[Federal Register Volume 60, Number 244 (Wednesday, December 20, 1995)]
[Rules and Regulations]
[Pages 65534-65547]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 95-30869]



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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.

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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 Sec. 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 

[[Page 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 Sec. 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 
Sec. 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 


[[Page 65536]]
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, Sec. 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 Sec. 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 Sec. 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, Sec. 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 Sec. 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 Sec. 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 Sec. 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 Sec. 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 
Sec. 1.162-27(e)(4)(i). However, the shareholder disclosure amendment 
was not 

[[Page 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 Sec. 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 Sec. 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 
Secs. 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 Sec. 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:


Sec. 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 performance-based 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 Sec. 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 

[[Page 65538]]
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 x $2,000,000/$3,000,000). Corporation Y has a 
nondeductible compensation expense of $600,000 
($900,000 x $2,000,000/$3,000,000). Corporation Z has a 
nondeductible compensation expense of $400,000 
($600,000 x $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 performance-based 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 

[[Page 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 

[[Page 65540]]
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. 

[[Page 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. 

[[Page 65542]]

    (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 self-employed 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 less- than-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 

[[Page 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- than-
5-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 

[[Page 65544]]
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 

[[Page 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 

[[Page 65546]]
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) 

[[Page 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 stock-based 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 stock-
based 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 performance-based 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.


Sec. 602.101  [Amended]

    Par. 4. In Sec. 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