65534 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

reinforced plastic ladders. The ANSI

standard requires specification of the

maximum working length of an

extension ladder, as well as several

other pieces of information not required

by the Extension Ladder Rule, including

the total length of the ladder’s sections

and the highest standing level of the

ladder. Compliance with the ANSI

standard, therefore, ensures compliance

with the labeling requirements of the

Extension Ladder Rule. Several

commenters noted this overlap in

coverage of the Extension Ladder Rule

and ANSI standard A14, and

recommended that the Rule be retained

unchanged.

Another commenter stated that the

Rule has imposed minor, incremental

costs, but opined that the benefits have

been significant in that consumers have

a better understanding of extension

ladder length. The commenter

questioned whether there was a

continuing need for this Rule given the

existence of ANSI standard A14 and UL

standard 184, which the commenter

stated also requires extension ladders to

be marked to indicate both the total

length of sections and the maximum

extended length or maximum working

length.

In addition to these specific

comments, one general comment,

applicable to several Commission Rules

being reviewed, was received from an

advertising agency association. This

organization recommended rescission of

the Extension Ladder Rule because the

general prohibitions of Section 5 of the

Federal Trade Commission Act covering

false and deceptive advertising apply to

the ladder industry. Thus, the

commenter concluded that the Rule

creates unnecessary administrative costs

for the government, industry members

and consumers.

Commission staff also engaged in an

informal review of industry practices by

examining the marking of length on

extension ladders available for retail

sale at several chain stores. That review

indicated general compliance with the

requirements of the Rule. Additionally,

a check of Commission records failed to

find any complaints regarding noncompliance with the Rule, or any

initiation of law enforcement actions

alleging violations of the Rule’s

requirements.

Accordingly, the Commission has

reviewed the rulemaking record and

determined to repeal the Extension

Ladder Rule due to changes in industry

practice, and the existence of industry

standards mandating the point-of-sale

disclosures required by the Rule.

III. Regulatory Flexibility Act

The Regulatory Flexibility Act (RFA),

5 U.S.C. 601–11, requires an analysis of

the anticipated impact of the repeal of

the Rule on small businesses. The

reasons for repeal of the Rule have been

explained in this Notice. Repeal of the

Rule would appear to have little or no

effect on small businesses. Moreover,

the Commission is not aware of any

existing federal laws or regulations that

would conflict with repeal of the Rule.

For these reasons, the Commission

certifies, pursuant to Section 605 of the

RFA, 5 U.S.C. 605, that this action will

not have a significant economic impact

on a substantial number of small

entities.

IV. Paperwork Reduction Act

The Extension Ladder Rule imposes

third-party disclosure requirements that

constitute ‘‘information collection

requirements’’ under the Paperwork

Reduction Act, 44 U.S.C. 3501 et seq.

Accordingly, repeal of the Rule would

eliminate any burdens on the public

imposed by these disclosure

requirements.

List of Subjects in 16 CFR Part 418

Advertisting, Extension ladders,

Trade practices.

PART 418—[REMOVED]

The Commission, under authority of

Section 18 of the Federal Trade

Commission Act, 15 U.S.C. 57a, amends

chapter I of title 16 of the Code of

Federal Regulations by removing Part

418.

By direction of the Commission.

Donald S. Clark,

Secretary.

FR Doc. 95–31011 Filed 12–19–95; 8:45 am]

BILLING CODE 6750–01–M

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8650]

RIN 1545–AS23

Disallowance of Deductions for

Employee Remuneration in Excess of

$1,000,000

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final

regulations relating to the disallowance

of deductions for employee

remuneration in excess of $1,000,000.

The regulations provide guidance to

taxpayers that are subject to section

162(m), which was added to the Code

by the Omnibus Budget Reconciliation

Act of 1993.

DATES: These regulations are effective

January 1, 1994.

For dates of applicability, see § 1.162–

27(j).

FOR FURTHER INFORMATION CONTACT:

Robert Misner or Charles T. Deliee at

(202)622–6060 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information

contained in these final regulations have

been reviewed and approved by the

Office of Management and Budget in

accordance with the Paperwork

Reduction Act (44 U.S.C. 3507) under

control number 1545–1466. Responses

to these collections of information are

required to obtain a tax deduction for

performance-based compensation in

excess of $1 million.

An agency may not conduct or

sponsor, and a person is not required to

respond to, a collection of information

unless the collection of information

displays a valid control number.

The estimated average annual burden

per respondent is 50 hours.

Comments concerning the accuracy of

this burden estimate and suggestions for

reducing this burden should be sent to

the Internal Revenue Service, Attn: IRS

Reports Clearance Officer, T:FP,

Washington, DC 20224, and to the

Office of Management and Budget, Attn:

Desk Officer for the Department of the

Treasury, Office of Information and

Regulatory Affairs, Washington, DC

20503.

Books or records relating to this

collection of information must be

retained as long as their contents may

become material in the administration

of any internal revenue law. Generally,

tax returns and tax return information

are confidential, as required by 26

U.S.C. 6103.

Background

Under section 162(m) of the Internal

Revenue Code, a publicly held

corporation is denied a deduction for

compensation paid to its ‘‘covered

employees’’ to the extent the

compensation exceeds $1,000,000 if the

compensation would otherwise be

deductible in a taxable year beginning

on or after January 1, 1994.

On December 20, 1993, proposed

regulations under section 162(m) (the

1993 proposed regulations) were

published in the Federal Register (58
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65535

FR 66310). Amendments to the

proposed regulations (the 1994

amendments) were published in the

Federal Register on December 2, 1994

(59 FR 61844). Public hearings were

held on May 9, 1994, and August 11,

1995. After consideration of the

comments that were received in

response to the notices of proposed

rulemaking and at the hearings, the IRS

and Treasury adopt the proposed

regulations as amended and revised by

this Treasury decision.

Explanation of Provisions

A. Overview of Provisions

As noted above, section 162(m)

provides that a publicly held

corporation is denied a deduction for

compensation paid to a ‘‘covered

employee’’ to the extent the

compensation exceeds $1,000,000. A

‘‘covered employee’’ includes the chief

executive officer (CEO), as well as any

other individual whose compensation is

required to be reported to the Securities

and Exchange Commission by reason of

that individual being among the four

highest compensated officers for the

taxable year (other than the CEO), as of

the end of the corporation’s taxable

year.

‘‘Performance-based compensation’’

and certain other compensation is not

subject to the deduction limitation of

section 162(m). Performance-based

compensation is remuneration payable

solely on account of the attainment of

one or more performance goals, but only

if: (1) the goals are determined by a

compensation committee of the board of

directors consisting solely of two or

more outside directors; (2) the material

terms under which the compensation is

to be paid are disclosed to the

shareholders and approved by a

majority in a separate vote before

payment is made; and (3) before any

payment is made, the compensation

committee certifies that the performance

goals and any other material terms have

been satisfied.

Compensation is also excluded from

the deduction limitation of section

162(m) if it is paid under a binding

written contract that was in existence on

February 17, 1993. In addition, in

accordance with the legislative history,

the proposed regulations exempt from

the limitation compensation that is paid

under an arrangement that existed

before the corporation became publicly

held, to the extent that the arrangement

is disclosed in the initial public

offering.

B. Discussion of Comments

Comments that relate to the

application of the proposed regulations

and the responses to the comments,

including an explanation of the

revisions reflected in the final

regulations, are summarized below.

Dividend Equivalents Paid on Stock

Options

Under the proposed regulations, the

performance-based exception to the

deduction limitation generally is

applied on a grant-by-grant basis. If the

facts and circumstances indicate,

however, that the employee would

receive all or part of the compensation

regardless of whether the performance

goal is attained, the compensation is not

performance based. For example, where

payment under a nonperformance based

bonus is contingent upon the failure to

attain the performance goals under an

otherwise performance-based bonus,

neither bonus arrangement will be

considered performance based. The

proposed regulations provide that

whether dividends (which generally are

not performance based) on restricted

stock are payable before attainment of

the performance goal, will not affect the

determination of whether the restricted

stock is performance based. The

proposed regulations also provide,

however, that if the amount of any

compensation the employee will receive

under a stock option is not based solely

on an increase in the value of the stock

after the date of grant (for example, an

option granted with an exercise price

that is less than the fair market value of

the stock as of the date of grant), none

of the compensation attributable to the

grant will be performance based.

Commentators raised the question of

whether nonperformance-based

dividend equivalents that are paid with

respect to a granted but unexercised

stock option irrespective of whether the

option is exercised will cause the

compensation paid upon the exercise of

the option to be nonperformance based.

Section 1.162–27(e)(2)(vi) of the final

regulations provides that such dividend

equivalents will not cause the

compensation paid upon the exercise of

the option to be nonperformance based,

provided that the payment of the

dividend equivalents is not conditioned

upon the employee exercising the

option. If the payment of the dividend

equivalent is conditioned upon the

employee exercising the option, the

dividend effectively reduces the

exercise price of the option, thereby

causing the option to be

nonperformance based upon its

exercise.

Bonus Pools

Section 1.162–27(e)(2)(ii) of the

proposed regulations provides that a

preestablished performance goal must

state, in terms of an objective formula or

standard, the method for computing the

amount of compensation payable to the

employee if the goal is attained. A

formula or standard is objective if a

third party having knowledge of the

relevant performance results could

calculate the amount to be paid to the

employee.

Section 1.162–27(e)(2)(iii) prohibits

discretion to increase the amount of

compensation to be paid under the

preestablished performance goal, but

permits the compensation committee to

reduce or eliminate the compensation

that is due upon attainment of the goal.

Examples 7 and 8 under § 1.162–

27(e)(2)(vii) of the proposed regulations

illustrated the application of these rules

to bonus pools. In Example 7, the

amount of the bonus pool was

determined under an objective formula.

However, because the compensation

committee retained the discretion to

determine the fraction of the bonus pool

that each covered employee would

receive, the compensation that any

individual could receive was not

determined under an objective formula

and, therefore, the bonus plan did not

satisfy the requirements of paragraph

(e)(2). In Example 8, the compensation

for any individual was determined

under an objective formula because each

employee’s share of the bonus pool was

specified and because, notwithstanding

the compensation committee’s ability to

reduce the compensation payable to

each individual employee, a reduction

in one employee’s bonus would not

result in an increase in the amount of

any other employee’s bonus.

Several commentators have indicated

that, in some cases where compensation

committees have stated the amount

payable to each individual under a

bonus pool plan as a percentage of the

bonus pool, the total of these

percentages has exceeded 100 percent of

the pool. The use of such overlapping

percentages is inconsistent with

§ 1.162–27(e)(2), as illustrated by both

Example 7 and Example 8. As noted,

Example 8 states that negative

discretion will not cause the bonus plan

to fail to satisfy the requirements of

paragraph (e)(2), ‘‘provided that a

reduction in the amount of one

employee’s bonus does not result in an

increase in the amount of any other

employee’s bonus.’’ Where the total of

the percentages payable under a bonus

pool plan exceeds 100 percent, it is

impossible to award each individual the
65536 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

stated percentage, and this necessary

exercise of negative discretion with

respect to one or more employees means

that it is impossible for a third party,

with knowledge of the relevant

performance results, to calculate the

amount to be paid to each employee.

Further, a reduction in at least some

employees’ bonuses will result in an

increase in the amount available to pay

other employees’ bonuses.

Accordingly, § 1.162–27(e)(2)(iii) is

amended to state more clearly that,

when the compensation to be paid to

each employee is stated in terms of a

percentage of a bonus pool, the sum of

the individual percentages for all

participants in the pool cannot exceed

100 percent. In addition, the principle

stated in Example 8, that the exercise of

negative discretion with respect to one

employee cannot increase the amount

payable to another employee, is

incorporated in paragraph (e)(2)(iii).

Example 8 is also revised to more

clearly illustrate this rule.

Although the IRS and Treasury

believe that the changes made merely

clarify the proposed regulations, it is

recognized that others have interpreted

the language of the proposed regulations

differently. Therefore, under § 1.162–

27(j)(2)(iv), this clarified rule will not be

applied to any compensation paid

before January 1, 2001, under a bonus

pool based on performance in any

period that began before December 20,

1995.

Outside Directors

Section 1.162–27(e)(3)(vi) provides

that a director is not precluded from

being an outside director solely because

he or she is a former officer of a

corporation that previously was an

affiliated corporation of the publicly

held corporation. The regulation is

revised to clarify that a former officer of

either a spun off or liquidated

corporation, that formerly was a

member of the affiliated group, is not

precluded from serving on the

compensation committee of the publicly

held member of the affiliated group.

Companies that Become Publicly Held

Without an Initial Public Offering

Under § 1.162–27(f), the $1 million

deduction limit does not apply to any

compensation plan or agreement that

existed before the corporation became

publicly held to the extent that the plan

or agreement was disclosed in the

prospectus accompanying the initial

public offering (IPO). This exception

may be relied on until the earliest of: (1)

the expiration of the plan or agreement,

(2) the material modification of the plan

or agreement, (3) the issuance of all

stock and other compensation that has

been allocated under the plan, or (4) the

first shareholder meeting at which

directors will be elected that occurs

after the close of the third calendar year

following the calendar year in which the

IPO occurs.

Commentators have asked whether

this rule applies to corporations that

become publicly held without an IPO.

As indicated in the legislative history

accompanying Code section 162(m), the

prospectus that accompanies the IPO

provides an opportunity to disclose the

terms of the plan or agreement to the

potential shareholders, and the

subsequent purchase of the stock with

that knowledge may be viewed as

tantamount to a favorable vote on the

compensation arrangement. When a

corporation becomes publicly held

without an IPO, there is no comparable

alternative means of satisfying the

requirements of section 162(m)(4)(C)(ii).

On the other hand, because there is no

requirement for privately held

corporations to comply with section

162(m), the IRS and Treasury recognize

the need for a transition rule for plans

and agreements that are in existence

when a privately held corporation

becomes publicly held without an IPO.

Accordingly, § 1.162–27(f)(1) is

revised to provide relief for privately

held corporations that become publicly

held without an IPO. Under the

transition rule for these corporations,

the reliance period in § 1.162–27(f)(2)

lapses upon the first meeting of

shareholders at which directors are to be

elected that occurs after the close of the

first calendar year following the

calendar year in which the corporation

becomes publicly held.

Written Binding Contracts

Section 1.162–27(h)(1) provides the

transition rules for compensation

payable under a written binding

contract that was in effect on February

17, 1993. Under those rules, a written

binding contract that is terminable or

cancelable by the corporation after

February 17, 1993, without the

employee’s consent is treated as a new

contract as of the date that any such

termination or cancelation, if made,

would be effective. The proposed

regulations further provide that, if the

terms of a contract provide that the

contract will be terminated or canceled

as of a certain date unless either the

corporation or the employee elects to

renew within 30 days of that date, the

contract is treated as renewed by the

corporation as of that date.

Commentators have suggested that

these regulations clarify the outcome

where a corporation will remain bound

by the terms of a contract beyond a

certain date at the sole discretion of the

employee. For example, if a contract

that is in effect on February 17, 1993,

provides that the employee has the sole

discretion to extend or renew the terms

beyond its stated expiration, without the

consent of the corporation, a question

arises whether the contract will be

considered a pre-February 17, 1993

written binding contract after the

employee chooses to extend.

Generally, the question of whether the

terms of a contract are binding is

determined under state law. The IRS

and Treasury believe that the rules for

determining whether a contract is

binding should be applied based on

whether the corporation is bound by the

terms of the contract. Thus, if a contract

provides the employee with the right to

extend or renew its terms without the

consent of the corporation, and the

corporation is legally obligated to pay

the agreed-upon compensation to the

employee if the employee chooses to

extend or renew the contract, the

contract will be considered binding on

the corporation. Accordingly, a new

sentence has been added to § 1.162–

27(h)(1)(i) to clarify that, if the

corporation will remain legally

obligated by the terms of a contract

beyond a certain date at the sole

discretion of the employee, the contract

will not be treated as a new contract as

of that date if the employee exercises

the discretion.

Awards Based on a Percentage of Salary

The 1994 amendments modified

§ 1.162–27(e)(2)(iii) to provide that, if

the terms of an objective formula or

standard fail to preclude discretion

merely because the amount of

compensation to be paid upon

attainment of the performance goal is

based, in whole or in part, on a

percentage of salary or base pay, the

objective formula or standard will not

be considered discretionary (and thus

§ 1.162–27(e)(2)(iii) will not be violated)

if the maximum dollar amount to be

paid is fixed at the time the performance

goal is established. The final regulations

clarify that a maximum dollar amount

need not be specified under this

provision if, at the time the performance

goal is established, the dollar amount of

salary or base pay is fixed. In such a

case, the use of salary or base pay does

not cause the formula to fail to preclude

discretion to increase compensation.

The 1994 amendments made a

corresponding amendment with respect

to salary-based formulas to the

shareholder disclosure rules in § 1.162–

27(e)(4)(i). However, the shareholder

disclosure amendment was not
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65537

explicitly limited to formulas that

would otherwise be discretionary. The

final regulations clarify that the

shareholder disclosure rule relating to

salary-based formulas applies only to

those formulas that would otherwise be

discretionary.

In addition, the final regulations

provide transition relief with respect to

the 1994 amendment of the shareholder

disclosure requirement relating to

salary-based formulas. New § 1.162–

27(j)(2)(v) provides that this disclosure

requirement applies only to plans

approved by shareholders after April 30,

1995.

In the case of a preestablished

performance goal that was established

prior to the publication of the 1994

amendments, a corporation could, of

course, rely upon a reasonable good

faith interpretation of the statutory

provisions to determine that the

performance goal was stated in terms of

an objective formula, to the extent the

issue to which the interpretation relates

was not covered by the 1993

regulations. An award made pursuant to

such a performance goal would not fail

to be performance based merely because

the award was made after the

publication of the 1994 amendments.

Stock-Based Compensation

The 1993 proposed regulations

provided transition relief for previously

approved plans and agreements that did

not satisfy the written binding contract

requirement as of February 17, 1993, but

that were approved by shareholders

before December 20, 1993. See § 1.162–

27(h)(3)(iii). The transition relief

applied to compensation paid prior to

the expiration of a reliance period. In

response to comments on the 1993

proposed regulations, the 1994

amendments expanded this relief to

encompass compensation paid after the

reliance period with respect to the

exercise of stock options and stock

appreciation rights, and the substantial

vesting of restricted property, provided

that the stock option, stock appreciation

right, or restricted property was granted

during the reliance period. Similar relief

provisions were also included in new

transition rules added by the 1994

amendments. (See §§ 1.162–27(f)(3),

(f)(4), (j)(2)(ii), and (j)(2)(iii) of the final

regulations.)

Commentators have asked that the

relief provided in the 1994 amendments

for stock options, stock appreciation

rights, and restricted property be

extended even further to cover other

stock-based compensation and deferred

compensation in general. After careful

consideration of the comments received,

the IRS and Treasury have concluded

that there is not adequate justification

for a further expansion of the 1994

expansion of the prior regulatory

transition relief for previously approved

plans and agreements, or the other

similar relief provisions added in 1994.

Subsidiaries That Become Separate

Publicly Held Corporations

Section 1.162–27(f)(4) of the proposed

regulations contains special rules for

subsidiaries that become separate

publicly held corporations. A transition

rule set forth in § 1.162–27(i)(2)(iii) of

the proposed regulations specified

delayed effective dates for these special

rules. However, commentators indicated

that the regulations were not explicit as

to which rules applied prior to the

delayed effective dates.

The final regulations clarify that

compensation paid prior to the delayed

effective dates by a subsidiary that

becomes a separate publicly held

corporation will not be subject to the $1

million deduction limit if the conditions

of the transition rule are satisfied. (This

transition rule and all other effective

date provisions have been moved from

paragraph (i) to paragraph (j) of the final

regulations. Paragraph (i) is reserved.)

Special Analysis

It has been determined that this

Treasury decision is not a significant

regulatory action as defined in EO

12866. Therefore, a regulatory

assessment is not required. It also has

been determined that section 553(b) of

the Administrative Procedure Act (5

U.S.C. chapter 5) and the Regulatory

Flexibility Act (5 U.S.C. chapter 6) do

not apply to these regulations, and,

therefore, a Regulatory Flexibility

Analysis is not required. Pursuant to

section 7805(f) of the Internal Revenue

Code, the notice of proposed rulemaking

preceding these regulations was

submitted to the Small Business

Administration for comment on its

impact on small business.

Drafting Information

The principal authors of these

regulations are Charles T. Deliee and

Robert Misner, Office of the Associate

Chief Counsel (Employee Benefits and

Exempt Organizations), Internal

Revenue Service. However, other

personnel from IRS and the Treasury

Department participated in their

development.

List of Subjects

26 CFR Part 1

Income taxes, reporting and

recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping

requirements.

Adoption of Amendments to the

Regulations

Accordingly, 26 CFR parts 1 and 602

are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority for part 1

continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.162–27 is added to

read as follows:

§ 1.162–27 Certain employee remuneration

in excess of $1,000,000.

(a) Scope. This section provides rules

for the application of the $1 million

deduction limit under section 162(m) of

the Internal Revenue Code. Paragraph

(b) of this section provides the general

rule limiting deductions under section

162(m). Paragraph (c) of this section

provides definitions of generally

applicable terms. Paragraph (d) of this

section provides an exception from the

deduction limit for compensation

payable on a commission basis.

Paragraph (e) of this section provides an

exception for qualified performancebased compensation. Paragraphs (f) and

(g) of this section provide special rules

for corporations that become publicly

held corporations and payments that are

subject to section 280G, respectively.

Paragraph (h) of this section provides

transition rules, including the rules for

contracts that are grandfathered and not

subject to section 162(m). Paragraph (j)

of this section contains the effective

date provisions. For rules concerning

the deductibility of compensation for

services that are not covered by section

162(m) and this section, see section

162(a)(1) and § 1.162–7. This section is

not determinative as to whether

compensation meets the requirements of

section 162(a)(1).

(b) Limitation on deduction. Section

162(m) precludes a deduction under

chapter 1 of the Internal Revenue Code

by any publicly held corporation for

compensation paid to any covered

employee to the extent that the

compensation for the taxable year

exceeds $1,000,000.

(c) Definitions—(1) Publicly held

corporation—(i) General rule. A publicly

held corporation means any corporation

issuing any class of common equity

securities required to be registered

under section 12 of the Exchange Act.

A corporation is not considered publicly

held if the registration of its equity

securities is voluntary. For purposes of

this section, whether a corporation is
65538 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

publicly held is determined based solely

on whether, as of the last day of its

taxable year, the corporation is subject

to the reporting obligations of section 12

of the Exchange Act.

(ii) Affiliated groups. A publicly held

corporation includes an affiliated group

of corporations, as defined in section

1504 (determined without regard to

section 1504(b)). For purposes of this

section, however, an affiliated group of

corporations does not include any

subsidiary that is itself a publicly held

corporation. Such a publicly held

subsidiary, and its subsidiaries (if any),

are separately subject to this section. If

a covered employee is paid

compensation in a taxable year by more

than one member of an affiliated group,

compensation paid by each member of

the affiliated group is aggregated with

compensation paid to the covered

employee by all other members of the

group. Any amount disallowed as a

deduction by this section must be

prorated among the payor corporations

in proportion to the amount of

compensation paid to the covered

employee by each such corporation in

the taxable year.

(2) Covered employee—(i) General

rule. A covered employee means any

individual who, on the last day of the

taxable year, is—

(A) The chief executive officer of the

corporation or is acting in such

capacity; or

(B) Among the four highest

compensated officers (other than the

chief executive officer).

(ii) Application of rules of the

Securities and Exchange Commission.

Whether an individual is the chief

executive officer described in paragraph

(c)(2)(i)(A) of this section or an officer

described in paragraph (c)(2)(i)(B) of

this section is determined pursuant to

the executive compensation disclosure

rules under the Exchange Act.

(3) Compensation—(i) In general. For

purposes of the deduction limitation

described in paragraph (b) of this

section, compensation means the

aggregate amount allowable as a

deduction under chapter 1 of the

Internal Revenue Code for the taxable

year (determined without regard to

section 162(m)) for remuneration for

services performed by a covered

employee, whether or not the services

were performed during the taxable year.

(ii) Exceptions. Compensation does

not include—

(A) Remuneration covered in section

3121(a)(1) through section 3121(a)(5)(D)

(concerning remuneration that is not

treated as wages for purposes of the

Federal Insurance Contributions Act);

and

(B) 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. In addition,

compensation does not include salary

reduction contributions described in

section 3121(v)(1).

(4) Compensation Committee. The

compensation committee means the

committee of directors (including any

subcommittee of directors) of the

publicly held corporation that has the

authority to establish and administer

performance goals described in

paragraph (e)(2) of this section, and to

certify that performance goals are

attained, as described in paragraph

(e)(5) of this section. A committee of

directors is not treated as failing to have

the authority to establish performance

goals merely because the goals are

ratified by the board of directors of the

publicly held corporation or, if

applicable, any other committee of the

board of directors. See paragraph (e)(3)

of this section for rules concerning the

composition of the compensation

committee.

(5) Exchange Act. The Exchange Act

means the Securities Exchange Act of

1934.

(6) Examples. This paragraph (c) may

be illustrated by the following

examples:

Example 1. Corporation X is a publicly

held corporation with a July 1 to June 30

fiscal year. For Corporation X’s taxable year

ending on June 30, 1995, Corporation X pays

compensation of $2,000,000 to A, an

employee. However, A’s compensation is not

required to be reported to shareholders under

the executive compensation disclosure rules

of the Exchange Act because A is neither the

chief executive officer nor one of the four

highest compensated officers employed on

the last day of the taxable year. A’s

compensation is not subject to the deduction

limitation of paragraph (b) of this section.

Example 2. C, a covered employee,

performs services and receives compensation

from Corporations X, Y, and Z, members of

an affiliated group of corporations.

Corporation X, the parent corporation, is a

publicly held corporation. The total

compensation paid to C from all affiliated

group members is $3,000,000 for the taxable

year, of which Corporation X pays

$1,500,000; Corporation Y pays $900,000;

and Corporation Z pays $600,000. Because

the compensation paid by all affiliated group

members is aggregated for purposes of

section 162(m), $2,000,000 of the aggregate

compensation paid is nondeductible.

Corporations X, Y, and Z each are treated as

paying a ratable portion of the nondeductible

compensation. Thus, two thirds of each

corporation’s payment will be nondeductible.

Corporation X has a nondeductible

compensation expense of $1,000,000

($1,500,000×$2,000,000/$3,000,000).

Corporation Y has a nondeductible

compensation expense of $600,000

($900,000×$2,000,000/$3,000,000).

Corporation Z has a nondeductible

compensation expense of $400,000

($600,000×$2,000,000/$3,000,000).

Example 3. Corporation W, a calendar year

taxpayer, has total assets equal to or

exceeding $5 million and a class of equity

security held of record by 500 or more

persons on December 31, 1994. However,

under the Exchange Act, Corporation W is

not required to file a registration statement

with respect to that security until April 30,

1995. Thus, Corporation W is not a publicly

held corporation on December 31, 1994, but

is a publicly held corporation on December

31, 1995.

Example 4. The facts are the same as in

Example 3, except that on December 15,

1996, Corporation W files with the Securities

and Exchange Commission to disclose that

Corporation W is no longer required to be

registered under section 12 of the Exchange

Act and to terminate its registration of

securities under that provision. Because

Corporation W is no longer subject to

Exchange Act reporting obligations as of

December 31, 1996, Corporation W is not a

publicly held corporation for taxable year

1996, even though the registration of

Corporation W’s securities does not terminate

until 90 days after Corporation W files with

the Securities and Exchange Commission.

(d) Exception for compensation paid

on a commission basis. The deduction

limit in paragraph (b) of this section

shall not apply to any compensation

paid on a commission basis. For this

purpose, compensation is 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

individual to whom the compensation is

paid. Compensation does not fail to be

attributable directly to the individual

merely because support services, such

as secretarial or research services, are

utilized in generating the income.

However, if compensation is paid on

account of broader performance

standards, such as income produced by

a business unit of the corporation, the

compensation does not qualify for the

exception provided under this

paragraph (d).

(e) Exception for qualified

performance-based compensation—

(1) In general. The deduction limit in

paragraph (b) of this section does not

apply to qualified performance-based

compensation. Qualified performancebased compensation is compensation

that meets all of the requirements of

paragraphs (e)(2) through (e)(5) of this

section.

(2) Performance goal requirement—(i)

Preestablished goal. Qualified

performance-based compensation must

be paid solely on account of the

attainment of one or more
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65539

preestablished, objective performance

goals. A performance goal is considered

preestablished if it is established in

writing by the compensation committee

not later than 90 days after the

commencement of the period of service

to which the performance goal relates,

provided that the outcome is

substantially uncertain at the time the

compensation committee actually

establishes the goal. However, in no

event will a performance goal be

considered to be preestablished if it is

established after 25 percent of the

period of service (as scheduled in good

faith at the time the goal is established)

has elapsed. A performance goal is

objective if a third party having

knowledge of the relevant facts could

determine whether the goal is met.

Performance goals can be based on one

or more business criteria that apply to

the individual, a business unit, or the

corporation as a whole. Such business

criteria could include, for example,

stock price, market share, sales, earnings

per share, return on equity, or costs. A

performance goal need not, however, be

based upon an increase or positive

result under a business criterion and

could include, for example, maintaining

the status quo or limiting economic

losses (measured, in each case, by

reference to a specific business

criterion). A performance goal does not

include the mere continued

employment of the covered employee.

Thus, a vesting provision based solely

on continued employment would not

constitute a performance goal. See

paragraph (e)(2)(vi) of this section for

rules on compensation that is based on

an increase in the price of stock.

(ii) Objective compensation formula.

A preestablished performance goal must

state, in terms of an objective formula or

standard, the method for computing the

amount of compensation payable to the

employee if the goal is attained. A

formula or standard is objective if a

third party having knowledge of the

relevant performance results could

calculate the amount to be paid to the

employee. In addition, a formula or

standard must specify the individual

employees or class of employees to

which it applies.

(iii) Discretion.

(A) The terms of an objective formula

or standard must preclude discretion to

increase the amount of compensation

payable that would otherwise be due

upon attainment of the goal. A

performance goal is not discretionary for

purposes of this paragraph (e)(2)(iii)

merely because the compensation

committee reduces or eliminates the

compensation or other economic benefit

that was due upon attainment of the

goal. However, the exercise of negative

discretion with respect to one employee

is not permitted to result in an increase

in the amount payable to another

employee. Thus, for example, in the

case of a bonus pool, if the amount

payable to each employee is stated in

terms of a percentage of the pool, the

sum of these individual percentages of

the pool is not permitted to exceed 100

percent. If the terms of an objective

formula or standard fail to preclude

discretion to increase the amount of

compensation merely because the

amount of compensation to be paid

upon attainment of the performance

goal is based, in whole or in part, on a

percentage of salary or base pay and the

dollar amount of the salary or base pay

is not fixed at the time the performance

goal is established, then the objective

formula or standard will not be

considered discretionary for purposes of

this paragraph (e)(2)(iii) if the maximum

dollar amount to be paid is fixed at that

time.

(B) If compensation is payable upon

or after the attainment of a performance

goal, and a change is made to accelerate

the payment of compensation to an

earlier date after the attainment of the

goal, the change will be treated as an

increase in the amount of compensation,

unless the amount of compensation paid

is discounted to reasonably reflect the

time value of money. If compensation is

payable upon or after the attainment of

a performance goal, and a change is

made to defer the payment of

compensation to a later date, any

amount paid in excess of the amount

that was originally owed to the

employee will not be treated as an

increase in the amount of compensation

if the additional amount is based either

on a reasonable rate of interest or on one

or more predetermined actual

investments (whether or not assets

associated with the amount originally

owed are actually invested therein) such

that the amount payable by the

employer at the later date will be based

on the actual rate of return of a specific

investment (including any decrease as

well as any increase in the value of an

investment). If compensation is payable

in the form of property, a change in the

timing of the transfer of that property

after the attainment of the goal will not

be treated as an increase in the amount

of compensation for purposes of this

paragraph (e)(2)(iii). Thus, for example,

if the terms of a stock grant provide for

stock to be transferred after the

attainment of a performance goal and

the transfer of the stock also is subject

to a vesting schedule, a change in the

vesting schedule that either accelerates

or defers the transfer of stock will not

be treated as an increase in the amount

of compensation payable under the

performance goal.

(C) Compensation attributable to a

stock option, stock appreciation right, or

other stock-based compensation does

not fail to satisfy the requirements of

this paragraph (e)(2) to the extent that a

change in the grant or award is made to

reflect a change in corporate

capitalization, such as a stock split or

dividend, or a corporate transaction,

such as any merger of a corporation into

another corporation, any consolidation

of two or more corporations into another

corporation, any separation of a

corporation (including a spinoff or other

distribution of stock or property by a

corporation), any reorganization of a

corporation (whether or not such

reorganization comes within the

definition of such term in section 368),

or any partial or complete liquidation by

a corporation.

(iv) Grant-by-grant determination.

The determination of whether

compensation satisfies the requirements

of this paragraph (e)(2) generally shall

be made on a grant-by-grant basis. Thus,

for example, whether compensation

attributable to a stock option grant

satisfies the requirements of this

paragraph (e)(2) generally is determined

on the basis of the particular grant made

and without regard to the terms of any

other option grant, or other grant of

compensation, to the same or another

employee. As a further example, except

as provided in paragraph (e)(2)(vi),

whether a grant of restricted stock or

other stock-based compensation satisfies

the requirements of this paragraph (e)(2)

is determined without regard to whether

dividends, dividend equivalents, or

other similar distributions with respect

to stock, on such stock-based

compensation are payable prior to the

attainment of the performance goal.

Dividends, dividend equivalents, or

other similar distributions with respect

to stock that are treated as separate

grants under this paragraph (e)(2)(iv) are

not performance-based compensation

unless they separately satisfy the

requirements of this paragraph (e)(2).

(v) Compensation contingent upon

attainment of performance goal.

Compensation does not satisfy the

requirements of this paragraph (e)(2) 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. Thus, if the payment of

compensation under a grant or award is

only nominally or partially contingent

on attaining a performance goal, none of

the compensation payable under the
65540 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

grant or award will be considered

performance-based. For example, if an

employee is entitled to a bonus under

either of two arrangements, where

payment under a nonperformance-based

arrangement is contingent upon the

failure to attain the performance goals

under an otherwise performance-based

arrangement, then neither arrangement

provides for compensation that satisfies

the requirements of this paragraph

(e)(2). Compensation does not fail to be

qualified performance-based

compensation merely because the plan

allows the compensation to be payable

upon death, disability, or change of

ownership or control, although

compensation actually paid on account

of those events prior to the attainment

of the performance goal would not

satisfy the requirements of this

paragraph (e)(2). As an exception to the

general rule set forth in the first

sentence of paragraph (e)(2)(iv) of this

section, the facts-and-circumstances

determination referred to in the first

sentence of this paragraph (e)(2)(v) is

made taking into account all plans,

arrangements, and agreements that

provide for compensation to the

employee.

(vi) Application of requirements to

stock options and stock appreciation

rights—(A) In general. Compensation

attributable to a stock option or a stock

appreciation right is deemed to satisfy

the requirements of this paragraph (e)(2)

if the grant or award is made by the

compensation committee; the plan

under which the option or right is

granted states the maximum number of

shares with respect to which options or

rights may be granted during a specified

period to any employee; and, under the

terms of the option or right, the amount

of compensation the employee could

receive is based solely on an increase in

the value of the stock after the date of

the grant or award. Conversely, if the

amount of compensation the employee

will receive under the grant or award is

not based solely on an increase in the

value of the stock after the date of grant

or award (e.g., in the case of restricted

stock, or an option that is granted with

an exercise price that is less than the fair

market value of the stock as of the date

of grant), none of the compensation

attributable to the grant or award is

qualified performance-based

compensation because it does not satisfy

the requirement of this paragraph

(e)(2)(vi)(A). Whether a stock option

grant is based solely on an increase in

the value of the stock after the date of

grant is determined without regard to

any dividend equivalent that may be

payable, provided that payment of the

dividend equivalent is not made

contingent on the exercise of the option.

The rule that the compensation

attributable to a stock option or stock

appreciation right must be based solely

on an increase in the value of the stock

after the date of grant or award does not

apply if the grant or award is made on

account of, or if the vesting or

exercisability of the grant or award is

contingent on, the attainment of a

performance goal that satisfies the

requirements of this paragraph (e)(2).

(B) Cancellation and repricing.

Compensation attributable to a stock

option or stock appreciation right does

not satisfy the requirements of this

paragraph (e)(2) to the extent that the

number of options granted exceeds the

maximum number of shares for which

options may be granted to the employee

as specified in the plan. If an option is

canceled, the canceled option continues

to be counted against the maximum

number of shares for which options may

be granted to the employee under the

plan. If, after grant, the exercise price of

an option is reduced, the transaction is

treated as a cancellation of the option

and a grant of a new option. In such

case, both the option that is deemed to

be canceled and the option that is

deemed to be granted reduce the

maximum number of shares for which

options may be granted to the employee

under the plan. This paragraph

(e)(2)(vi)(B) also applies in the case of a

stock appreciation right where, after the

award is made, the base amount on

which stock appreciation is calculated

is reduced to reflect a reduction in the

fair market value of stock.

(vii) Examples. This paragraph (e)(2)

may be illustrated by the following

examples:

Example 1. No later than 90 days after the

start of a fiscal year, but while the outcome

is substantially uncertain, Corporation S

establishes a bonus plan under which A, the

chief executive officer, will receive a cash

bonus of $500,000, if year-end corporate sales

are increased by at least 5 percent. The

compensation committee retains the right, if

the performance goal is met, to reduce the

bonus payment to A if, in its judgment, other

subjective factors warrant a reduction. The

bonus will meet the requirements of this

paragraph (e)(2).

Example 2. The facts are the same as in

Example 1, except that the bonus is based on

a percentage of Corporation S’s total sales for

the fiscal year. Because Corporation S is

virtually certain to have some sales for the

fiscal year, the outcome of the performance

goal is not substantially uncertain, and

therefore the bonus does not meet the

requirements of this paragraph (e)(2).

Example 3. The facts are the same as in

Example 1, except that the bonus is based on

a percentage of Corporation S’s total profits

for the fiscal year. Although some sales are

virtually certain for virtually all public

companies, it is substantially uncertain

whether a company will have profits for a

specified future period even if the company

has a history of profitability. Therefore, the

bonus will meet the requirements of this

paragraph (e)(2).

Example 4. B is the general counsel of

Corporation R, which is engaged in patent

litigation with Corporation S. Representatives

of Corporation S have informally indicated to

Corporation R a willingness to settle the

litigation for $50,000,000. Subsequently, the

compensation committee of Corporation R

agrees to pay B a bonus if B obtains a formal

settlement for at least $50,000,000. The

bonus to B does not meet the requirement of

this paragraph (e)(2) because the performance

goal was not established at a time when the

outcome was substantially uncertain.

Example 5. Corporation S, a public utility,

adopts a bonus plan for selected salaried

employees that will pay a bonus at the end

of a 3-year period of $750,000 each if, at the

end of the 3 years, the price of S stock has

increased by 10 percent. The plan also

provides that the 10-percent goal will

automatically adjust upward or downward by

the percentage change in a published utilities

index. Thus, for example, if the published

utilities index shows a net increase of 5

percent over a 3-year period, then the

salaried employees would receive a bonus

only if Corporation S stock has increased by

15 percent. Conversely, if the published

utilities index shows a net decrease of 5

percent over a 3-year period, then the

salaried employees would receive a bonus if

Corporation S stock has increased by 5

percent. Because these automatic

adjustments in the performance goal are

preestablished, the bonus meets the

requirement of this paragraph (e)(2),

notwithstanding the potential changes in the

performance goal.

Example 6. The facts are the same as in

Example 5, except that the bonus plan

provides that, at the end of the 3-year period,

a bonus of $750,000 will be paid to each

salaried employee if either the price of

Corporation S stock has increased by 10

percent or the earnings per share on

Corporation S stock have increased by 5

percent. If both the earnings-per-share goal

and the stock-price goal are preestablished,

the compensation committee’s discretion to

choose to pay a bonus under either of the two

goals does not cause any bonus paid under

the plan to fail to meet the requirement of

this paragraph (e)(2) because each goal

independently meets the requirements of this

paragraph (e)(2). The choice to pay under

either of the two goals is tantamount to the

discretion to choose not to pay under one of

the goals, as provided in paragraph (e)(2)(iii)

of this section.

Example 7. Corporation U establishes a

bonus plan under which a specified class of

employees will participate in a bonus pool if

certain preestablished performance goals are

attained. The amount of the bonus pool is

determined under an objective formula.

Under the terms of the bonus plan, the

compensation committee retains the

discretion to determine the fraction of the

bonus pool that each employee may receive.
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65541

The bonus plan does not satisfy the

requirements of this paragraph (e)(2).

Although the aggregate amount of the bonus

plan is determined under an objective

formula, a third party could not determine

the amount that any individual could receive

under the plan.

Example 8. The facts are the same as in

Example 7, except that the bonus plan

provides that a specified share of the bonus

pool is payable to each employee, and the

total of these shares does not exceed 100%

of the pool. The bonus plan satisfies the

requirements of this paragraph (e)(2). In

addition, the bonus plan will satisfy the

requirements of this paragraph (e)(2) even if

the compensation committee retains the

discretion to reduce the compensation

payable to any individual employee,

provided that a reduction in the amount of

one employee’s bonus does not result in an

increase in the amount of any other

employee’s bonus.

Example 9. Corporation V establishes a

stock option plan for salaried employees. The

terms of the stock option plan specify that no

salaried employee shall receive options for

more than 100,000 shares over any 3-year

period. The compensation committee grants

options for 50,000 shares to each of several

salaried employees. The exercise price of

each option is equal to or greater than the fair

market value at the time of each grant.

Compensation attributable to the exercise of

the options satisfies the requirements of this

paragraph (e)(2). If, however, the terms of the

options provide that the exercise price is less

than fair market value at the date of grant, no

compensation attributable to the exercise of

those options satisfies the requirements of

this paragraph (e)(2) unless issuance or

exercise of the options was contingent upon

the attainment of a preestablished

performance goal that satisfies this paragraph

(e)(2).

Example 10. The facts are the same as in

Example 9, except that, within the same 3-

year grant period, the fair market value of

Corporation V stock is significantly less than

the exercise price of the options. The

compensation committee reprices those

options to that lower current fair market

value of Corporation V stock. The repricing

of the options for 50,000 shares held by each

salaried employee is treated as the grant of

new options for an additional 50,000 shares

to each employee. Thus, each of the salaried

employees is treated as having received

grants for 100,000 shares. Consequently, if

any additional options are granted to those

employees during the 3-year period,

compensation attributable to the exercise of

those additional options would not satisfy

the requirements of this paragraph (e)(2). The

results would be the same if the

compensation committee canceled the

outstanding options and issued new options

to the same employees that were exercisable

at the fair market value of Corporation V

stock on the date of reissue.

Example 11. Corporation W maintains a

plan under which each participating

employee may receive incentive stock

options, nonqualified stock options, stock

appreciation rights, or grants of restricted

Corporation W stock. The plan specifies that

each participating employee may receive

options, stock appreciation rights, restricted

stock, or any combination of each, for no

more than 20,000 shares over the life of the

plan. The plan provides that stock options

may be granted with an exercise price of less

than, equal to, or greater than fair market

value on the date of grant. Options granted

with an exercise price equal to, or greater

than, fair market value on the date of grant

do not fail to meet the requirements of this

paragraph (e)(2) merely because the

compensation committee has the discretion

to determine the types of awards (i.e.,

options, rights, or restricted stock) to be

granted to each employee or the discretion to

issue options or make other compensation

awards under the plan that would not meet

the requirements of this paragraph (e)(2).

Whether an option granted under the plan

satisfies the requirements of this paragraph

(e)(2) is determined on the basis of the

specific terms of the option and without

regard to other options or awards under the

plan.

Example 12. Corporation X maintains a

plan under which stock appreciation rights

may be awarded to key employees. The plan

permits the compensation committee to make

awards under which the amount of

compensation payable to the employee is

equal to the increase in the stock price plus

a percentage ‘‘gross up’’ intended to offset the

tax liability of the employee. In addition, the

plan permits the compensation committee to

make awards under which the amount of

compensation payable to the employee is

equal to the increase in the stock price, based

on the highest price, which is defined as the

highest price paid for Corporation X stock (or

offered in a tender offer or other arms-length

offer) during the 90 days preceding exercise.

Compensation attributable to awards under

the plan satisfies the requirements of

paragraph (e)(2)(vi) of this section, provided

that the terms of the plan specify the

maximum number of shares for which

awards may be made.

Example 13. Corporation W adopts a plan

under which a bonus will be paid to the CEO

only if there is a 10% increase in earnings

per share during the performance period. The

plan provides that earnings per share will be

calculated without regard to any change in

accounting standards that may be required by

the Financial Accounting Standards Board

after the goal is established. After the goal is

established, such a change in accounting

standards occurs. Corporation W’s reported

earnings, for purposes of determining

earnings per share under the plan, are

adjusted pursuant to this plan provision to

factor out this change in standards. This

adjustment will not be considered an

exercise of impermissible discretion because

it is made pursuant to the plan provision.

Example 14. Corporation X adopts a

performance-based incentive pay plan with a

four-year performance period. Bonuses under

the plan are scheduled to be paid in the first

year after the end of the performance period

(year 5). However, in the second year of the

performance period, the compensation

committee determines that any bonuses

payable in year 5 will instead, for bona fide

business reasons, be paid in year 10. The

compensation committee also determines

that any compensation that would have been

payable in year 5 will be adjusted to reflect

the delay in payment. The adjustment will be

based on the greater of the future rate of

return of a specified mutual fund that invests

in blue chip stocks or of a specified venture

capital investment over the five-year deferral

period. Each of these investments,

considered by itself, is a predetermined

actual investment because it is based on the

future rate of return of an actual investment.

However, the adjustment in this case is not

based on predetermined actual investments

within the meaning of paragraph (e)(2)(iii)(B)

of this section because the amount payable

by Corporation X in year 10 will be based on

the greater of the two investment returns and,

thus, will not be based on the actual rate of

return on either specific investment.

Example 15. The facts are the same as in

Example 14, except that the increase will be

based on Moody’s Average Corporate Bond

Yield over the five-year deferral period.

Because this index reflects a reasonable rate

of interest, the increase in the compensation

payable that is based on the index’s rate of

return is not considered an impermissible

increase in the amount of compensation

payable under the formula.

Example 16. The facts are the same as in

Example 14, except that the increase will be

based on the rate of return for the Standard

& Poor’s 500 Index. This index does not

measure interest rates and thus does not

represent a reasonable rate of interest. In

addition, this index does not represent an

actual investment. Therefore, any additional

compensation payable based on the rate of

return of this index will result in an

impermissible increase in the amount

payable under the formula. If, in contrast, the

increase were based on the rate of return of

an existing mutual fund that is invested in

a manner that seeks to approximate the

Standard & Poor’s 500 Index, the increase

would be based on a predetermined actual

investment within the meaning of paragraph

(e)(2)(iii)(B) of this section and thus would

not result in an impermissible increase in the

amount payable under the formula.

(3) Outside directors—(i) General rule.

The performance goal under which

compensation is paid must be

established by a compensation

committee comprised solely of two or

more outside directors. A director is an

outside director if the director—

(A) Is not a current employee of the

publicly held corporation;

(B) Is not a former employee of the

publicly held corporation who receives

compensation for prior services (other

than benefits under a tax-qualified

retirement plan) during the taxable year;

(C) Has not been an officer of the

publicly held corporation; and

(D) Does not receive remuneration

from the publicly held corporation,

either directly or indirectly, in any

capacity other than as a director. For

this purpose, remuneration includes any

payment in exchange for goods or

services.
65542 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

(ii) Remuneration received. For

purposes of this paragraph (e)(3),

remuneration is received, directly or

indirectly, by a director in each of the

following circumstances:

(A) If remuneration is paid, directly or

indirectly, to the director personally or

to an entity in which the director has a

beneficial ownership interest of greater

than 50 percent. For this purpose,

remuneration is considered paid when

actually paid (and throughout the

remainder of that taxable year of the

corporation) and, if earlier, throughout

the period when a contract or agreement

to pay remuneration is outstanding.

(B) If remuneration, other than de

minimis remuneration, was paid by the

publicly held corporation in its

preceding taxable year to an entity in

which the director has a beneficial

ownership interest of at least 5 percent

but not more than 50 percent. For this

purpose, remuneration is considered

paid when actually paid or, if earlier,

when the publicly held corporation

becomes liable to pay it.

(C) If remuneration, other than de

minimis remuneration, was paid by the

publicly held corporation in its

preceding taxable year to an entity by

which the director is employed or selfemployed other than as a director. For

this purpose, remuneration is

considered paid when actually paid or,

if earlier, when the publicly held

corporation becomes liable to pay it.

(iii) De minimis remuneration—(A) In

general. For purposes of paragraphs

(e)(3)(ii)(B) and (C) of this section,

remuneration that was paid by the

publicly held corporation in its

preceding taxable year to an entity is de

minimis if payments to the entity did

not exceed 5 percent of the gross

revenue of the entity for its taxable year

ending with or within that preceding

taxable year of the publicly held

corporation.

(B) Remuneration for personal

services and substantial owners.

Notwithstanding paragraph (e)(3)(iii)(A)

of this section, remuneration in excess

of $60,000 is not de minimis if the

remuneration is paid to an entity

described in paragraph (e)(3)(ii)(B) of

this section, or is paid for personal

services to an entity described in

paragraph (e)(3)(ii)(C) of this section.

(iv) Remuneration for personal

services. For purposes of paragraph

(e)(3)(iii)(B) of this section,

remuneration from a publicly held

corporation is for personal services if—

(A) The remuneration is paid to an

entity for personal or professional

services, consisting of legal, accounting,

investment banking, and management

consulting services (and other similar

services that may be specified by the

Commissioner in revenue rulings,

notices, or other guidance published in

the Internal Revenue Bulletin),

performed for the publicly held

corporation, and the remuneration is not

for services that are incidental to the

purchase of goods or to the purchase of

services that are not personal services;

and

(B) The director performs significant

services (whether or not as an

employee) for the corporation, division,

or similar organization (within the

entity) that actually provides the

services described in paragraph

(e)(3)(iv)(A) of this section to the

publicly held corporation, or more than

50 percent of the entity’s gross revenues

(for the entity’s preceding taxable year)

are derived from that corporation,

subsidiary, or similar organization.

(v) Entity defined. For purposes of this

paragraph (e)(3), entity means an

organization that is a sole

proprietorship, trust, estate, partnership,

or corporation. The term also includes

an affiliated group of corporations as

defined in section 1504 (determined

without regard to section 1504(b)) and a

group of organizations that would be an

affiliated group but for the fact that one

or more of the organizations are not

incorporated. However, the aggregation

rules referred to in the preceding

sentence do not apply for purposes of

determining whether a director has a

beneficial ownership interest of at least

5 percent or greater than 50 percent.

(vi) Employees and former officers.

Whether a director is an employee or a

former officer is determined on the basis

of the facts at the time that the

individual is serving as a director on the

compensation committee. Thus, a

director is not precluded from being an

outside director solely because the

director is a former officer of a

corporation that previously was an

affiliated corporation of the publicly

held corporation. For example, a

director of a parent corporation of an

affiliated group is not precluded from

being an outside director solely because

that director is a former officer of an

affiliated subsidiary that was spun off or

liquidated. However, an outside director

would no longer be an outside director

if a corporation in which the director

was previously an officer became an

affiliated corporation of the publicly

held corporation.

(vii) Officer. Solely for purposes of

this paragraph (e)(3), officer means an

administrative executive who is or was

in regular and continued service. The

term implies continuity of service and

excludes those employed for a special

and single transaction. An individual

who merely has (or had) the title of

officer but not the authority of an officer

is not considered an officer. The

determination of whether an individual

is or was an officer is based on all of the

facts and circumstances in the particular

case, including without limitation the

source of the individual’s authority, the

term for which the individual is elected

or appointed, and the nature and extent

of the individual’s duties.

(viii) Members of affiliated groups.

For purposes of this paragraph (e)(3),

the outside directors of the publicly

held member of an affiliated group are

treated as the outside directors of all

members of the affiliated group.

(ix) Examples. This paragraph (e)(3)

may be illustrated by the following

examples:

Example 1. Corporations X and Y are

members of an affiliated group of

corporations as defined in section 1504, until

July 1, 1994, when Y is sold to another group.

Prior to the sale, A served as an officer of

Corporation Y. After July 1, 1994, A is not

treated as a former officer of Corporation X

by reason of having been an officer of Y.

Example 2. Corporation Z, a calendar-year

taxpayer, uses the services of a law firm by

which B is employed, but in which B has a

less-than-5-percent ownership interest. The

law firm reports income on a July 1 to June

30 basis. Corporation Z appoints B to serve

on its compensation committee for calendar

year 1998 after determining that, in calendar

year 1997, it did not become liable to the law

firm for remuneration exceeding the lesser of

$60,000 or five percent of the law firm’s gross

revenue (calculated for the year ending June

30, 1997). On October 1, 1998, Corporation

Z becomes liable to pay remuneration of

$50,000 to the law firm on June 30, 1999. For

the year ending June 30, 1998, the law firm’s

gross revenue was less than $1 million. Thus,

in calendar year 1999, B is not an outside

director. However, B may satisfy the

requirements for an outside director in

calendar year 2000, if, in calendar year 1999,

Corporation Z does not become liable to the

law firm for additional remuneration. This is

because the remuneration actually paid on

June 30, 1999 was considered paid on

October 1, 1998 under paragraph (e)(3)(ii)(C)

of this section.

Example 3. Corporation Z, a publicly held

corporation, purchases goods from

Corporation A. D, an executive and lessthan-5-percent owner of Corporation A, sits

on the board of directors of Corporation Z

and on its compensation committee. For

1997, Corporation Z obtains representations

to the effect that D is not eligible for any

commission for D’s sales to Corporation Z

and that, for purposes of determining D’s

compensation for 1997, Corporation A’s sales

to Corporation Z are not otherwise treated

differently than sales to other customers of

Corporation A (including its affiliates, if any)

or are irrelevant. In addition, Corporation Z

has no reason to believe that these

representations are inaccurate or that it is

otherwise paying remuneration indirectly to

D personally. Thus, in 1997, no remuneration
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65543

is considered paid by Corporation Z

indirectly to D personally under paragraph

(e)(3)(ii)(A) of this section.

Example 4. (i) Corporation W, a publicly

held corporation, purchases goods from

Corporation T. C, an executive and less- than5-percent owner of Corporation T, sits on the

board of directors of Corporation W and on

its compensation committee. Corporation T

develops a new product and agrees on

January 1, 1998 to pay C a bonus of $500,000

if Corporation W contracts to purchase the

product. Even if Corporation W purchases

the new product, sales to Corporation W will

represent less than 5 percent of Corporation

T’s gross revenues. In 1999, Corporation W

contracts to purchase the new product and,

in 2000, C receives the $500,000 bonus from

Corporation T. In 1998, 1999, and 2000,

Corporation W does not obtain any

representations relating to indirect

remuneration to C personally (such as the

representations described in Example 3).

(ii) Thus, in 1998, 1999, and 2000,

remuneration is considered paid by

Corporation W indirectly to C personally

under paragraph (e)(3)(ii)(A) of this section.

Accordingly, in 1998, 1999, and 2000, C is

not an outside director of Corporation W. The

result would have been the same if

Corporation W had obtained appropriate

representations but nevertheless had reason

to believe that it was paying remuneration

indirectly to C personally.

Example 5. Corporation R, a publicly held

corporation, purchases utility service from

Corporation Q, a public utility. The chief

executive officer, and less-than-5-percent

owner, of Corporation Q is a director of

Corporation R. Corporation R pays

Corporation Q more than $60,000 per year for

the utility service, but less than 5 percent of

Corporation Q’s gross revenues. Because

utility services are not personal services, the

fees paid are not subject to the $60,000 de

minimis rule for remuneration for personal

services within the meaning of paragraph

(e)(3)(iii)(B) of this section. Thus, the chief

executive officer qualifies as an outside

director of Corporation R, unless disqualified

on some other basis.

Example 6. Corporation A, a publicly held

corporation, purchases management

consulting services from Division S of

Conglomerate P. The chief financial officer of

Division S is a director of Corporation A.

Corporation A pays more than $60,000 per

year for the management consulting services,

but less than 5 percent of Conglomerate P’s

gross revenues. Because management

consulting services are personal services

within the meaning of paragraph (e)(3)(iv)(A)

of this section, and the chief financial officer

performs significant services for Division S,

the fees paid are subject to the $60,000 de

minimis rule as remuneration for personal

services. Thus, the chief financial officer

does not qualify as an outside director of

Corporation A.

Example 7. The facts are the same as in

Example 6, except that the chief executive

officer, and less-than-5-percent owner, of the

parent company of Conglomerate P is a

director of Corporation A and does not

perform significant services for Division S. If

the gross revenues of Division S do not

constitute more than 50 percent of the gross

revenues of Conglomerate P for P’s preceding

taxable year, the chief executive officer will

qualify as an outside director of Corporation

A, unless disqualified on some other basis.

(4) Shareholder approval

requirement—(i) General rule. The

material terms of the performance goal

under which the compensation is to be

paid must be disclosed to and

subsequently approved by the

shareholders of the publicly held

corporation before the compensation is

paid. The requirements of this

paragraph (e)(4) are not satisfied if the

compensation would be paid regardless

of whether the material terms are

approved by shareholders. The material

terms include the employees eligible to

receive compensation; a description of

the business criteria on which the

performance goal is based; and either

the maximum amount of compensation

that could be paid to any employee or

the formula used to calculate the

amount of compensation to be paid to

the employee if the performance goal is

attained (except that, in the case of a

formula that fails to preclude discretion

to increase the amount of compensation

(as described in paragraph (e)(2)(iii)(A)

of this section) merely because the

amount of compensation to be paid is

based, in whole or in part, on a

percentage of salary or base pay and the

dollar amount of the salary or base pay

is not fixed at the time the performance

goal is established, the maximum dollar

amount of compensation that could be

paid to the employee must be

disclosed).

(ii) Eligible employees. Disclosure of

the employees eligible to receive

compensation need not be so specific as

to identify the particular individuals by

name. A general description of the class

of eligible employees by title or class is

sufficient, such as the chief executive

officer and vice presidents, or all

salaried employees, all executive

officers, or all key employees.

(iii) Description of business criteria—

(A) In general. Disclosure of the

business criteria on which the

performance goal is based need not

include the specific targets that must be

satisfied under the performance goal.

For example, if a bonus plan provides

that a bonus will be paid if earnings per

share increase by 10 percent, the 10-

percent figure is a target that need not

be disclosed to shareholders. However,

in that case, disclosure must be made

that the bonus plan is based on an

earnings-per-share business criterion. In

the case of a plan under which

employees may be granted stock options

or stock appreciation rights, no specific

description of the business criteria is

required if the grants or awards are

based on a stock price that is no less

than current fair market value.

(B) Disclosure of confidential

information. The requirements of this

paragraph (e)(4) may be satisfied even

though information that otherwise

would be a material term of a

performance goal is not disclosed to

shareholders, provided that 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. Whether disclosure would

adversely affect the corporation is

determined on the basis of the facts and

circumstances. If the compensation

committee makes such a determination,

the disclosure to shareholders must

state the compensation committee’s

belief that the information is

confidential commercial or business

information, the disclosure of which

would adversely affect the company. In

addition, the ability not to disclose

confidential information does not

eliminate the requirement that

disclosure be made of the maximum

amount of compensation that is payable

to an individual under a performance

goal. Confidential information does not

include the identity of an executive or

the class of executives to which a

performance goal applies or the amount

of compensation that is payable if the

goal is satisfied.

(iv) Description of compensation.

Disclosure as to the compensation

payable under a performance goal 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. If

the terms of the performance goal do not

provide for a maximum dollar amount,

the disclosure must include the formula

under which the compensation would

be calculated. Thus, for example, if

compensation attributable to the

exercise of stock options is equal to the

difference in the exercise price and the

current value of the stock, disclosure

would be required of the maximum

number of shares for which grants may

be made to any employee and the

exercise price of those options (e.g., fair

market value on date of grant). In that

case, shareholders could calculate the

maximum amount of compensation that

would be attributable to the exercise of

options on the basis of their

assumptions as to the future stock price.

(v) Disclosure requirements of the

Securities and Exchange Commission.

To the extent not otherwise specifically

provided in this paragraph (e)(4),

whether the material terms of a
65544 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

performance goal are adequately

disclosed to shareholders is determined

under the same standards as apply

under the Exchange Act.

(vi) Frequency of disclosure. Once the

material terms of a performance goal 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.

If, however, the compensation

committee has authority to change the

targets under a performance goal after

shareholder approval of the goal,

material terms of the performance goal

must be disclosed to and reapproved by

shareholders no later than the first

shareholder meeting that occurs in the

fifth year following the year in which

shareholders previously approved the

performance goal.

(vii) Shareholder vote. For purposes

of this paragraph (e)(4), the material

terms of a performance goal are

approved by shareholders if, in a

separate vote, a majority of the votes

cast on the issue (including abstentions

to the extent abstentions are counted as

voting under applicable state law) are

cast in favor of approval.

(viii) Members of affiliated group. For

purposes of this paragraph (e)(4), the

shareholders of the publicly held

member of the affiliated group are

treated as the shareholders of all

members of the affiliated group.

(ix) Examples. This paragraph (e)(4)

may be illustrated by the following

examples:

Example 1. Corporation X adopts a plan

that will pay a specified class of its

executives an annual cash bonus based on

the overall increase in corporate sales during

the year. Under the terms of the plan, the

cash bonus of each executive equals $100,000

multiplied by the number of percentage

points by which sales increase in the current

year when compared to the prior year.

Corporation X discloses to its shareholders

prior to the vote both the class of executives

eligible to receive awards and the annual

formula of $100,000 multiplied by the

percentage increase in sales. This disclosure

meets the requirements of this paragraph

(e)(4). Because the compensation committee

does not have the authority to establish a

different target under the plan, Corporation X

need not redisclose to its shareholders and

obtain their reapproval of the material terms

of the plan until those material terms are

changed.

Example 2. The facts are the same as in

Example 1 except that Corporation X

discloses only that bonuses will be paid on

the basis of the annual increase in sales. This

disclosure does not meet the requirements of

this paragraph (e)(4) because it does not

include the formula for calculating the

compensation or a maximum amount of

compensation to be paid if the performance

goal is satisfied.

Example 3. Corporation Y adopts an

incentive compensation plan in 1995 that

will pay a specified class of its executives a

bonus every 3 years based on the following

3 factors: increases in earnings per share,

reduction in costs for specified divisions, and

increases in sales by specified divisions. The

bonus is payable in cash or in Corporation Y

stock, at the option of the executive. Under

the terms of the plan, prior to the beginning

of each 3-year period, the compensation

committee determines the specific targets

under each of the three factors (i.e., the

amount of the increase in earnings per share,

the reduction in costs, and the amount of

sales) that must be met in order for the

executives to receive a bonus. Under the

terms of the plan, the compensation

committee retains the discretion to determine

whether a bonus will be paid under any one

of the goals. The terms of the plan also

specify that no executive may receive a

bonus in excess of $1,500,000 for any 3-year

period. To satisfy the requirements of this

paragraph (e)(4), Corporation Y obtains

shareholder approval of the plan at its 1995

annual shareholder meeting. In the proxy

statement issued to shareholders,

Corporation Y need not disclose to

shareholders the specific targets that are set

by the compensation committee. However,

Corporation Y must disclose that bonuses are

paid on the basis of earnings per share,

reductions in costs, and increases in sales of

specified divisions. Corporation Y also must

disclose the maximum amount of

compensation that any executive may receive

under the plan is $1,500,000 per 3-year

period. Unless changes in the material terms

of the plan are made earlier, Corporation Y

need not disclose the material terms of the

plan to the shareholders and obtain their

reapproval until the first shareholders’

meeting held in 2000.

Example 4. The same facts as in Example

3, except that prior to the beginning of the

second 3-year period, the compensation

committee determines that different targets

will be set under the plan for that period

with regard to all three of the performance

criteria (i.e., earnings per share, reductions in

costs, and increases in sales). In addition, the

compensation committee raises the

maximum dollar amount that can be paid

under the plan for a 3-year period to

$2,000,000. The increase in the maximum

dollar amount of compensation under the

plan is a changed material term. Thus, to

satisfy the requirements of this paragraph

(e)(4), Corporation Y must disclose to and

obtain approval by the shareholders of the

plan as amended.

Example 5. In 1998, Corporation Z

establishes a plan under which a specified

group of executives will receive a cash bonus

not to exceed $750,000 each if a new product

that has been in development is completed

and ready for sale to customers by January 1,

2000. Although the completion of the new

product is a material term of the performance

goal under this paragraph (e)(4), the

compensation committee determines that the

disclosure to shareholders of the performance

goal would adversely affect Corporation Z

because its competitors would be made

aware of the existence and timing of its new

product. In this case, the requirements of this

paragraph (e)(4) are satisfied if all other

material terms, including the maximum

amount of compensation, are disclosed and

the disclosure affirmatively states that the

terms of the performance goal are not being

disclosed because the compensation

committee has determined that those terms

include confidential information, the

disclosure of which would adversely affect

Corporation Z.

(5) Compensation committee

certification. The compensation

committee must certify in writing prior

to payment of the compensation that the

performance goals and any other

material terms were in fact satisfied. For

this purpose, approved minutes of the

compensation committee meeting in

which the certification is made are

treated as a written certification.

Certification by the compensation

committee is not required for

compensation that is attributable solely

to the increase in the stock of the

publicly held corporation.

(f) Companies that become publicly

held, spinoffs, and similar

transactions—(1) In general. In the case

of a corporation that was not a publicly

held corporation and then becomes a

publicly held corporation, the

deduction limit of paragraph (b) of this

section does not apply to any

remuneration paid pursuant to a

compensation plan or agreement that

existed during the period in which the

corporation was not publicly held.

However, in the case of such a

corporation that becomes publicly held

in connection with an initial public

offering, this relief applies only to the

extent that the prospectus

accompanying the initial public offering

disclosed information concerning those

plans or agreements that satisfied all

applicable securities laws then in effect.

In accordance with paragraph (c)(1)(ii)

of this section, a corporation that is a

member of an affiliated group that

includes a publicly held corporation is

considered publicly held and, therefore,

cannot rely on this paragraph (f)(1).

(2) Reliance period. Paragraph (f)(1) of

this section may be relied upon until the

earliest of—

(i) The expiration of the plan or

agreement;

(ii) The material modification of the

plan or agreement, within the meaning

of paragraph (h)(1)(iii) of this section;

(iii) The issuance of all employer

stock and other compensation that has

been allocated under the plan; or

(iv) The first meeting of shareholders

at which directors are to be elected that

occurs after the close of the third

calendar year following the calendar

year in which the initial public offering
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65545

occurs or, in the case of a privately held

corporation that becomes publicly held

without an initial public offering, the

first calendar year following the

calendar year in which the corporation

becomes publicly held.

(3) Stock-based compensation.

Paragraph (f)(1) of this section will

apply to any compensation received

pursuant to the exercise of a stock

option or stock appreciation right, or the

substantial vesting of restricted

property, granted under a plan or

agreement described in paragraph (f)(1)

of this section if the grant occurs on or

before the earliest of the events

specified in paragraph (f)(2) of this

section.

(4) Subsidiaries that become separate

publicly held corporations—(i) In

general. If a subsidiary that is a member

of the affiliated group described in

paragraph (c)(1)(ii) of this section

becomes a separate publicly held

corporation (whether by spinoff or

otherwise), any remuneration paid to

covered employees of the new publicly

held corporation will satisfy the

exception for performance-based

compensation described in paragraph

(e) of this section if the conditions in

either paragraph (f)(4)(ii) or (f)(4)(iii) of

this section are satisfied.

(ii) Prior establishment and approval.

Remuneration satisfies the requirements

of this paragraph (f)(4)(ii) if the

remuneration satisfies the requirements

for performance-based compensation set

forth in paragraphs (e)(2), (e)(3), and

(e)(4) of this section (by application of

paragraphs (e)(3)(viii) and (e)(4)(viii) of

this section) before the corporation

becomes a separate publicly held

corporation, and the certification

required by paragraph (e)(5) of this

section is made by the compensation

committee of the new publicly held

corporation (but if the performance

goals are attained before the corporation

becomes a separate publicly held

corporation, the certification may be

made by the compensation committee

referred to in paragraph (e)(3)(viii) of

this section before it becomes a separate

publicly held corporation). Thus, this

paragraph (f)(4)(ii) requires that the

outside directors and shareholders

(within the meaning of paragraphs

(e)(3)(viii) and (e)(4)(viii) of this section)

of the corporation before it becomes a

separate publicly held corporation

establish and approve, respectively, the

performance-based compensation for

the covered employees of the new

publicly held corporation in accordance

with paragraphs (e)(3) and (e)(4) of this

section.

(iii) Transition period. Remuneration

satisfies the requirements of this

paragraph (f)(4)(iii) if the remuneration

satisfies all of the requirements of

paragraphs (e)(2), (e)(3), and (e)(5) of

this section. The outside directors

(within the meaning of paragraph

(e)(3)(viii) of this section) of the

corporation before it becomes a separate

publicly held corporation, or the outside

directors of the new publicly held

corporation, may establish and

administer the performance goals for the

covered employees of the new publicly

held corporation for purposes of

satisfying the requirements of

paragraphs (e)(2) and (e)(3) of this

section. The certification required by

paragraph (e)(5) of this section must be

made by the compensation committee of

the new publicly held corporation.

However, a taxpayer may rely on this

paragraph (f)(4)(iii) to satisfy the

requirements of paragraph (e) of this

section only for compensation paid, or

stock options, stock appreciation rights,

or restricted property granted, prior to

the first regularly scheduled meeting of

the shareholders of the new publicly

held corporation that occurs more than

12 months after the date the corporation

becomes a separate publicly held

corporation. Compensation paid, or

stock options, stock appreciation rights,

or restricted property granted, on or

after the date of that meeting of

shareholders must satisfy all

requirements of paragraph (e) of this

section, including the shareholder

approval requirement of paragraph (e)(4)

of this section, in order to satisfy the

requirements for performance-based

compensation.

(5) Example. The following example

illustrates the application of paragraph

(f)(4)(ii) of this section:

Example. Corporation P, which is publicly

held, decides to spin off Corporation S, a

wholly owned subsidiary of Corporation P.

After the spinoff, Corporation S will be a

separate publicly held corporation. Before

the spinoff, the compensation committee of

Corporation P, pursuant to paragraph

(e)(3)(viii) of this section, establishes a bonus

plan for the executives of Corporation S that

provides for bonuses payable after the spinoff

and that satisfies the requirements of

paragraph (e)(2) of this section. If, pursuant

to paragraph (e)(4)(viii) of this section, the

shareholders of Corporation P approve the

plan prior to the spinoff, that approval will

satisfy the requirements of paragraph (e)(4) of

this section with respect to compensation

paid pursuant to the bonus plan after the

spinoff. However, the compensation

committee of Corporation S will be required

to certify that the goals are satisfied prior to

the payment of the bonuses in order for the

bonuses to be considered performance-based

compensation.

(g) Coordination with disallowed

excess parachute payments. The

$1,000,000 limitation in paragraph (b) of

this section is reduced (but not below

zero) by the amount (if any) that would

have been included in the compensation

of the covered employee for the taxable

year but for being disallowed by reason

of section 280G. For example, assume

that during a taxable year a corporation

pays $1,500,000 to a covered employee

and no portion satisfies the exception in

paragraph (d) of this section for

commissions or paragraph (e) of this

section for qualified performance-based

compensation. Of the $1,500,000,

$600,000 is an excess parachute

payment, as defined in section

280G(b)(1) and is disallowed by reason

of that section. Because the excess

parachute payment reduces the

limitation of paragraph (b) of this

section, the corporation can deduct

$400,000, and $500,000 of the otherwise

deductible amount is nondeductible by

reason of section 162(m).

(h) Transition rules—(1)

Compensation payable under a written

binding contract which was in effect on

February 17, 1993—(i) General rule. The

deduction limit of paragraph (b) of this

section does not apply to any

compensation payable under a written

binding contract that was in effect on

February 17, 1993. The preceding

sentence does not apply unless, under

applicable state law, the corporation is

obligated to pay the compensation if the

employee performs services. However,

the deduction limit of paragraph (b) of

this section does apply to a contract that

is renewed after February 17, 1993. A

written binding contract that is

terminable or cancelable by the

corporation after February 17, 1993,

without the employee’s consent is

treated as a new contract as of the date

that any such termination or

cancellation, if made, would be

effective. Thus, for example, if the terms

of a contract provide that it will be

automatically renewed as of a certain

date unless either the corporation or the

employee gives notice of termination of

the contract at least 30 days before that

date, the contract is treated as a new

contract as of the date that termination

would be effective if that notice were

given. Similarly, for example, if the

terms of a contract provide that the

contract will be terminated or canceled

as of a certain date unless either the

corporation or the employee elects to

renew within 30 days of that date, the

contract is treated as renewed by the

corporation as of that date.

Alternatively, if the corporation will

remain legally obligated by the terms of

a contract beyond a certain date at the

sole discretion of the employee, the
65546 Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations

contract will not be treated as a new

contract as of that date if the employee

exercises the discretion to keep the

corporation bound to the contract. A

contract is not treated as terminable or

cancelable if it can be terminated or

canceled only by terminating the

employment relationship of the

employee.

(ii) Compensation payable under a

plan or arrangement. If a compensation

plan or arrangement meets the

requirements of paragraph (h)(1)(i) of

this section, the compensation paid to

an employee pursuant to the plan or

arrangement will not be subject to the

deduction limit of paragraph (b) of this

section even though the employee was

not eligible to participate in the plan as

of February 17, 1993. However, the

preceding sentence does not apply

unless the employee was employed on

February 17, 1993, by the corporation

that maintained the plan or

arrangement, or the employee had the

right to participate in the plan or

arrangement under a written binding

contract as of that date.

(iii) Material modifications.

(A) Paragraph (h)(1)(i) of this section

will not apply to any written binding

contract that is materially modified. A

material modification occurs when the

contract is amended to increase the

amount of compensation payable to the

employee. If a binding written contract

is materially modified, it is treated as a

new contract entered into as of the date

of the material modification. Thus,

amounts received by an employee under

the contract prior to a material

modification are not affected, but

amounts received subsequent to the

material modification are not treated as

paid under a binding, written contract

described in paragraph (h)(1)(i) of this

section.

(B) A modification of the contract that

accelerates the payment of

compensation will be treated as a

material modification unless the amount

of compensation paid is discounted to

reasonably reflect the time value of

money. If the contract is modified to

defer the payment of compensation, any

compensation paid in excess of the

amount that was originally payable to

the employee under the contract will

not be treated as a material modification

if the additional amount is based on

either a reasonable rate of interest or one

or more predetermined actual

investments (whether or not assets

associated with the amount originally

owed are actually invested therein) such

that the amount payable by the

employer at the later date will be based

on the actual rate of return of the

specific investment (including any

decrease as well as any increase in the

value of the investment).

(C) The adoption of a supplemental

contract or agreement that provides for

increased compensation, or the payment

of additional compensation, is a

material modification of a binding,

written contract where 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 written

binding contract. However, a material

modification of a written binding

contract does not include a

supplemental payment that is equal to

or less than a reasonable cost-of-living

increase over the payment made in the

preceding year under that written

binding contract. In addition, a

supplemental payment of compensation

that satisfies the requirements of

qualified performance-based

compensation in paragraph (e) of this

section will not be treated as a material

modification.

(iv) Examples. The following

examples illustrate the exception of this

paragraph (h)(1):

Example 1. Corporation X executed a 3-

year compensation arrangement with C on

February 15, 1993, that constitutes a written

binding contract under applicable state law.

The terms of the arrangement provide for

automatic extension after the 3-year term for

additional 1-year periods, unless the

corporation exercises its option to terminate

the arrangement within 30 days of the end of

the 3-year term or, thereafter, within 30 days

before each anniversary date. Termination of

the compensation arrangement does not

require the termination of C’s employment

relationship with Corporation X. Unless

terminated, the arrangement is treated as

renewed on February 15, 1996, and the

deduction limit of paragraph (b) of this

section applies to payments under the

arrangement after that date.

Example 2. Corporation Y executed a 5-

year employment agreement with B on

January 1, 1992, providing for a salary of

$900,000 per year. Assume that this

agreement constitutes a written binding

contract under applicable state law. In 1992

and 1993, B receives the salary of $900,000

per year. In 1994, Corporation Y increases B’s

salary with a payment of $20,000. The

$20,000 supplemental payment does not

constitute a material modification of the

written binding contract because the $20,000

payment is less than or equal to a reasonable

cost-of-living increase from 1993. However,

the $20,000 supplemental payment is subject

to the limitation in paragraph (b) of this

section. On January 1, 1995, Corporation Y

increases B’s salary to $1,200,000. The

$280,000 supplemental payment is a material

modification of the written binding contract

because the additional compensation is paid

on the basis of substantially the same

elements or conditions as the compensation

that is otherwise paid under the written

binding contract and it is greater than a

reasonable, annual cost-of-living increase.

Because the written binding contract is

materially modified as of January 1, 1995, all

compensation paid to B in 1995 and

thereafter is subject to the deduction

limitation of section 162(m).

Example 3. Assume the same facts as in

Example 2, except that instead of an increase

in salary, B receives a restricted stock grant

subject to B’s continued employment for the

balance of the contract. The restricted stock

grant is not a material modification of the

binding written contract because any

additional compensation paid to B under the

grant is not paid on the basis of substantially

the same elements and conditions as B’s

salary because it is based both on the stock

price and B’s continued service. However,

compensation attributable to the restricted

stock grant is subject to the deduction

limitation of section 162(m).

(2) Special transition rule for outside

directors. A director who is a

disinterested director is treated as

satisfying the requirements of an outside

director under paragraph (e)(3) of this

section until the first meeting of

shareholders at which directors are to be

elected that occurs on or after January

1, 1996. For purposes of this paragraph

(h)(2) and paragraph (h)(3) of this

section, a director is a disinterested

director if the director is disinterested

within the meaning of Rule 16b–

3(c)(2)(i), 17 CFR 240.16b–3(c)(2)(i),

under the Exchange Act (including the

provisions of Rule 16b–3(d)(3), as in

effect on April 30, 1991).

(3) Special transition rule for

previously-approved plans—(i) In

general. Any compensation paid under

a plan or agreement approved by

shareholders before December 20, 1993,

is treated as satisfying the requirements

of paragraphs (e)(3) and (e)(4) of this

section, provided that the directors

administering the plan or agreement are

disinterested directors and the plan was

approved by shareholders in a manner

consistent with Rule 16b–3(b), 17 CFR

240.16b–3(b), under the Exchange Act

or Rule 16b–3(a), 17 CFR 240.16b–3(a)

(as contained in 17 CFR part 240 revised

April 1, 1990). In addition, for purposes

of satisfying the requirements of

paragraph (e)(2)(vi) of this section, a

plan or agreement is treated as stating a

maximum number of shares with

respect to which an option or right may

be granted to any employee if the plan

or agreement that was approved by the

shareholders provided for an aggregate

limit, consistent with Rule 16b–3(b), 17

CFR 250.16b–3(b), on the shares of

employer stock with respect to which

awards may be made under the plan or

agreement.

(ii) Reliance period. The transition

rule provided in this paragraph (h)(3)
Federal Register / Vol. 60, No. 244 / Wednesday, December 20, 1995 / Rules and Regulations 65547

shall continue and may be relied upon

until the earliest of—

(A) The expiration or material

modification of the plan or agreement;

(B) The issuance of all employer stock

and other compensation that has been

allocated under the plan; or

(C) The first meeting of shareholders

at which directors are to be elected that

occurs after December 31, 1996.

(iii) Stock-based compensation. This

paragraph (h)(3) will apply to any

compensation received pursuant to the

exercise of a stock option or stock

appreciation right, or the substantial

vesting of restricted property, granted

under a plan or agreement described in

paragraph (h)(3)(i) of this section if the

grant occurs on or before the earliest of

the events specified in paragraph

(h)(3)(ii) of this section.

(iv) Example. The following example

illustrates the application of this

paragraph (h)(3):

Example. Corporation Z adopted a stock

option plan in 1991. Pursuant to Rule 16b–

3 under the Exchange Act, the stock option

plan has been administered by disinterested

directors and was approved by Corporation Z

shareholders. Under the terms of the plan,

shareholder approval is not required again

until 2001. In addition, the terms of the stock

option plan include an aggregate limit on the

number of shares available under the plan.

Option grants under the Corporation Z plan

are made with an exercise price equal to or

greater than the fair market value of

Corporation Z stock. Compensation

attributable to the exercise of options that are

granted under the plan before the earliest of

the dates specified in paragraph (h)(3)(ii) of

this section will be treated as satisfying the

requirements of paragraph (e) of this section

for qualified performance-based

compensation, regardless of when the

options are exercised.

(i) (Reserved)

(j) Effective date—(1) In general.

Section 162(m) and this section apply to

compensation that is otherwise

deductible by the corporation in a

taxable year beginning on or after

January 1, 1994.

(2) Delayed effective date for certain

provisions—(i) Date on which

remuneration is considered paid.

Notwithstanding paragraph (j)(1) of this

section, the rules in the second sentence

of each of paragraphs (e)(3)(ii)(A),

(e)(3)(ii)(B), and (e)(3)(ii)(C) of this

section for determining the date or dates

on which remuneration is considered

paid to a director are effective for

taxable years beginning on or after

January 1, 1995. Prior to those taxable

years, taxpayers must follow the rules in

paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and

(e)(3)(ii)(C) of this section or another

reasonable, good faith interpretation of

section 162(m) with respect to the date

or dates on which remuneration is

considered paid to a director.

(ii) Separate treatment of publicly

held subsidiaries. Notwithstanding

paragraph (j)(1) of this section, the rule

in paragraph (c)(1)(ii) of this section that

treats publicly held subsidiaries as

separately subject to section 162(m) is

effective as of the first regularly

scheduled meeting of the shareholders

of the publicly held subsidiary that

occurs more than 12 months after

December 2, 1994. The rule for stockbased compensation set forth in

paragraph (f)(3) of this section will

apply for this purpose, except that the

grant must occur before the shareholder

meeting specified in this paragraph

(j)(2)(ii). Taxpayers may choose to rely

on the rule referred to in the first

sentence of this paragraph (j)(2)(ii) for

the period prior to the effective date of

the rule.

(iii) Subsidiaries that become separate

publicly held corporations.

Notwithstanding paragraph (j)(1) of this

section, if a subsidiary of a publicly

held corporation becomes a separate

publicly held corporation as described

in paragraph (f)(4)(i) of this section,

then, for the duration of the reliance

period described in paragraph (f)(2) of

this section, the rules of paragraph (f)(1)

of this section are treated as applying

(and the rules of paragraph (f)(4) of this

section do not apply) to remuneration

paid to covered employees of that new

publicly held corporation pursuant to a

plan or agreement that existed prior to

December 2, 1994, provided that the

treatment of that remuneration as

performance-based is in accordance

with a reasonable, good faith

interpretation of section 162(m).

However, if remuneration is paid to

covered employees of that new publicly

held corporation pursuant to a plan or

agreement that existed prior to

December 2, 1994, but that

remuneration is not performance-based

under a reasonable, good faith

interpretation of section 162(m), the

rules of paragraph (f)(1) of this section

will be treated as applying only until

the first regularly scheduled meeting of

shareholders that occurs more than 12

months after December 2, 1994. The

rules of paragraph (f)(4) of this section

will apply as of that first regularly

scheduled meeting. The rule for stockbased compensation set forth in

paragraph (f)(3) of this section will

apply for purposes of this paragraph

(j)(2)(iii), except that the grant must

occur before the shareholder meeting

specified in the preceding sentence if

the remuneration is not performancebased under a reasonable, good faith

interpretation of section 162(m).

Taxpayers may choose to rely on the

rules of paragraph (f)(4) of this section

for the period prior to the applicable

effective date referred to in the first or

second sentence of this paragraph

(j)(2)(iii).

(iv) Bonus pools. Notwithstanding

paragraph (j)(1) of this section, the rules

in paragraph (e)(2)(iii)(A) that limit the

sum of individual percentages of a

bonus pool to 100 percent will not

apply to remuneration paid before

January 1, 2001, based on performance

in any performance period that began

prior to December 20, 1995.

(v) Compensation based on a

percentage of salary or base pay.

Notwithstanding paragraph (j)(1) of this

section, the requirement in paragraph

(e)(4)(i) of this section that, in the case

of certain formulas based on a

percentage of salary or base pay, a

corporation disclose to shareholders the

maximum dollar amount of

compensation that could be paid to the

employee, will apply only to plans

approved by shareholders after April 30,

1995.

PART 602—OMB CONTROL NUMBERS

UNDER THE PAPERWORK

REDUCTION ACT

Par. 3. The authority citation for part

602 continues to read as follows:

Authority: 26 U.S.C. 7805.

§ 602.101 [Amended]

Par. 4. In § 602.101, paragraph (c) is

amended by adding the entry ‘‘1.162–

27. . . . 1545–1466’’ in numerical order

to the table.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: December 12, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95–30869 Filed 12–19–95; 8:45 am]

BILLING CODE 4830–01–U

26 CFR Part 1

[TD 8635]

RIN 1545–AS92

Nonbank Trustee Net Worth

Requirements

AGENCY: Internal Revenue Service (IRS),

Treasury.

ACTION: Final and temporary

regulations.

SUMMARY: This document contains

regulations that provide guidance to

nonbank trustees with respect to the

adequacy of net worth requirements that

must be satisfied in order to be or