether or not a material modification has occurred. Therefore, modifications could be made to the plan or arrangement so long as they did not have the effect of increasing the amount of compensation payable to the employee. For example, amending a stock option to allow the exercise price to be paid by issuance of a recourse note bearing a reasonable rate of interest should not be a material modification. A change that accelerates the payment of compensation will be treated as a material modification unless the compensation paid is discounted to reasonably reflect the time value of money.(40) Finally, the adoption of a supplemental contract that provides for increased compensation, or the payment of additional compensation, is a material modification if the facts and circumstances show that the additional compensation is paid on the basis of substantially the same elements or conditions as the compensation that is otherwise paid under the binding written contract.(41) Therefore, should an employer decide to supplement the compensation paid to someone covered by this transition rule, the employer should be careful to base this additional compensation on different elements or conditions than that on which the binding contract is based. Finally, the proposed regulations provide that a supplemental payment of compensation that satisfies the requirements for performance-based compensation will not result in a material modification, nor will a supplemental payment that is equal to or greater than a reasonable cost of living increase over the payment made in the preceding year.

(39)Prop. Regs. Sec. 1.162-27(h)(1)(iii)(A).

(40)Prop. Regs. Sec. 1.162-27(h)(1)(iii)(B).

(41)Prop. Regs. Sec. 1.162-27(h)(1)(iii)(C).

* Outside directors

For purposes of determining whether a director is an outside director, a director who meets the definition of disinterested director within the meaning of SEC Rule 16b-3(c)(2)(i), 17 CFR 240.16b-3(c)(2)(i), under the Securities Exchange Act, will be treated as an outside director until the first meeting of shareholders at which directors are to be elected after July 1, 1994.(42)

(42)Prop. Regs. Sec. 1.162-27(h)(2).

* Previously approved plans

The proposed regulations also provide that any compensation paid under a plan or agreement approved by shareholders before Dec. 20, 1993 is treated as satisfying the outside director and shareholder approval requirements for performance-based compensation provided that the directors establishing and administering the plan are disinterested directors and the plan was approved by shareholders in a manner consistent with SEC Rule 16b-3(b) or SEC Rule 16b-3(a) as in effect on Apr. 30, 1991.(43) It should be noted that this transition rule does not provide relief from the requirements that the compensation must be paid pursuant to a performance goal and that the compensation committee certify that the goal has been met before the compensation can be paid. To meet the performance goal requirement, the transition rule does provide that the requirement that the maximum number of shares with respect to which an option or SAR may be granted to any employee for a specified period will be treated as met if the plan that was approved by the shareholders provided for an aggregate limit on the number of shares of employer stock with respect to which the awards may be made. This transition rule expires on the earliest of (1) the expiration or material modification of the plan, (2) the issuance of all employer stock that has been allocated under the plan or (3) the first meeting of shareholders at which directors are to be elected occurring after Dec. 31, 1996.(44)

(43)Prop. Regs. Sec. 1.162-27(h)(3)(i).

(44)Prop. Regs. Sec. 1.162-27(h)(3)(ii).

Strategies for Dealing With the Cap

There are a number of strategies to minimize the effect of the $1 million annual cap on compensation deductions.

* Base salary

Employers should consider the use of nonqualified deferred compensation arrangements to minimize or completely avoid the new $1 million limitation with respect to base salary. These arrangements could be elective, nonelective or a combination of both. The goal would be to defer base salary to a point in time that it is deductible. There are two basic structures that can be used. First, base salary could be deferred under an agreement that provides that it will be paid when the employee is no longer a covered employee. Alternatively, the deferral agreement could provide that the deferred base salary will be paid at the first point in time that it is deductible. This approach could create problems in administration, however, since deductibility will depend on the other components of the employee's compensation package, e.g., bonuses and stock option exercises. Bonuses present a particular problem in trying to administer this type of arrangement since bonuses earned during an employer's year are deductible by the employer in the year earned if paid within 21/2 months of the end of the employer's year. Therefore, in some situations it may not be possible to know how much deferred base salary to pay in a particular year until the year has ended.

* Bonus plans

Convert to performance-based compensation: Employers should consider converting their bonus plans to arrangements that meet the requirements for performance-based compensation. To retain maximum discretion, employers could implement two approaches, either individually or in concert. First, the compensation committee could be empowered to reduce the amount of an otherwise payable bonus. Alternatively, employers could consider dividing their bonus plan into an objective arrangement and a discretionary arrangement. Maintenance of a discretionary arrangement may, however, call into question whether the objective arrangement is in fact performance-based compensation. It should be possible, however, to structure the arrangement in such a way that maintenance of the discretionary arrangement does not disqualify the objective arrangement as performance-based compensation.

Nonperformance-based compensation: An employer could implement a nonqualified deferred compensation arrangement as part of its nonperformance-based bonus plans to minimize, or completely avoid, the new $1 million limitation. The principles involved in this type of arrangement are the same as those for base salary.

* Stock options and SARs

Employers should consider granting stock options and SARs at FMV. If the options or rights are granted at FMV and the other requirements for performance-based compensation are met, the income from the exercise of the stock options or SARs will not be counted as part of the $1 million limitation. If stock options or SARs are granted at less than FMV, any income resulting from their exercise will not result in a deduction disallowance if the option or SAR meets the requirements of the general rule for qualifying as performance-based compensation. If they do not, then the exercise of the option or warrant could be deferred until the individual is no longer a covered employee.

* Inside director fees

It is unclear under the proposed regulations whether director fees paid to an individual who is also a covered employee are subject to the $1 million limitation. Should the IRS provide additional favorable guidance in this area, employers may want to consider reducing the salary of an inside director and paying director fees that are consistent with the fees paid to outside directors.

Conclusion

Under the Revenue Reconciliation Act of 1993, the tax consequences of paying compensation to a corporation's CEO and other covered employees can vary dramatically depending on the structure of the compensation package. While the proposed regulations answer a number of questions, an even greater number remain unresolved. During this period of uncertainty, employers should carefully review their current compensation arrangements and implement revised compensation programs that make sense from both a business and tax perspective.