CEO compensation at community banks is often approaching $1 million or greater as bank profits and stock prices improve, and as merger and acquisition activity increases. Compensation committees are finding they must now address the cumbersome and confusing $1 million pay cap limitation under Internal Revenue Code (IRC) Section 162(m) in order to preserve the bank’s tax deduction for certain compensation payments. Understanding the regulation and how it applies to the bank’s compensation programs is the first step in developing an effective process for maintaining compliance.
What is IRC Section 162(m)?
Public companies are prohibited from receiving a corporate tax deduction for compensation over $1 million paid to a covered employee (i.e., proxy-reported executive). Under the code, compensation is based on the executive’s realized taxable wages in any given year, including actual incentives paid and the value of any vested shares and exercised stock options.
However, Section 162(m) provides an exception for “qualified performance-based compensation” and this exception is widely used to exempt annual incentive plan payments and equity compensation from the $1 million limit. The requirements to qualify compensation as performance-based are summarized below.
Understanding How IRC Section 162(m) Applies
In general, the following types of compensation can qualify for the performance-based exception if Section 162(m) requirements are met:
- Short-term incentive compensation with specific performance goals. Discretionary components can be managed by creating a process that funds the plan at a maximum level using specific goals and exercising negative discretion to reduce the payouts.
- Performance-based stock or stock units. Goals need to be specified at the beginning of the performance period and generally should not include discretionary elements.
- Stock option and stock appreciation rights.
- Certain deferred compensation as long as the contribution is funded using specified performance goals.
What makes Section 162(m) confusing to many directors is that compensation must be qualified as performance-based at the time of award, even though realization of the compensation and its deductibility may be several years in the future. In thinking through whether 162(m) may apply, directors need to foresee the level of compensation likely to be provided in the future. The future may include growing to an asset size where market-based compensation above $1 million is a reality for the CEO and other proxy-named executives.
Creating an Effective 162(m) Process
The first step in the process is to determine whether the bank is likely to be affected by 162(m). Target compensation provided to CEOs at banks with assets exceeding $1 billion generally begins to approach the $1 million level. Therefore, it is usually wise for public banks growing to that size during the time period in which a compensation program is paying out to proactively plan for compliance. The following suggestions can aid compensation committees in ensuring an effective process:
- Incorporate all 162(m) language into an omnibus incentive plan. Having one plan in which annual incentives and equity compensation may be awarded keeps shareholder approval simple and eliminates the need to track multiple plans.
- Add the process to qualify compensation as performance-based per 162(m) to the compensation committee’s calendar, keeping in mind the timing requirements for approval.
- Develop a reminder system to ensure performance measures are approved by shareholders every five years as required by 162(m).
- Obtain expert guidance whenever the committee is contemplating modifications to goals, accelerations and vestings. Individual modifications can disqualify awards from the performance-based exception for all covered employees.
Compensation committees have a responsibility to ensure that the bank preserves the tax deductibility of performance-based compensation. In doing so, compensation committees need to consider the bank’s future growth and how it relates to the compensation of their executive officers. Proper planning and development of a well-defined 162(m) process now can ensure the future deductibility of compensation expenses.
The key performance-based compensation requirements under the law:
- The compensation terms (or plan) and performance measures are approved by shareholders within five years of the award date
- Plan includes the maximum amount payable to any one covered employee
- Performance goals are substantially uncertain at the time the goal is established
- Compensation is awarded by a committee of at least two independent directors
- Performance goals are established by the compensation committee within the lesser of 90 days or 25 percent of the performance period
- Performance achievement is certified in writing by the compensation committee.