A Phantom Menace for IPO Companies - US Tax Regulations Restrict the Use of Restricted Stock Units

April 17, 2015

Section 162(m) of the Internal Revenue Code (“Section 162(m)”) provides for a $1 million dollar limitation on the amount of compensation paid to each of certain named executive officers that public companies may deduct in any year, unless an exception applies. One of the regulatory transitional rules (the "IPO Transition Rule") provides that, in the case of a company that becomes subject to Section 162(m) as the result of an IPO, compensation paid pursuant to a plan or agreement that existed before the IPO and was disclosed to shareholders in connection with the IPO in compliance with applicable securities laws will not be subject to the $1 million dollar deduction limitation for a transition period. This transition period can last until the first shareholder meeting at which directors are elected that occurs in the fourth year following the IPO. 

Recent final regulations under Section 162(m) will dramatically curtail the practical ability of pre-IPO companies and new IPO companies to use restricted stock units or similar deferred equity rights ("RSUs") as a method of compensating affected executives, where Section 162(m) is sought to be avoided. 

The IPO Transition Rule explicitly provides that stock options, stock appreciation rights and shares of restricted stock granted either before an IPO or during the applicable transition period are not subject to the $1 million dollar deduction limitation under Section 162(m), regardless of when the stock options or stock appreciation rights are exercised or the shares of restricted stock vest. In a number of private letter rulings,1 the Internal Revenue Service (“IRS”) determined that RSUs are eligible for the same relief under the IPO Transition Rule as shares of restricted stock, and therefore would not be subject to the $1 million dollar deduction limitation if they are granted before or during the applicable transition period, regardless of when they are settled. This approach was important in that, if RSUs were eligible for relief under the IPO Transition Rule based on when they are settled rather than when they are granted, then any RSUs settled beyond the applicable transition period would be subject to Section 162(m), unless some other exception were to apply. 

On June 24, 2011, regulations were proposed under which the IPO Transition Rule would apply to RSUs by reference to when they are settled, not by reference to when the RSUs are granted. On March 31, 2015, the proposed regulations were published, with the IRS adopting the same position in the proposed regulations with respect to the IPO Transition Rule. As a result of these final regulations, pre-IPO companies and companies that recently completed an IPO should be particularly careful before using RSUs (as opposed to restricted stock, stock options or stock appreciation rights), if those RSUs may be settled outside the applicable transition period. 

It is noted that, in response to comments from the American Bar Association and others, the IRS did offer some relief from the impact of the new rules, providing that the final regulations on this point will not be retroactively effective, but rather will be effective as of April 1, 2015. Thus, RSUs granted before this date are not affected by the final regulations. 

In addition, in general terms, the final regulations clarify that, to qualify for the special Section 162(m) exception for performance-based compensation that is in the nature of a stock option or other stock right, the plan must expressly contain a per-person limitation, as opposed to merely containing an overall plan limitation. The final regulations also clarify that plans may satisfy this per-person requirement by specifying the maximum aggregate number of shares underlying all equity-based awards that may be granted to a person during a specific period. A specific limit for each type of award available under the plan is not required. These clarifications are effective retroactively to the June 24, 2011 introduction of the proposed regulations. 

If you have any questions about the final Section 162(m) regulations, please contact one of the Dechert attorneys listed below or any Dechert attorney with whom you regularly work. 


1) PLR 200406026 (Nov. 3, 2003); PLR 200449012 (Aug. 12, 2004). Note that private letter rulings cannot be relied upon by any persons other than those taxpayers to whom they are written.

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