Service Issues New Revenue Ruling on Dividends and Dividend Equivalent Grants That Can Be Treated As Performance-Based Compensation for Purposes of Section 162(m)
In Rev. Rul. 2012-19, 2012-28 IRB, which was issued on June 25, 2012, the Service issued an important ruling on whether dividends and dividend equivalents related to restricted stock and restricted stock units (“RSU”) can be treated as performance-based compensation for purposes of §162(m)(4)(c) provided that each must separately meet the requirements under that provision to qualify as performance-based compensation.
Section 162(m)(1) Limitation
Under §162(m)(1) a “publicly held corporation” is not permitted to deduct under §162(a) as an ordinary and necessary business expense, compensation paid to a “covered employee” to the extent such compensation exceeds $1 million. A “covered employee” includes a group of five or less of the company’s most highly compensated employees and commissions and compensation conditioned on the meeting of clearly defined performance goals are generally excepted from the ceiling. Even if the excess compensation is non-deductible, it is still included in the employee’s gross income and and subject to federal income tax. The $1 million limitation is applicable only to the compensation of a “covered employee” which includes: (i) the CEO of the company as of the last day of the corporation’s taxable year or the person then acting in such capacity; and (ii) any other employee whose “total compensation” must be reported to shareholders under the Securities Exchange Act “by reason of such employee being among the four highest compensated officers for the taxable year.” § 162(m)(3). Treas. Reg. § 1.162-27(c)(6) Ex. 17. Where SEC rules require require disclosure for fewer than four executives in addition to the chief executive officer, “then only those for whom disclosure is required are covered employees. HR Rep. No. 213, 103d Cong., 1st Sess. 585 (Conf. Rep. 1993). See IRS Notice 2007-49, 2007-1 C.B. 1429 (providing changes to the application of this provision based on changes in the Exchange Act compensation disclosure rules). See also Notice 2008-94, 2008-44 IRB (application of §§162(m)(5) and 280G(e) under the TARP legislation, PL 110-343, 10/3/2008).
Two Fact Patterns Contained in Rev. Rul. 2012-19
Corps. X and Y are publicly held corporations. §162(m)(2). Both have restricted common stock and RSU plans based on the common stock of each. The restricted stock and RSUs granted under the plans of both corporations vest upon reaching certain preestablished, objective performance goals and otherwise meet the requirements of Treas. Reg. § 1.162-27(e). Therefore, compensation received due to the vesting of the restricted stock and vesting and payment of the RSUs is qualified performance-based compensation that is excluded from the applicable employee’s compensation subject to the §162(m) limitation.
Situation 1:Dividends Subject to Performance Goals Being Satisfied. X Corp.’s plan provides that dividends and dividend equivalents otherwise payable to an employee during the period from grant through vesting with respect to performance-based restricted stock and RSU awards granted to the employee are accumulated and become vested and payable only if the related performance goals with respect to the restricted stock and RSUs are satisfied. All other requirements of § 1.162-27(e) are met with respect to the grant of rights to dividends and dividend equivalents.
Situation 2; Dividends Paid with Respect to Restricted Stock and RSU Awards Not Subject to Satisfaction of Performance Goals. Under the second scenario in the ruling, Corp. Y’s plan provides for payment to an employee during the period from grant to vesting of dividends and dividend equivalents with respect to performance-based restricted stock and RSU awards granted to the employee at the same time dividends are paid on common stock of Corporation Y regardless of whether the performance goals established with respect to the restricted stock and RSUs are satisfied.
Section 162(m)(4)(A) defines “ applicable employee remuneration,” with respect to any covered employee for any taxable year, subject to the overall limitation. Section 162(m)(4)(C) states that “applicable employee remuneration” does not include any remuneration payable solely on account of the attainment of one or more performance goals, but only if (i) the performance goals are determined by a compensation committee of the board of directors of the taxpayer which is comprised solely of two or more outside directors, (ii) the material terms under which the remuneration is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the vote in a separate shareholder vote before payment of such remuneration, and (iii) before any payment of such remuneration, the compensation committee certifies that the performance goals and other material terms were in fact satisfied. See Treas. Regs. §§1.162-27(e)(2)-(e)(5).
In particular, Treas. Reg. §1.162-27(e)(2)(i) requires that qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals. Treas. Reg. §1.162-27-(e)(2)(ii) provides that a pre-established 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. This is determined on a grant-by-grant basis. Treas. Reg. §1.162-27(e)(2)(iv). Treas. Reg. §1.162-27(e)(2)(iv) further provides that, except as provided in Treas. Reg. § 1.162-27(e)(2)(vi) (relating to stock options and stock appreciation rights), whether a grant of restricted stock or other stock-based compensation satisfies the performance goal requirements 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. (emphasis added) Dividends, dividend equivalents, or other similar distributions with respect to stock that are treated as separate grants under Treas. Reg. § 1.162-27(e)(2)(iv) are not performance-based compensation unless they separately satisfy the performance goal requirements.
Service’s Analysis in Rev. Rul. 2012-19
The Service starts its analysis by citing Treas. Reg. § 1.162-27(e)(2)(iv), by citing the operative rule that the dividends and dividend equivalents under Corps. X’s and Y’s plans are grants of compensation that are separate and apart from the related restricted stock and RSU grants. Therefore, the grants of the dividends and dividend equivalents must separately satisfy the requirements of Treas. Reg. § 1.162-27(e) to be qualified performance-based compensation.
Situation 1; Dividends Subject to Performance Goals Being Satisfied. Under Corp. X’s plan, participants' rights to restricted stock and RSUs are subject to performance goals which satisfy the requirements of Treas. Reg.§ 1.162-27(e) and are excluded from applicable remuneration for purposes of the limitation in § 162(m)(1). Under the same plan, participants' rights to dividends and dividend equivalents vest and become payable only if the same performance goals that apply to the related grants of restricted stock and RSUs are satisfied. Based on the separate grant-by-grant test, the ruling concludes that the dividends and dividend equivalents under X's plan are excluded from applicable remuneration for § 162(m)(1) purposes and are excluded from the $1 million limitation.
Situation 2; Dividends Paid with Respect to Restricted Stock and RSU Awards Not Subject to Satisfaction of Performance Goals.. The dividends and dividend equivalents under Corp. Y’s plan fail to satisfy the requirements under § 162(m)(4)(C) and Treas. Reg. § 1.162-27(e) since the rights to these amounts do not vest and become payable solely on account of the attainment of pre-established performance goals. Such amounts are not qualified-performance based compensation and are therefore included in “applicable employee remuneration” under §162(m)(1).