Human Capital & Careers

Watch Out for Exec-Pay Tax Deduction Traps

A recent error by Barnes &spamp; Noble in its granting of stock options offers some lessons for CFOs and compensation committees.
Andrew LiazosSeptember 17, 2012

The compensation committee grants your CEO an option to acquire 1 million shares of the company’s publicly traded common stock. The option grant is timely reported to the Securities and Exchange Commission in a Form 4 filing. Then months later, you learn the grant exceeded the maximum number of shares permitted under terms of the compensation plan approved by stockholders by a half-million shares!

That’s an embarrassment and administrative burden to be sure, and it’s just what recently befell Barnes & Noble, based on a review of its 2012 proxy statement.

Compensation realized by the CEO (and the three other most highly compensated executive officers other than the CFO) upon exercising a stock option is deductible, notwithstanding the $1 million limit on the corporate-tax deductibility of such compensation under Section 162(m) of the Internal Revenue Code, if the grant meets the requirements for the “performance-based compensation” exception.

One such requirement is that the plan set forth the maximum number of shares for which grants can be made to an employee during a specified period. To comply, the Barnes & Noble stock plan was designed so that no participant could receive options (or stock appreciation rights [SARs]) for more than 1 million shares during any 36-month period.

Where things went wrong for Barnes & Noble is that the compensation committee made a large option grant to its CEO, William Lynch, without, apparently, taking into account an earlier grant. On December 9, 2011, the compensation committee granted Lynch the right to acquire 1 million shares at $16 per share. According to prior SEC filings, Barnes & Noble had granted its CEO an option to purchase 500,000 shares during the prior fiscal year on April 1, 2010. As a result, the December 9 grant exceeded the plan limit by 500,000 shares.

Many companies established formal stock-option grant procedures after the option-backdating debacles in the mid-2000s. These procedures govern what documents must be completed in order to have a completed grant for tax and accounting purposes, who may make grants, and when options may be granted (to avoid the perception that the timing of option grants is being manipulated to result in a low exercise price). It’s possible that some companies do not include in such procedures steps to ensure that grants do not exceed plan limits, especially when the Section 162(m) grant limit is based on a rolling multiyear period.

In addition to reviewing what process is used to ensure that option grants comply with plan terms, it’s worth considering how Section 162(m) grant limits are structured under the plan. For example, a company may want to consider using a relatively high share limit based on a 12-month period instead of a multiyear period. Separate limits can also be used for different types of equity awards (such as performance-based full-share awards versus stock options).

Individual grant limits are not required to be used for awards that are not intended to comply with the performance-based compensation exception. Examples include time-based restricted stock and restricted stock units (RSUs) and equity awards to employees who are not (and very unlikely to become) executive officers potentially subject to the Section 162(m) deduction limitation.

If an option cannot be granted due to a limit under plan terms, there is a way to work around that problem up front. A stock option can be granted using the then-current stock price as the exercise price consistent with tax-law rules  so long as exercise is contingent on obtaining shareholder approval of the grant. An important detail to keep in mind, however, is that the compensation expense for accounting purposes with respect to any such option grant typically will not be measured until the date of the stockholder approval.

It appears that everything eventually worked out well for the Barnes & Noble CEO, notwithstanding the option-grant gaffe. At the company’s September 11 annual meeting, stockholders approved an increase in the three-year option/SAR per-employee limit from 1 million shares to 2 million. Based on a review of securities filings, the CEO later that day received an option to receive an additional 500,000 shares to make up for the shares that did not become part of the December 9 option grant. However, instead of using the December 9 exercise price of $16 per share, the exercise price for the make-whole option grant was $11.52 per share (based on the then-current stock price). The result would not have been so happy for the CEO had stockholders rejected the increase to the limit or the stock price had moved in the other direction.

In addition, it appears that Barnes & Noble avoided having to restate its financial statements. According to its 2012 proxy statement, the company treated the portion of the December 9 CEO option that exceeded the plan limit as being “ineffective” and “never granted.” If an option award is considered not to have been granted from a legal perspective, the previously recorded compensation expense for the portion of the invalid award may be subject to adjustment, which, if material, could trigger a restatement.

[Editor’s note: Barnes & Noble declined to comment for this article.]

A recent Internal Revenue Service ruling suggests that CFOs also should check on how dividends and dividend equivalents are paid under performance-based restricted stock and RSUs. Dividends and dividend equivalents can qualify for the 162(m) performance-based compensation exemption provided five performance conditions are required to be met (and are met) prior to payment. What’s problematic is if dividends and dividend equivalents are automatically paid to the employee regardless of actual performance. Revenue Ruling 2012-19 confirms the performance requirement for dividends and dividend equivalents to qualify for the exemption, and the IRS is challenging deductions of nonperformance-based dividends and dividend equivalents.

There’s also a related accounting point to keep in mind. Dividends and dividend equivalents that are automatically paid under a restricted stock or RSU award whether performance-based or not ­will be treated as a “participating security” for accounting purposes. This treatment will typically reduce the income available to common shareholders for purposes of calculating earnings per share. If that happens, EPS will be reduced, even if the company does not pay any dividends. It will also complicate calculating and reporting EPS. So, it’s worth checking how dividends and dividend equivalents are handled under restricted stock and RSUs, and whether award documents accurately reflect actual practice.

Andrew Liazos heads the executive compensation practice at law firm McDermott Will & Emery.