On March 31, 2004, the Financial Accounting Standards Board (“FASB”) released its long-awaited Exposure Draft of a Proposed Statement of Financial Accounting Standards for Share-Based Payments (“Exposure Draft”). The Exposure Draft requires a charge to earnings for financial accounting purposes for stock-based compensation (and cash compensation that is based on the company’s stock price) paid to employees and non-employee directors. (Excluded from the Exposure Draft is a discussion regarding the financial accounting treatment of Employee Stock Ownership Plans (ESOPs) and equity compensation paid to non-employees. Additional guidance on these topics is expected from FASB at a later date.) If the standards set forth in the Exposure Draft are adopted as final, the new accounting rules will be effective for public companies for fiscal years beginning after December 15, 2004, and for private companies for fiscal years beginning after December 15, 2005.

Why the Shift Away from Stock Options?

The Exposure Draft dramatically impacts the financial accounting treatment of stock options. Currently stock options are not expensed, which, some argue, is why options are such a popular compensation vehicle. Under the Exposure Draft, stock options will be expensed.

One of the more immediate reactions to the release of the Exposure Draft is that companies are now, if they weren’t already, considering the use of stock compensation vehicles other than traditional stock options. With the new accounting treatment, stock options may no longer be the most attractive form of stock compensation. This change in the accounting treatment puts stock options on par with other forms of stock compensation and, coupled with the more severe dilutive effect of stock options compared to other forms of stock compensation, has made stock options less attractive to many companies. If your company is considering a shift away from stock options to other forms of stock compensation, one of the issues that you need to address is how to ensure that 100% of the income recognized by the employees under these alternative stock compensation vehicles is deductible by the company.

Section 162(m) of the Code

Section 162(m) of the Internal Revenue Code (“Code”) denies a tax deduction to public companies for compensation paid in excess of $1 million to the Chief Executive Officer or any of the other four highest paid executive officers (the “Covered Employees”). Two types of compensation are excluded from this calculation: commissions and performance-based compensation.

Income from stock options and stock appreciation rights (“SARs”) qualifies as performance-based compensation if the following conditions are met:

• the option or SAR is granted under a stockholder approved plan;
• the plan states the maximum number of shares that can be granted under an option or SAR to an individual during a specified period (usually one year);
• the exercise price of the option or SAR is equal to or greater than the fair market value of the stock underlying the award on the date of grant; and
• the option or SAR is granted by a committee of the Board of Directors composed of two or more outside directors (usually the compensation committee).

No similar rule applies to restricted stock, restricted stock units, performance shares or phantom shares. This means that if your company plans to grant stock awards other than stock options (and SARs) to the Covered Employees, the company will have to take additional steps to qualify the income recognized from such stock awards as performance-based compensation under Section 162(m) of the Code.

Rules for Qualifying Income as Performance Based Compensation

The rules for qualifying the income recognized from restricted stock and other non-option/SAR forms of stock compensation are the same as for qualifying cash bonuses as performance-based compensation. There are four steps that must be followed:

• Performance Goal Requirement
  The stock award must be granted or vested solely upon the attainment of one or more pre-established performance goals established by the compensation committee. The compensation committee must establish the performance goal either prior to the beginning of the service period in which the goal must be attained, or within 90 days of the beginning of the service period but while the outcome of the goal is still uncertain and not more than 25% of the service period has lapsed. The performance goal must be objective so that a third party could clearly determine whether or not the goal has been attained.

  The compensation committee must also determine the maximum number of shares subject to the stock award or a formula by which the number of shares subject to the award can be calculated. Most frequently the compensation committee will cast the award in terms of the maximum number of shares that may be issued. This maximum number may be stated in the company’s stockholder-approved equity compensation plan, as discussed above with respect to stock options and SARs. Finally, the compensation committee can not have the discretion to increase the number of shares subject to the award once the performance goal has been established.

• Composition of the Compensation Committee
  The committee that grants the performance-based stock awards must consist of two or more outside directors. Generally speaking, the compensation committee of most public companies will consist of two or more “outside directors” as that term is defined under Section 162(m) of the Code. You should note, however, that the definition of “outside director” is different from the definition of “independent director” under the stock exchanges’ rules and “non-employee director” under Section 16 of the Securities Exchange Act of 1934. For example, a former officer of the company will never be considered an outside director under Section 162(m) of the Code regardless of the amount of time that has elapsed since he or she served as an officer.
• Stockholder Disclosure and Approval
  The material terms of the performance-based compensation must be disclosed to the stockholders and approved by a majority of them. The material terms include the employees eligible for the stock awards and the business criteria upon which the performance goals are based. Also, the stockholders of the company must approve the maximum number of shares subject to the stock award or a formula by which the number of shares subject to the award can be calculated.
• Compensation Committee Certification
  The compensation committee must certify in writing that the performance goals have been attained prior to the grant or vesting of the stock award.

Conclusion

This article is intended as a general summary of the requirements of Section 162(m) of the Code, and is not intended to provide details on all aspects of performance-based compensation. If your company is planning a shift away from stock options toward other types of equity compensation, Section 162(m) compliance should be considered. First, check your stockholder-approved equity incentive plan document to determine if the stockholders have approved limits on the number of stock appreciation rights and other stock awards that can be granted to an individual in a certain period. Your plan also might contain business criteria from which the compensation committee can formulate performance goals. If your plan contains both annual limits on the number of shares that can be awarded to an individual and business criteria, your company may not have to take many additional steps to qualify the income recognized from stock awards as performance-based compensation under Section 162(m) of the Code. If your equity compensation plan does not contain these provisions, consider amending and restating your plan and submitting it to the stockholders for their approval.

Alternatively, consider adopting a separate bonus plan that works in conjunction with your equity compensation plan and submitting the bonus plan to the stockholders for approval. In this instance the stockholder-approved bonus plan will contain the annual limits or formula by which the number of shares subject to the award can be calculated, as well as the business criteria from which the compensation committee can formulate performance goals; however, the awards will be granted under the company’s stockholder-approved equity incentive plan and the shares underlying the awards will be issued from the share reserve of such plan.

Please feel free to contact us if you have questions about Section 162(m), equity compensation in general or the affect of the Exposure Draft on equity compensation.