chevron-down Created with Sketch Beta.
July 23, 2013 The Tax Lawyer

Restricted Stock Units Settled After the Transition Period for Newly Publicly Held Companies: Section 162(m) Realignment of Performance and Pay for Restricted Stock Units

Vol. 66, No. 3 - Spring 2013

Seth Popick


    As part of a broader corporate policy, corporations and tax planners should consider the tax implications of various executive compensation arrangements, especially at significant corporate events such as the point at which a corporation’s stock becomes publicly traded. In an effort to protect investors from excessive executive compensation, Congress sought to align payment and performance in 1993 by adopting Code section 162(m), which capped corporate deductions for non-performance-based compensation. Following the adoption of section 162(m) in 1993 by Public Law number 103-66 section 13211, which caps deductions for certain executive compensation packages at $1 million, the Treasury Department promulgated rules exempting compensation expenses of newly publicly held companies (transition rules) that are paid prior to defined events occurring after the company’s stock is initially publicly traded (transition period). The transition rules further permit the full deduction of some forms of stock-based compensation that are settled and deductible after the end of the transition period. These rules permit companies to take deductions for compensation expenses arising from "the exercise of a stock option or stock appreciation right, or the substantial vesting of restricted property" that meets the requirements set forth in the Regulations. While the Treasury Department mostly follows congressional intent to align pay and performance by creating two tiers of compensation deductions for full-value compensation and performance-based compensation, the Treasury Department’s favored treatment of restricted property under the transition rules does not fit the framework Congress provided.

    Additionally, the Regulations are vague as to the treatment of restricted stock units (RSUs) as restricted property for this purpose. During summer 2011, the Treasury Department proposed a new regulation that clarifies the transition rules by explicitly separating RSUs—and phantom stock arrangements— from restricted property, thus not permitting a deduction of RSUs after the end of the transition period. If the Proposed Regulation is adopted, companies will continue to receive favorable treatment for restricted property, which includes other full-value grants such as restricted stock but not for RSUs.

    The Treasury Department’s Proposed Regulation fails to accomplish the policy goals for section 162(m), which are eliminating deductions for excessive executive compensation and aligning executive compensation with performance. Full-value grants—such as restricted stock and RSUs—provide value to the recipient equal to the fair market value of the underlying stock at the time of grant, meaning the value is not connected to performance because the value of the services provided by the recipient is not necessarily commensurate with the value received as a result of the grant. The Proposed Regulation focuses too narrowly on RSUs, a subset of full-value grants, rather than meeting the policy objectives of section 162(m) to align compensation and performance.

    The relevant background information for this argument is presented in Parts II and III and a discussion of examples of why the Proposed Regulation does not meet the policy objectives of section 162(m) is in Part IV. Specifically, Part II of this Comment provides an overview of the policy rationale supporting section 162(m) and introduces the transition rules and the Proposed Regulation. Part III provides an overview of the taxation of RSUs. Part IV describes the impact of the Proposed Regulation on the parties’ taxes and how the parties may avoid this impact. Part IV concludes by suggesting alternatives that the Treasury Department may pursue to realign restricted property and RSUs within the framework of "pay for performance."

Read the full article or download the complete issue.