[Code of Federal Regulations]
[Title 26, Volume 2]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.162-27]

[Page 800-817]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.162-27  Certain employee remuneration in excess of $1,000,000.

    (a) Scope. This section provides rules for the application of the $1 
million deduction limit under section 162(m) of the Internal Revenue 
Code. Paragraph (b) of this section provides the general rule limiting 
deductions under section 162(m). Paragraph (c) of this section provides 
definitions of generally applicable terms. Paragraph (d) of this section 
provides an exception from the deduction limit for compensation payable 
on a commission basis. Paragraph (e) of this section provides an 
exception for qualified performance-based compensation. Paragraphs (f) 
and (g) of this section provide special rules for corporations that 
become publicly held corporations and payments that are subject to 
section 280G, respectively. Paragraph (h) of this section provides 
transition rules, including the rules for contracts that are 
grandfathered and not subject to section 162(m). Paragraph (j) of this 
section contains the effective date provisions. For rules concerning the 
deductibility of compensation for services that are not covered by 
section 162(m) and this section, see section 162(a)(1) and Sec. 1.162-
7. This section is not determinative as to whether compensation meets 
the requirements of section 162(a)(1).
    (b) Limitation on deduction. Section 162(m) precludes a deduction 
under chapter 1 of the Internal Revenue Code by any publicly held 
corporation for compensation paid to any covered employee to the extent 
that the compensation for the taxable year exceeds $1,000,000.
    (c) Definitions--(1) Publicly held corporation--(i) General rule. A 
publicly held corporation means any corporation issuing any class of 
common equity securities required to be registered under section 12 of 
the Exchange Act. A corporation is not considered publicly held if the 
registration of its equity securities is voluntary. For purposes of this 
section, whether a corporation is publicly held is determined based 
solely on whether, as of the last day of its taxable year, the 
corporation is subject to the reporting obligations of section 12 of the 
Exchange Act.
    (ii) Affiliated groups. A publicly held corporation includes an 
affiliated group of corporations, as defined in section 1504 (determined 
without regard to section 1504(b)). For purposes of this section, 
however, an affiliated group of corporations does not include any 
subsidiary that is itself a publicly held corporation. Such a publicly 
held subsidiary, and its subsidiaries (if any), are separately subject 
to this section. If a covered employee is paid compensation in a taxable 
year by more than one member of an affiliated group, compensation paid 
by each member of the affiliated group is aggregated with compensation 
paid to

[[Page 801]]

the covered employee by all other members of the group. Any amount 
disallowed as a deduction by this section must be prorated among the 
payor corporations in proportion to the amount of compensation paid to 
the covered employee by each such corporation in the taxable year.
    (2) Covered employee--(i) General rule. A covered employee means any 
individual who, on the last day of the taxable year, is--
    (A) The chief executive officer of the corporation or is acting in 
such capacity; or
    (B) Among the four highest compensated officers (other than the 
chief executive officer).
    (ii) Application of rules of the Securities and Exchange Commission. 
Whether an individual is the chief executive officer described in 
paragraph (c)(2)(i)(A) of this section or an officer described in 
paragraph (c)(2)(i)(B) of this section is determined pursuant to the 
executive compensation disclosure rules under the Exchange Act.
    (3) Compensation--(i) In general. For purposes of the deduction 
limitation described in paragraph (b) of this section, compensation 
means the aggregate amount allowable as a deduction under chapter 1 of 
the Internal Revenue Code for the taxable year (determined without 
regard to section 162(m)) for remuneration for services performed by a 
covered employee, whether or not the services were performed during the 
taxable year.
    (ii) Exceptions. Compensation does not include--
    (A) Remuneration covered in section 3121(a)(5)(A) through section 
3121(a)(5)(D) (concerning remuneration that is not treated as wages for 
purposes of the Federal Insurance Contributions Act); and
    (B) Remuneration consisting of any benefit provided to or on behalf 
of an employee if, at the time the benefit is provided, it is reasonable 
to believe that the employee will be able to exclude it from gross 
income. In addition, compensation does not include salary reduction 
contributions described in section 3121(v)(1).
    (4) Compensation Committee. The compensation committee means the 
committee of directors (including any subcommittee of directors) of the 
publicly held corporation that has the authority to establish and 
administer performance goals described in paragraph (e)(2) of this 
section, and to certify that performance goals are attained, as 
described in paragraph (e)(5) of this section. A committee of directors 
is not treated as failing to have the authority to establish performance 
goals merely because the goals are ratified by the board of directors of 
the publicly held corporation or, if applicable, any other committee of 
the board of directors. See paragraph (e)(3) of this section for rules 
concerning the composition of the compensation committee.
    (5) Exchange Act. The Exchange Act means the Securities Exchange Act 
of 1934.
    (6) Examples. This paragraph (c) may be illustrated by the following 
examples:

    Example 1. Corporation X is a publicly held corporation with a July 
1 to June 30 fiscal year. For Corporation X's taxable year ending on 
June 30, 1995, Corporation X pays compensation of $2,000,000 to A, an 
employee. However, A's compensation is not required to be reported to 
shareholders under the executive compensation disclosure rules of the 
Exchange Act because A is neither the chief executive officer nor one of 
the four highest compensated officers employed on the last day of the 
taxable year. A's compensation is not subject to the deduction 
limitation of paragraph (b) of this section.
    Example 2. C, a covered employee, performs services and receives 
compensation from Corporations X, Y, and Z, members of an affiliated 
group of corporations. Corporation X, the parent corporation, is a 
publicly held corporation. The total compensation paid to C from all 
affiliated group members is $3,000,000 for the taxable year, of which 
Corporation X pays $1,500,000; Corporation Y pays $900,000; and 
Corporation Z pays $600,000. Because the compensation paid by all 
affiliated group members is aggregated for purposes of section 162(m), 
$2,000,000 of the aggregate compensation paid is nondeductible. 
Corporations X, Y, and Z each are treated as paying a ratable portion of 
the nondeductible compensation. Thus, two thirds of each corporation's 
payment will be nondeductible. Corporation X has a nondeductible 
compensation expense of $1,000,000 ($1,500,000x$2,000,000/$3,000,000). 
Corporation Y has a nondeductible compensation expense of $600,000 
($900,000x$2,000,000/$3,000,000). Corporation Z has a nondeductible 
compensation expense of $400,000 ($600,000x$2,000,000/$3,000,000).

[[Page 802]]

    Example 3. Corporation W, a calendar year taxpayer, has total assets 
equal to or exceeding $5 million and a class of equity security held of 
record by 500 or more persons on December 31, 1994. However, under the 
Exchange Act, Corporation W is not required to file a registration 
statement with respect to that security until April 30, 1995. Thus, 
Corporation W is not a publicly held corporation on December 31, 1994, 
but is a publicly held corporation on December 31, 1995.
    Example 4. The facts are the same as in Example 3, except that on 
December 15, 1996, Corporation W files with the Securities and Exchange 
Commission to disclose that Corporation W is no longer required to be 
registered under section 12 of the Exchange Act and to terminate its 
registration of securities under that provision. Because Corporation W 
is no longer subject to Exchange Act reporting obligations as of 
December 31, 1996, Corporation W is not a publicly held corporation for 
taxable year 1996, even though the registration of Corporation W's 
securities does not terminate until 90 days after Corporation W files 
with the Securities and Exchange Commission.

    (d) Exception for compensation paid on a commission basis. The 
deduction limit in paragraph (b) of this section shall not apply to any 
compensation paid on a commission basis. For this purpose, compensation 
is paid on a commission basis if the facts and circumstances show that 
it is paid solely on account of income generated directly by the 
individual performance of the individual to whom the compensation is 
paid. Compensation does not fail to be attributable directly to the 
individual merely because support services, such as secretarial or 
research services, are utilized in generating the income. However, if 
compensation is paid on account of broader performance standards, such 
as income produced by a business unit of the corporation, the 
compensation does not qualify for the exception provided under this 
paragraph (d).
    (e) Exception for qualified performance-based compensation--
    (1) In general. The deduction limit in paragraph (b) of this section 
does not apply to qualified performance-based compensation. Qualified 
performance-based compensation is compensation that meets all of the 
requirements of paragraphs (e)(2) through (e)(5) of this section.
    (2) Performance goal requirement--(i) Preestablished goal. Qualified 
performance-based compensation must be paid solely on account of the 
attainment of one or more preestablished, objective performance goals. A 
performance goal is considered preestablished if it is established in 
writing by the compensation committee not later than 90 days after the 
commencement of the period of service to which the performance goal 
relates, provided that the outcome is substantially uncertain at the 
time the compensation committee actually establishes the goal. However, 
in no event will a performance goal be considered to be preestablished 
if it is established after 25 percent of the period of service (as 
scheduled in good faith at the time the goal is established) has 
elapsed. A performance goal is objective if a third party having 
knowledge of the relevant facts could determine whether the goal is met. 
Performance goals can be based on one or more business criteria that 
apply to the individual, a business unit, or the corporation as a whole. 
Such business criteria could include, for example, stock price, market 
share, sales, earnings per share, return on equity, or costs. A 
performance goal need not, however, be based upon an increase or 
positive result under a business criterion and could include, for 
example, maintaining the status quo or limiting economic losses 
(measured, in each case, by reference to a specific business criterion). 
A performance goal does not include the mere continued employment of the 
covered employee. Thus, a vesting provision based solely on continued 
employment would not constitute a performance goal. See paragraph 
(e)(2)(vi) of this section for rules on compensation that is based on an 
increase in the price of stock.
    (ii) Objective compensation formula. A preestablished 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. A formula or standard is objective if a third 
party having knowledge of the relevant performance results could 
calculate the amount to be paid to the employee. In addition, a formula 
or standard must specify the individual employees or class of employees 
to which it applies.

[[Page 803]]

    (iii) Discretion.
    (A) The terms of an objective formula or standard must preclude 
discretion to increase the amount of compensation payable that would 
otherwise be due upon attainment of the goal. A performance goal is not 
discretionary for purposes of this paragraph (e)(2)(iii) merely because 
the compensation committee reduces or eliminates the compensation or 
other economic benefit that was due upon attainment of the goal. 
However, the exercise of negative discretion with respect to one 
employee is not permitted to result in an increase in the amount payable 
to another employee. Thus, for example, in the case of a bonus pool, if 
the amount payable to each employee is stated in terms of a percentage 
of the pool, the sum of these individual percentages of the pool is not 
permitted to exceed 100 percent. If the terms of an objective formula or 
standard fail to preclude discretion to increase the amount of 
compensation merely because the amount of compensation to be paid upon 
attainment of the performance goal is based, in whole or in part, on a 
percentage of salary or base pay and the dollar amount of the salary or 
base pay is not fixed at the time the performance goal is established, 
then the objective formula or standard will not be considered 
discretionary for purposes of this paragraph (e)(2)(iii) if the maximum 
dollar amount to be paid is fixed at that time.
    (B) If compensation is payable upon or after the attainment of a 
performance goal, and a change is made to accelerate the payment of 
compensation to an earlier date after the attainment of the goal, the 
change will be treated as an increase in the amount of compensation, 
unless the amount of compensation paid is discounted to reasonably 
reflect the time value of money. If compensation is payable upon or 
after the attainment of a performance goal, and a change is made to 
defer the payment of compensation to a later date, any amount paid in 
excess of the amount that was originally owed to the employee will not 
be treated as an increase in the amount of compensation if the 
additional amount is based either on a reasonable rate of interest or on 
one or more predetermined actual investments (whether or not assets 
associated with the amount originally owed are actually invested 
therein) such that the amount payable by the employer at the later date 
will be based on the actual rate of return of a specific investment 
(including any decrease as well as any increase in the value of an 
investment). If compensation is payable in the form of property, a 
change in the timing of the transfer of that property after the 
attainment of the goal will not be treated as an increase in the amount 
of compensation for purposes of this paragraph (e)(2)(iii). Thus, for 
example, if the terms of a stock grant provide for stock to be 
transferred after the attainment of a performance goal and the transfer 
of the stock also is subject to a vesting schedule, a change in the 
vesting schedule that either accelerates or defers the transfer of stock 
will not be treated as an increase in the amount of compensation payable 
under the performance goal.
    (C) Compensation attributable to a stock option, stock appreciation 
right, or other stock-based compensation does not fail to satisfy the 
requirements of this paragraph (e)(2) to the extent that a change in the 
grant or award is made to reflect a change in corporate capitalization, 
such as a stock split or dividend, or a corporate transaction, such as 
any merger of a corporation into another corporation, any consolidation 
of two or more corporations into another corporation, any separation of 
a corporation (including a spinoff or other distribution of stock or 
property by a corporation), any reorganization of a corporation (whether 
or not such reorganization comes within the definition of such term in 
section 368), or any partial or complete liquidation by a corporation.
    (iv) Grant-by-grant determination. The determination of whether 
compensation satisfies the requirements of this paragraph (e)(2) 
generally shall be made on a grant-by-grant basis. Thus, for example, 
whether compensation attributable to a stock option grant satisfies the 
requirements of this paragraph (e)(2) generally is determined on the 
basis of the particular grant made and without regard to the terms of 
any other option grant, or other grant of

[[Page 804]]

compensation, to the same or another employee. As a further example, 
except as provided in paragraph (e)(2)(vi), whether a grant of 
restricted stock or other stock-based compensation satisfies the 
requirements of this paragraph (e)(2) 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. Dividends, dividend 
equivalents, or other similar distributions with respect to stock that 
are treated as separate grants under this paragraph (e)(2)(iv) are not 
performance-based compensation unless they separately satisfy the 
requirements of this paragraph (e)(2).
    (v) Compensation contingent upon attainment of performance goal. 
Compensation does not satisfy the requirements of this paragraph (e)(2) 
if the facts and circumstances indicate that the employee would receive 
all or part of the compensation regardless of whether the performance 
goal is attained. Thus, if the payment of compensation under a grant or 
award is only nominally or partially contingent on attaining a 
performance goal, none of the compensation payable under the grant or 
award will be considered performance-based. For example, if an employee 
is entitled to a bonus under either of two arrangements, where payment 
under a nonperformance-based arrangement is contingent upon the failure 
to attain the performance goals under an otherwise performance-based 
arrangement, then neither arrangement provides for compensation that 
satisfies the requirements of this paragraph (e)(2). Compensation does 
not fail to be qualified performance-based compensation merely because 
the plan allows the compensation to be payable upon death, disability, 
or change of ownership or control, although compensation actually paid 
on account of those events prior to the attainment of the performance 
goal would not satisfy the requirements of this paragraph (e)(2). As an 
exception to the general rule set forth in the first sentence of 
paragraph (e)(2)(iv) of this section, the facts-and-circumstances 
determination referred to in the first sentence of this paragraph 
(e)(2)(v) is made taking into account all plans, arrangements, and 
agreements that provide for compensation to the employee.
    (vi) Application of requirements to stock options and stock 
appreciation rights--(A) In general. Compensation attributable to a 
stock option or a stock appreciation right is deemed to satisfy the 
requirements of this paragraph (e)(2) if the grant or award is made by 
the compensation committee; the plan under which the option or right is 
granted states the maximum number of shares with respect to which 
options or rights may be granted during a specified period to any 
employee; and, under the terms of the option or right, the amount of 
compensation the employee could receive is based solely on an increase 
in the value of the stock after the date of the grant or award. 
Conversely, if the amount of compensation the employee will receive 
under the grant or award is not based solely on an increase in the value 
of the stock after the date of grant or award (e.g., in the case of 
restricted stock, or an option that is granted with an exercise price 
that is less than the fair market value of the stock as of the date of 
grant), none of the compensation attributable to the grant or award is 
qualified performance-based compensation because it does not satisfy the 
requirement of this paragraph (e)(2)(vi)(A). Whether a stock option 
grant is based solely on an increase in the value of the stock after the 
date of grant is determined without regard to any dividend equivalent 
that may be payable, provided that payment of the dividend equivalent is 
not made contingent on the exercise of the option. The rule that the 
compensation attributable to a stock option or stock appreciation right 
must be based solely on an increase in the value of the stock after the 
date of grant or award does not apply if the grant or award is made on 
account of, or if the vesting or exercisability of the grant or award is 
contingent on, the attainment of a performance goal that satisfies the 
requirements of this paragraph (e)(2).
    (B) Cancellation and repricing. Compensation attributable to a stock 
option or stock appreciation right does not satisfy the requirements of 
this

[[Page 805]]

paragraph (e)(2) to the extent that the number of options granted 
exceeds the maximum number of shares for which options may be granted to 
the employee as specified in the plan. If an option is canceled, the 
canceled option continues to be counted against the maximum number of 
shares for which options may be granted to the employee under the plan. 
If, after grant, the exercise price of an option is reduced, the 
transaction is treated as a cancellation of the option and a grant of a 
new option. In such case, both the option that is deemed to be canceled 
and the option that is deemed to be granted reduce the maximum number of 
shares for which options may be granted to the employee under the plan. 
This paragraph (e)(2)(vi)(B) also applies in the case of a stock 
appreciation right where, after the award is made, the base amount on 
which stock appreciation is calculated is reduced to reflect a reduction 
in the fair market value of stock.
    (vii) Examples. This paragraph (e)(2) may be illustrated by the 
following examples:

    Example 1. No later than 90 days after the start of a fiscal year, 
but while the outcome is substantially uncertain, Corporation S 
establishes a bonus plan under which A, the chief executive officer, 
will receive a cash bonus of $500,000, if year-end corporate sales are 
increased by at least 5 percent. The compensation committee retains the 
right, if the performance goal is met, to reduce the bonus payment to A 
if, in its judgment, other subjective factors warrant a reduction. The 
bonus will meet the requirements of this paragraph (e)(2).
    Example 2. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total sales for the 
fiscal year. Because Corporation S is virtually certain to have some 
sales for the fiscal year, the outcome of the performance goal is not 
substantially uncertain, and therefore the bonus does not meet the 
requirements of this paragraph (e)(2).
    Example 3. The facts are the same as in Example 1, except that the 
bonus is based on a percentage of Corporation S's total profits for the 
fiscal year. Although some sales are virtually certain for virtually all 
public companies, it is substantially uncertain whether a company will 
have profits for a specified future period even if the company has a 
history of profitability. Therefore, the bonus will meet the 
requirements of this paragraph (e)(2).
    Example 4. B is the general counsel of Corporation R, which is 
engaged in patent litigation with Corporation S. Representatives of 
Corporation S have informally indicated to Corporation R a willingness 
to settle the litigation for $50,000,000. Subsequently, the compensation 
committee of Corporation R agrees to pay B a bonus if B obtains a formal 
settlement for at least $50,000,000. The bonus to B does not meet the 
requirement of this paragraph (e)(2) because the performance goal was 
not established at a time when the outcome was substantially uncertain.
    Example 5. Corporation S, a public utility, adopts a bonus plan for 
selected salaried employees that will pay a bonus at the end of a 3-year 
period of $750,000 each if, at the end of the 3 years, the price of S 
stock has increased by 10 percent. The plan also provides that the 10-
percent goal will automatically adjust upward or downward by the 
percentage change in a published utilities index. Thus, for example, if 
the published utilities index shows a net increase of 5 percent over a 
3-year period, then the salaried employees would receive a bonus only if 
Corporation S stock has increased by 15 percent. Conversely, if the 
published utilities index shows a net decrease of 5 percent over a 3-
year period, then the salaried employees would receive a bonus if 
Corporation S stock has increased by 5 percent. Because these automatic 
adjustments in the performance goal are preestablished, the bonus meets 
the requirement of this paragraph (e)(2), notwithstanding the potential 
changes in the performance goal.
    Example 6. The facts are the same as in Example 5, except that the 
bonus plan provides that, at the end of the 3-year period, a bonus of 
$750,000 will be paid to each salaried employee if either the price of 
Corporation S stock has increased by 10 percent or the earnings per 
share on Corporation S stock have increased by 5 percent. If both the 
earnings-per-share goal and the stock-price goal are preestablished, the 
compensation committee's discretion to choose to pay a bonus under 
either of the two goals does not cause any bonus paid under the plan to 
fail to meet the requirement of this paragraph (e)(2) because each goal 
independently meets the requirements of this paragraph (e)(2). The 
choice to pay under either of the two goals is tantamount to the 
discretion to choose not to pay under one of the goals, as provided in 
paragraph (e)(2)(iii) of this section.
    Example 7. Corporation U establishes a bonus plan under which a 
specified class of employees will participate in a bonus pool if certain 
preestablished performance goals are attained. The amount of the bonus 
pool is determined under an objective formula. Under the terms of the 
bonus plan, the compensation committee retains the discretion to 
determine the fraction of the bonus pool that each employee may receive. 
The bonus

[[Page 806]]

plan does not satisfy the requirements of this paragraph (e)(2). 
Although the aggregate amount of the bonus plan is determined under an 
objective formula, a third party could not determine the amount that any 
individual could receive under the plan.
    Example 8. The facts are the same as in Example 7, except that the 
bonus plan provides that a specified share of the bonus pool is payable 
to each employee, and the total of these shares does not exceed 100% of 
the pool. The bonus plan satisfies the requirements of this paragraph 
(e)(2). In addition, the bonus plan will satisfy the requirements of 
this paragraph (e)(2) even if the compensation committee retains the 
discretion to reduce the compensation payable to any individual 
employee, provided that a reduction in the amount of one employee's 
bonus does not result in an increase in the amount of any other 
employee's bonus.
    Example 9. Corporation V establishes a stock option plan for 
salaried employees. The terms of the stock option plan specify that no 
salaried employee shall receive options for more than 100,000 shares 
over any 3-year period. The compensation committee grants options for 
50,000 shares to each of several salaried employees. The exercise price 
of each option is equal to or greater than the fair market value at the 
time of each grant. Compensation attributable to the exercise of the 
options satisfies the requirements of this paragraph (e)(2). If, 
however, the terms of the options provide that the exercise price is 
less than fair market value at the date of grant, no compensation 
attributable to the exercise of those options satisfies the requirements 
of this paragraph (e)(2) unless issuance or exercise of the options was 
contingent upon the attainment of a preestablished performance goal that 
satisfies this paragraph (e)(2).
    Example 10. The facts are the same as in Example 9, except that, 
within the same 3-year grant period, the fair market value of 
Corporation V stock is significantly less than the exercise price of the 
options. The compensation committee reprices those options to that lower 
current fair market value of Corporation V stock. The repricing of the 
options for 50,000 shares held by each salaried employee is treated as 
the grant of new options for an additional 50,000 shares to each 
employee. Thus, each of the salaried employees is treated as having 
received grants for 100,000 shares. Consequently, if any additional 
options are granted to those employees during the 3-year period, 
compensation attributable to the exercise of those additional options 
would not satisfy the requirements of this paragraph (e)(2). The results 
would be the same if the compensation committee canceled the outstanding 
options and issued new options to the same employees that were 
exercisable at the fair market value of Corporation V stock on the date 
of reissue.
    Example 11. Corporation W maintains a plan under which each 
participating employee may receive incentive stock options, nonqualified 
stock options, stock appreciation rights, or grants of restricted 
Corporation W stock. The plan specifies that each participating employee 
may receive options, stock appreciation rights, restricted stock, or any 
combination of each, for no more than 20,000 shares over the life of the 
plan. The plan provides that stock options may be granted with an 
exercise price of less than, equal to, or greater than fair market value 
on the date of grant. Options granted with an exercise price equal to, 
or greater than, fair market value on the date of grant do not fail to 
meet the requirements of this paragraph (e)(2) merely because the 
compensation committee has the discretion to determine the types of 
awards (i.e., options, rights, or restricted stock) to be granted to 
each employee or the discretion to issue options or make other 
compensation awards under the plan that would not meet the requirements 
of this paragraph (e)(2). Whether an option granted under the plan 
satisfies the requirements of this paragraph (e)(2) is determined on the 
basis of the specific terms of the option and without regard to other 
options or awards under the plan.
    Example 12. Corporation X maintains a plan under which stock 
appreciation rights may be awarded to key employees. The plan permits 
the compensation committee to make awards under which the amount of 
compensation payable to the employee is equal to the increase in the 
stock price plus a percentage ``gross up'' intended to offset the tax 
liability of the employee. In addition, the plan permits the 
compensation committee to make awards under which the amount of 
compensation payable to the employee is equal to the increase in the 
stock price, based on the highest price, which is defined as the highest 
price paid for Corporation X stock (or offered in a tender offer or 
other arms-length offer) during the 90 days preceding exercise. 
Compensation attributable to awards under the plan satisfies the 
requirements of paragraph (e)(2)(vi) of this section, provided that the 
terms of the plan specify the maximum number of shares for which awards 
may be made.
    Example 13. Corporation W adopts a plan under which a bonus will be 
paid to the CEO only if there is a 10% increase in earnings per share 
during the performance period. The plan provides that earnings per share 
will be calculated without regard to any change in accounting standards 
that may be required by the Financial Accounting Standards Board after 
the goal is established. After the goal is established, such a change in 
accounting standards occurs. Corporation W's

[[Page 807]]

reported earnings, for purposes of determining earnings per share under 
the plan, are adjusted pursuant to this plan provision to factor out 
this change in standards. This adjustment will not be considered an 
exercise of impermissible discretion because it is made pursuant to the 
plan provision.
    Example 14. Corporation X adopts a performance-based incentive pay 
plan with a four-year performance period. Bonuses under the plan are 
scheduled to be paid in the first year after the end of the performance 
period (year 5). However, in the second year of the performance period, 
the compensation committee determines that any bonuses payable in year 5 
will instead, for bona fide business reasons, be paid in year 10. The 
compensation committee also determines that any compensation that would 
have been payable in year 5 will be adjusted to reflect the delay in 
payment. The adjustment will be based on the greater of the future rate 
of return of a specified mutual fund that invests in blue chip stocks or 
of a specified venture capital investment over the five-year deferral 
period. Each of these investments, considered by itself, is a 
predetermined actual investment because it is based on the future rate 
of return of an actual investment. However, the adjustment in this case 
is not based on predetermined actual investments within the meaning of 
paragraph (e)(2)(iii)(B) of this section because the amount payable by 
Corporation X in year 10 will be based on the greater of the two 
investment returns and, thus, will not be based on the actual rate of 
return on either specific investment.
    Example 15. The facts are the same as in Example 14, except that the 
increase will be based on Moody's Average Corporate Bond Yield over the 
five-year deferral period. Because this index reflects a reasonable rate 
of interest, the increase in the compensation payable that is based on 
the index's rate of return is not considered an impermissible increase 
in the amount of compensation payable under the formula.
    Example 16. The facts are the same as in Example 14, except that the 
increase will be based on the rate of return for the Standard & Poor's 
500 Index. This index does not measure interest rates and thus does not 
represent a reasonable rate of interest. In addition, this index does 
not represent an actual investment. Therefore, any additional 
compensation payable based on the rate of return of this index will 
result in an impermissible increase in the amount payable under the 
formula. If, in contrast, the increase were based on the rate of return 
of an existing mutual fund that is invested in a manner that seeks to 
approximate the Standard & Poor's 500 Index, the increase would be based 
on a predetermined actual investment within the meaning of paragraph 
(e)(2)(iii)(B) of this section and thus would not result in an 
impermissible increase in the amount payable under the formula.

    (3) Outside directors--(i) General rule. The performance goal under 
which compensation is paid must be established by a compensation 
committee comprised solely of two or more outside directors. A director 
is an outside director if the director--
    (A) Is not a current employee of the publicly held corporation;
    (B) Is not a former employee of the publicly held corporation who 
receives compensation for prior services (other than benefits under a 
tax-qualified retirement plan) during the taxable year;
    (C) Has not been an officer of the publicly held corporation; and
    (D) Does not receive remuneration from the publicly held 
corporation, either directly or indirectly, in any capacity other than 
as a director. For this purpose, remuneration includes any payment in 
exchange for goods or services.
    (ii) Remuneration received. For purposes of this paragraph (e)(3), 
remuneration is received, directly or indirectly, by a director in each 
of the following circumstances:
    (A) If remuneration is paid, directly or indirectly, to the director 
personally or to an entity in which the director has a beneficial 
ownership interest of greater than 50 percent. For this purpose, 
remuneration is considered paid when actually paid (and throughout the 
remainder of that taxable year of the corporation) and, if earlier, 
throughout the period when a contract or agreement to pay remuneration 
is outstanding.
    (B) If remuneration, other than de minimis remuneration, was paid by 
the publicly held corporation in its preceding taxable year to an entity 
in which the director has a beneficial ownership interest of at least 5 
percent but not more than 50 percent. For this purpose, remuneration is 
considered paid when actually paid or, if earlier, when the publicly 
held corporation becomes liable to pay it.
    (C) If remuneration, other than de minimis remuneration, was paid by 
the publicly held corporation in its preceding taxable year to an entity 
by which the director is employed or self-employed other than as a 
director. For

[[Page 808]]

this purpose, remuneration is considered paid when actually paid or, if 
earlier, when the publicly held corporation becomes liable to pay it.
    (iii) De minimis remuneration--(A) In general. For purposes of 
paragraphs (e)(3)(ii)(B) and (C) of this section, remuneration that was 
paid by the publicly held corporation in its preceding taxable year to 
an entity is de minimis if payments to the entity did not exceed 5 
percent of the gross revenue of the entity for its taxable year ending 
with or within that preceding taxable year of the publicly held 
corporation.
    (B) Remuneration for personal services and substantial owners. 
Notwithstanding paragraph (e)(3)(iii)(A) of this section, remuneration 
in excess of $60,000 is not de minimis if the remuneration is paid to an 
entity described in paragraph (e)(3)(ii)(B) of this section, or is paid 
for personal services to an entity described in paragraph (e)(3)(ii)(C) 
of this section.
    (iv) Remuneration for personal services. For purposes of paragraph 
(e)(3)(iii)(B) of this section, remuneration from a publicly held 
corporation is for personal services if--
    (A) The remuneration is paid to an entity for personal or 
professional services, consisting of legal, accounting, investment 
banking, and management consulting services (and other similar services 
that may be specified by the Commissioner in revenue rulings, notices, 
or other guidance published in the Internal Revenue Bulletin), performed 
for the publicly held corporation, and the remuneration is not for 
services that are incidental to the purchase of goods or to the purchase 
of services that are not personal services; and
    (B) The director performs significant services (whether or not as an 
employee) for the corporation, division, or similar organization (within 
the entity) that actually provides the services described in paragraph 
(e)(3)(iv)(A) of this section to the publicly held corporation, or more 
than 50 percent of the entity's gross revenues (for the entity's 
preceding taxable year) are derived from that corporation, subsidiary, 
or similar organization.
    (v) Entity defined. For purposes of this paragraph (e)(3), entity 
means an organization that is a sole proprietorship, trust, estate, 
partnership, or corporation. The term also includes an affiliated group 
of corporations as defined in section 1504 (determined without regard to 
section 1504(b)) and a group of organizations that would be an 
affiliated group but for the fact that one or more of the organizations 
are not incorporated. However, the aggregation rules referred to in the 
preceding sentence do not apply for purposes of determining whether a 
director has a beneficial ownership interest of at least 5 percent or 
greater than 50 percent.
    (vi) Employees and former officers. Whether a director is an 
employee or a former officer is determined on the basis of the facts at 
the time that the individual is serving as a director on the 
compensation committee. Thus, a director is not precluded from being an 
outside director solely because the director is a former officer of a 
corporation that previously was an affiliated corporation of the 
publicly held corporation. For example, a director of a parent 
corporation of an affiliated group is not precluded from being an 
outside director solely because that director is a former officer of an 
affiliated subsidiary that was spun off or liquidated. However, an 
outside director would no longer be an outside director if a corporation 
in which the director was previously an officer became an affiliated 
corporation of the publicly held corporation.
    (vii) Officer. Solely for purposes of this paragraph (e)(3), officer 
means an administrative executive who is or was in regular and continued 
service. The term implies continuity of service and excludes those 
employed for a special and single transaction. An individual who merely 
has (or had) the title of officer but not the authority of an officer is 
not considered an officer. The determination of whether an individual is 
or was an officer is based on all of the facts and circumstances in the 
particular case, including without limitation the source of the 
individual's authority, the term for which the individual is elected or 
appointed, and the nature and extent of the individual's duties.

[[Page 809]]

    (viii) Members of affiliated groups. For purposes of this paragraph 
(e)(3), the outside directors of the publicly held member of an 
affiliated group are treated as the outside directors of all members of 
the affiliated group.
    (ix) Examples. This paragraph (e)(3) may be illustrated by the 
following examples:

    Example 1. Corporations X and Y are members of an affiliated group 
of corporations as defined in section 1504, until July 1, 1994, when Y 
is sold to another group. Prior to the sale, A served as an officer of 
Corporation Y. After July 1, 1994, A is not treated as a former officer 
of Corporation X by reason of having been an officer of Y.
    Example 2. Corporation Z, a calendar-year taxpayer, uses the 
services of a law firm by which B is employed, but in which B has a 
less-than-5-percent ownership interest. The law firm reports income on a 
July 1 to June 30 basis. Corporation Z appoints B to serve on its 
compensation committee for calendar year 1998 after determining that, in 
calendar year 1997, it did not become liable to the law firm for 
remuneration exceeding the lesser of $60,000 or five percent of the law 
firm's gross revenue (calculated for the year ending June 30, 1997). On 
October 1, 1998, Corporation Z becomes liable to pay remuneration of 
$50,000 to the law firm on June 30, 1999. For the year ending June 30, 
1998, the law firm's gross revenue was less than $1 million. Thus, in 
calendar year 1999, B is not an outside director. However, B may satisfy 
the requirements for an outside director in calendar year 2000, if, in 
calendar year 1999, Corporation Z does not become liable to the law firm 
for additional remuneration. This is because the remuneration actually 
paid on June 30, 1999 was considered paid on October 1, 1998 under 
paragraph (e)(3)(ii)(C) of this section.
    Example 3. Corporation Z, a publicly held corporation, purchases 
goods from Corporation A. D, an executive and less- than-5-percent owner 
of Corporation A, sits on the board of directors of Corporation Z and on 
its compensation committee. For 1997, Corporation Z obtains 
representations to the effect that D is not eligible for any commission 
for D's sales to Corporation Z and that, for purposes of determining D's 
compensation for 1997, Corporation A's sales to Corporation Z are not 
otherwise treated differently than sales to other customers of 
Corporation A (including its affiliates, if any) or are irrelevant. In 
addition, Corporation Z has no reason to believe that these 
representations are inaccurate or that it is otherwise paying 
remuneration indirectly to D personally. Thus, in 1997, no remuneration 
is considered paid by Corporation Z indirectly to D personally under 
paragraph (e)(3)(ii)(A) of this section.
    Example 4. (i) Corporation W, a publicly held corporation, purchases 
goods from Corporation T. C, an executive and less- than-5-percent owner 
of Corporation T, sits on the board of directors of Corporation W and on 
its compensation committee. Corporation T develops a new product and 
agrees on January 1, 1998 to pay C a bonus of $500,000 if Corporation W 
contracts to purchase the product. Even if Corporation W purchases the 
new product, sales to Corporation W will represent less than 5 percent 
of Corporation T's gross revenues. In 1999, Corporation W contracts to 
purchase the new product and, in 2000, C receives the $500,000 bonus 
from Corporation T. In 1998, 1999, and 2000, Corporation W does not 
obtain any representations relating to indirect remuneration to C 
personally (such as the representations described in Example 3).
    (ii) Thus, in 1998, 1999, and 2000, remuneration is considered paid 
by Corporation W indirectly to C personally under paragraph 
(e)(3)(ii)(A) of this section. Accordingly, in 1998, 1999, and 2000, C 
is not an outside director of Corporation W. The result would have been 
the same if Corporation W had obtained appropriate representations but 
nevertheless had reason to believe that it was paying remuneration 
indirectly to C personally.
    Example 5. Corporation R, a publicly held corporation, purchases 
utility service from Corporation Q, a public utility. The chief 
executive officer, and less-than-5-percent owner, of Corporation Q is a 
director of Corporation R. Corporation R pays Corporation Q more than 
$60,000 per year for the utility service, but less than 5 percent of 
Corporation Q's gross revenues. Because utility services are not 
personal services, the fees paid are not subject to the $60,000 de 
minimis rule for remuneration for personal services within the meaning 
of paragraph (e)(3)(iii)(B) of this section. Thus, the chief executive 
officer qualifies as an outside director of Corporation R, unless 
disqualified on some other basis.
    Example 6. Corporation A, a publicly held corporation, purchases 
management consulting services from Division S of Conglomerate P. The 
chief financial officer of Division S is a director of Corporation A. 
Corporation A pays more than $60,000 per year for the management 
consulting services, but less than 5 percent of Conglomerate P's gross 
revenues. Because management consulting services are personal services 
within the meaning of paragraph (e)(3)(iv)(A) of this section, and the 
chief financial officer performs significant services for Division S, 
the fees paid are subject to the $60,000 de minimis rule as remuneration 
for personal services. Thus, the chief financial officer does not 
qualify as an outside director of Corporation A.

[[Page 810]]

    Example 7. The facts are the same as in Example 6, except that the 
chief executive officer, and less-than-5-percent owner, of the parent 
company of Conglomerate P is a director of Corporation A and does not 
perform significant services for Division S. If the gross revenues of 
Division S do not constitute more than 50 percent of the gross revenues 
of Conglomerate P for P's preceding taxable year, the chief executive 
officer will qualify as an outside director of Corporation A, unless 
disqualified on some other basis.

    (4) Shareholder approval requirement--(i) General rule. The material 
terms of the performance goal under which the compensation is to be paid 
must be disclosed to and subsequently approved by the shareholders of 
the publicly held corporation before the compensation is paid. The 
requirements of this paragraph (e)(4) are not satisfied if the 
compensation would be paid regardless of whether the material terms are 
approved by shareholders. The material terms include the employees 
eligible to receive compensation; a description of the business criteria 
on which the performance goal is based; and either the maximum amount of 
compensation that could be paid to any employee or the formula used to 
calculate the amount of compensation to be paid to the employee if the 
performance goal is attained (except that, in the case of a formula 
based, in whole or in part, on a percentage of salary or base pay, the 
maximum dollar amount of compensation that could be paid to the employee 
must be disclosed).
    (ii) Eligible employees. Disclosure of the employees eligible to 
receive compensation need not be so specific as to identify the 
particular individuals by name. A general description of the class of 
eligible employees by title or class is sufficient, such as the chief 
executive officer and vice presidents, or all salaried employees, all 
executive officers, or all key employees.
    (iii) Description of business criteria--(A) In general. Disclosure 
of the business criteria on which the performance goal is based need not 
include the specific targets that must be satisfied under the 
performance goal. For example, if a bonus plan provides that a bonus 
will be paid if earnings per share increase by 10 percent, the 10-
percent figure is a target that need not be disclosed to shareholders. 
However, in that case, disclosure must be made that the bonus plan is 
based on an earnings-per-share business criterion. In the case of a plan 
under which employees may be granted stock options or stock appreciation 
rights, no specific description of the business criteria is required if 
the grants or awards are based on a stock price that is no less than 
current fair market value.
    (B) Disclosure of confidential information. The requirements of this 
paragraph (e)(4) may be satisfied even though information that otherwise 
would be a material term of a performance goal is not disclosed to 
shareholders, provided that the compensation committee determines that 
the information is confidential commercial or business information, the 
disclosure of which would have an adverse effect on the publicly held 
corporation. Whether disclosure would adversely affect the corporation 
is determined on the basis of the facts and circumstances. If the 
compensation committee makes such a determination, the disclosure to 
shareholders must state the compensation committee's belief that the 
information is confidential commercial or business information, the 
disclosure of which would adversely affect the company. In addition, the 
ability not to disclose confidential information does not eliminate the 
requirement that disclosure be made of the maximum amount of 
compensation that is payable to an individual under a performance goal. 
Confidential information does not include the identity of an executive 
or the class of executives to which a performance goal applies or the 
amount of compensation that is payable if the goal is satisfied.
    (iv) Description of compensation. Disclosure as to the compensation 
payable under a performance goal must be specific enough so that 
shareholders can determine the maximum amount of compensation that could 
be paid to any employee during a specified period. If the terms of the 
performance goal do not provide for a maximum dollar amount, the 
disclosure must include the formula under which the compensation would 
be calculated. Thus, for example, if compensation attributable to the 
exercise of stock options is equal to

[[Page 811]]

the difference in the exercise price and the current value of the stock, 
disclosure would be required of the maximum number of shares for which 
grants may be made to any employee and the exercise price of those 
options (e.g., fair market value on date of grant). In that case, 
shareholders could calculate the maximum amount of compensation that 
would be attributable to the exercise of options on the basis of their 
assumptions as to the future stock price.
    (v) Disclosure requirements of the Securities and Exchange 
Commission. To the extent not otherwise specifically provided in this 
paragraph (e)(4), whether the material terms of a performance goal are 
adequately disclosed to shareholders is determined under the same 
standards as apply under the Exchange Act.
    (vi) Frequency of disclosure. Once the material terms of a 
performance goal are disclosed to and approved by shareholders, no 
additional disclosure or approval is required unless the compensation 
committee changes the material terms of the performance goal. If, 
however, the compensation committee has authority to change the targets 
under a performance goal after shareholder approval of the goal, 
material terms of the performance goal must be disclosed to and 
reapproved by shareholders no later than the first shareholder meeting 
that occurs in the fifth year following the year in which shareholders 
previously approved the performance goal.
    (vii) Shareholder vote. For purposes of this paragraph (e)(4), the 
material terms of a performance goal are approved by shareholders if, in 
a separate vote, a majority of the votes cast on the issue (including 
abstentions to the extent abstentions are counted as voting under 
applicable state law) are cast in favor of approval.
    (viii) Members of affiliated group. For purposes of this paragraph 
(e)(4), the shareholders of the publicly held member of the affiliated 
group are treated as the shareholders of all members of the affiliated 
group.
    (ix) Examples. This paragraph (e)(4) may be illustrated by the 
following examples:

    Example 1. Corporation X adopts a plan that will pay a specified 
class of its executives an annual cash bonus based on the overall 
increase in corporate sales during the year. Under the terms of the 
plan, the cash bonus of each executive equals $100,000 multiplied by the 
number of percentage points by which sales increase in the current year 
when compared to the prior year. Corporation X discloses to its 
shareholders prior to the vote both the class of executives eligible to 
receive awards and the annual formula of $100,000 multiplied by the 
percentage increase in sales. This disclosure meets the requirements of 
this paragraph (e)(4). Because the compensation committee does not have 
the authority to establish a different target under the plan, 
Corporation X need not redisclose to its shareholders and obtain their 
reapproval of the material terms of the plan until those material terms 
are changed.
    Example 2. The facts are the same as in Example 1 except that 
Corporation X discloses only that bonuses will be paid on the basis of 
the annual increase in sales. This disclosure does not meet the 
requirements of this paragraph (e)(4) because it does not include the 
formula for calculating the compensation or a maximum amount of 
compensation to be paid if the performance goal is satisfied.
    Example 3. Corporation Y adopts an incentive compensation plan in 
1995 that will pay a specified class of its executives a bonus every 3 
years based on the following 3 factors: increases in earnings per share, 
reduction in costs for specified divisions, and increases in sales by 
specified divisions. The bonus is payable in cash or in Corporation Y 
stock, at the option of the executive. Under the terms of the plan, 
prior to the beginning of each 3-year period, the compensation committee 
determines the specific targets under each of the three factors (i.e., 
the amount of the increase in earnings per share, the reduction in 
costs, and the amount of sales) that must be met in order for the 
executives to receive a bonus. Under the terms of the plan, the 
compensation committee retains the discretion to determine whether a 
bonus will be paid under any one of the goals. The terms of the plan 
also specify that no executive may receive a bonus in excess of 
$1,500,000 for any 3-year period. To satisfy the requirements of this 
paragraph (e)(4), Corporation Y obtains shareholder approval of the plan 
at its 1995 annual shareholder meeting. In the proxy statement issued to 
shareholders, Corporation Y need not disclose to shareholders the 
specific targets that are set by the compensation committee. However, 
Corporation Y must disclose that bonuses are paid on the basis of 
earnings per share, reductions in costs, and increases in sales of 
specified divisions. Corporation Y also must disclose the maximum amount 
of compensation that any executive may receive under the plan is 
$1,500,000 per 3-year period. Unless changes in

[[Page 812]]

the material terms of the plan are made earlier, Corporation Y need not 
disclose the material terms of the plan to the shareholders and obtain 
their reapproval until the first shareholders' meeting held in 2000.
    Example 4. The same facts as in Example 3, except that prior to the 
beginning of the second 3-year period, the compensation committee 
determines that different targets will be set under the plan for that 
period with regard to all three of the performance criteria (i.e., 
earnings per share, reductions in costs, and increases in sales). In 
addition, the compensation committee raises the maximum dollar amount 
that can be paid under the plan for a 3-year period to $2,000,000. The 
increase in the maximum dollar amount of compensation under the plan is 
a changed material term. Thus, to satisfy the requirements of this 
paragraph (e)(4), Corporation Y must disclose to and obtain approval by 
the shareholders of the plan as amended.
    Example 5. In 1998, Corporation Z establishes a plan under which a 
specified group of executives will receive a cash bonus not to exceed 
$750,000 each if a new product that has been in development is completed 
and ready for sale to customers by January 1, 2000. Although the 
completion of the new product is a material term of the performance goal 
under this paragraph (e)(4), the compensation committee determines that 
the disclosure to shareholders of the performance goal would adversely 
affect Corporation Z because its competitors would be made aware of the 
existence and timing of its new product. In this case, the requirements 
of this paragraph (e)(4) are satisfied if all other material terms, 
including the maximum amount of compensation, are disclosed and the 
disclosure affirmatively states that the terms of the performance goal 
are not being disclosed because the compensation committee has 
determined that those terms include confidential information, the 
disclosure of which would adversely affect Corporation Z.

    (5) Compensation committee certification. The compensation committee 
must certify in writing prior to payment of the compensation that the 
performance goals and any other material terms were in fact satisfied. 
For this purpose, approved minutes of the compensation committee meeting 
in which the certification is made are treated as a written 
certification. Certification by the compensation committee is not 
required for compensation that is attributable solely to the increase in 
the value of the stock of the publicly held corporation.
    (f) Companies that become publicly held, spinoffs, and similar 
transactions--(1) In general. In the case of a corporation that was not 
a publicly held corporation and then becomes a publicly held 
corporation, the deduction limit of paragraph (b) of this section does 
not apply to any remuneration paid pursuant to a compensation plan or 
agreement that existed during the period in which the corporation was 
not publicly held. However, in the case of such a corporation that 
becomes publicly held in connection with an initial public offering, 
this relief applies only to the extent that the prospectus accompanying 
the initial public offering disclosed information concerning those plans 
or agreements that satisfied all applicable securities laws then in 
effect. In accordance with paragraph (c)(1)(ii) of this section, a 
corporation that is a member of an affiliated group that includes a 
publicly held corporation is considered publicly held and, therefore, 
cannot rely on this paragraph (f)(1).
    (2) Reliance period. Paragraph (f)(1) of this section may be relied 
upon until the earliest of--
    (i) The expiration of the plan or agreement;
    (ii) The material modification of the plan or agreement, within the 
meaning of paragraph (h)(1)(iii) of this section;
    (iii) The issuance of all employer stock and other compensation that 
has been allocated under the plan; or
    (iv) The first meeting of shareholders at which directors are to be 
elected that occurs after the close of the third calendar year following 
the calendar year in which the initial public offering occurs or, in the 
case of a privately held corporation that becomes publicly held without 
an initial public offering, the first calendar year following the 
calendar year in which the corporation becomes publicly held.
    (3) Stock-based compensation. Paragraph (f)(1) of this section will 
apply to any compensation received pursuant to the exercise of a stock 
option or stock appreciation right, or the substantial vesting of 
restricted property, granted under a plan or agreement described in 
paragraph (f)(1) of this section if the grant occurs on or before the 
earliest of the events specified in paragraph (f)(2) of this section.

[[Page 813]]

    (4) Subsidiaries that become separate publicly held corporations--
(i) In general. If a subsidiary that is a member of the affiliated group 
described in paragraph (c)(1)(ii) of this section becomes a separate 
publicly held corporation (whether by spinoff or otherwise), any 
remuneration paid to covered employees of the new publicly held 
corporation will satisfy the exception for performance-based 
compensation described in paragraph (e) of this section if the 
conditions in either paragraph (f)(4)(ii) or (f)(4)(iii) of this section 
are satisfied.
    (ii) Prior establishment and approval. Remuneration satisfies the 
requirements of this paragraph (f)(4)(ii) if the remuneration satisfies 
the requirements for performance-based compensation set forth in 
paragraphs (e)(2), (e)(3), and (e)(4) of this section (by application of 
paragraphs (e)(3)(viii) and (e)(4)(viii) of this section) before the 
corporation becomes a separate publicly held corporation, and the 
certification required by paragraph (e)(5) of this section is made by 
the compensation committee of the new publicly held corporation (but if 
the performance goals are attained before the corporation becomes a 
separate publicly held corporation, the certification may be made by the 
compensation committee referred to in paragraph (e)(3)(viii) of this 
section before it becomes a separate publicly held corporation). Thus, 
this paragraph (f)(4)(ii) requires that the outside directors and 
shareholders (within the meaning of paragraphs (e)(3)(viii) and 
(e)(4)(viii) of this section) of the corporation before it becomes a 
separate publicly held corporation establish and approve, respectively, 
the performance-based compensation for the covered employees of the new 
publicly held corporation in accordance with paragraphs (e)(3) and 
(e)(4) of this section.
    (iii) Transition period. Remuneration satisfies the requirements of 
this paragraph (f)(4)(iii) if the remuneration satisfies all of the 
requirements of paragraphs (e)(2), (e)(3), and (e)(5) of this section. 
The outside directors (within the meaning of paragraph (e)(3)(viii) of 
this section) of the corporation before it becomes a separate publicly 
held corporation, or the outside directors of the new publicly held 
corporation, may establish and administer the performance goals for the 
covered employees of the new publicly held corporation for purposes of 
satisfying the requirements of paragraphs (e)(2) and (e)(3) of this 
section. The certification required by paragraph (e)(5) of this section 
must be made by the compensation committee of the new publicly held 
corporation. However, a taxpayer may rely on this paragraph (f)(4)(iii) 
to satisfy the requirements of paragraph (e) of this section only for 
compensation paid, or stock options, stock appreciation rights, or 
restricted property granted, prior to the first regularly scheduled 
meeting of the shareholders of the new publicly held corporation that 
occurs more than 12 months after the date the corporation becomes a 
separate publicly held corporation. Compensation paid, or stock options, 
stock appreciation rights, or restricted property granted, on or after 
the date of that meeting of shareholders must satisfy all requirements 
of paragraph (e) of this section, including the shareholder approval 
requirement of paragraph (e)(4) of this section, in order to satisfy the 
requirements for performance-based compensation.
    (5) Example. The following example illustrates the application of 
paragraph (f)(4)(ii) of this section:

    Example. Corporation P, which is publicly held, decides to spin off 
Corporation S, a wholly owned subsidiary of Corporation P. After the 
spinoff, Corporation S will be a separate publicly held corporation. 
Before the spinoff, the compensation committee of Corporation P, 
pursuant to paragraph (e)(3)(viii) of this section, establishes a bonus 
plan for the executives of Corporation S that provides for bonuses 
payable after the spinoff and that satisfies the requirements of 
paragraph (e)(2) of this section. If, pursuant to paragraph (e)(4)(viii) 
of this section, the shareholders of Corporation P approve the plan 
prior to the spinoff, that approval will satisfy the requirements of 
paragraph (e)(4) of this section with respect to compensation paid 
pursuant to the bonus plan after the spinoff. However, the compensation 
committee of Corporation S will be required to certify that the goals 
are satisfied prior to the payment of the bonuses in order for the 
bonuses to be considered performance-based compensation.

    (g) Coordination with disallowed excess parachute payments. The 
$1,000,000 limitation in paragraph (b) of this section

[[Page 814]]

is reduced (but not below zero) by the amount (if any) that would have 
been included in the compensation of the covered employee for the 
taxable year but for being disallowed by reason of section 280G. For 
example, assume that during a taxable year a corporation pays $1,500,000 
to a covered employee and no portion satisfies the exception in 
paragraph (d) of this section for commissions or paragraph (e) of this 
section for qualified performance-based compensation. Of the $1,500,000, 
$600,000 is an excess parachute payment, as defined in section 
280G(b)(1) and is disallowed by reason of that section. Because the 
excess parachute payment reduces the limitation of paragraph (b) of this 
section, the corporation can deduct $400,000, and $500,000 of the 
otherwise deductible amount is nondeductible by reason of section 
162(m).
    (h) Transition rules--(1) Compensation payable under a written 
binding contract which was in effect on February 17, 1993--(i) General 
rule. The deduction limit of paragraph (b) of this section does not 
apply to any compensation payable under a written binding contract that 
was in effect on February 17, 1993. The preceding sentence does not 
apply unless, under applicable state law, the corporation is obligated 
to pay the compensation if the employee performs services. However, the 
deduction limit of paragraph (b) of this section does apply to a 
contract that is renewed after February 17, 1993. A written binding 
contract that is terminable or cancelable by the corporation after 
February 17, 1993, without the employee's consent is treated as a new 
contract as of the date that any such termination or cancellation, if 
made, would be effective. Thus, for example, if the terms of a contract 
provide that it will be automatically renewed as of a certain date 
unless either the corporation or the employee gives notice of 
termination of the contract at least 30 days before that date, the 
contract is treated as a new contract as of the date that termination 
would be effective if that notice were given. Similarly, for example, if 
the terms of a contract provide that the contract will be terminated or 
canceled as of a certain date unless either the corporation or the 
employee elects to renew within 30 days of that date, the contract is 
treated as renewed by the corporation as of that date. Alternatively, if 
the corporation will remain legally obligated by the terms of a contract 
beyond a certain date at the sole discretion of the employee, the 
contract will not be treated as a new contract as of that date if the 
employee exercises the discretion to keep the corporation bound to the 
contract. A contract is not treated as terminable or cancelable if it 
can be terminated or canceled only by terminating the employment 
relationship of the employee.
    (ii) Compensation payable under a plan or arrangement. If a 
compensation plan or arrangement meets the requirements of paragraph 
(h)(1)(i) of this section, the compensation paid to an employee pursuant 
to the plan or arrangement will not be subject to the deduction limit of 
paragraph (b) of this section even though the employee was not eligible 
to participate in the plan as of February 17, 1993. However, the 
preceding sentence does not apply unless the employee was employed on 
February 17, 1993, by the corporation that maintained the plan or 
arrangement, or the employee had the right to participate in the plan or 
arrangement under a written binding contract as of that date.
    (iii) Material modifications.
    (A) Paragraph (h)(1)(i) of this section will not apply to any 
written binding contract that is materially modified. A material 
modification occurs when the contract is amended to increase the amount 
of compensation payable to the employee. If a binding written contract 
is materially modified, it is treated as a new contract entered into as 
of the date of the material modification. Thus, amounts received by an 
employee under the contract prior to a material modification are not 
affected, but amounts received subsequent to the material modification 
are not treated as paid under a binding, written contract described in 
paragraph (h)(1)(i) of this section.
    (B) A modification of the contract that accelerates the payment of 
compensation will be treated as a material modification unless the 
amount of compensation paid is discounted to reasonably reflect the time 
value of

[[Page 815]]

money. If the contract is modified to defer the payment of compensation, 
any compensation paid in excess of the amount that was originally 
payable to the employee under the contract will not be treated as a 
material modification if the additional amount is based on either a 
reasonable rate of interest or one or more predetermined actual 
investments (whether or not assets associated with the amount originally 
owed are actually invested therein) such that the amount payable by the 
employer at the later date will be based on the actual rate of return of 
the specific investment (including any decrease as well as any increase 
in the value of the investment).
    (C) The adoption of a supplemental contract or agreement that 
provides for increased compensation, or the payment of additional 
compensation, is a material modification of a binding, written contract 
where the facts and circumstances show that the additional compensation 
is paid on the basis of substantially the same elements or conditions as 
the compensation that is otherwise paid under the written binding 
contract. However, a material modification of a written binding contract 
does not include a supplemental payment that is equal to or less than a 
reasonable cost-of-living increase over the payment made in the 
preceding year under that written binding contract. In addition, a 
supplemental payment of compensation that satisfies the requirements of 
qualified performance-based compensation in paragraph (e) of this 
section will not be treated as a material modification.
    (iv) Examples. The following examples illustrate the exception of 
this paragraph (h)(1):

    Example 1. Corporation X executed a 3-year compensation arrangement 
with C on February 15, 1993, that constitutes a written binding contract 
under applicable state law. The terms of the arrangement provide for 
automatic extension after the 3-year term for additional 1-year periods, 
unless the corporation exercises its option to terminate the arrangement 
within 30 days of the end of the 3-year term or, thereafter, within 30 
days before each anniversary date. Termination of the compensation 
arrangement does not require the termination of C's employment 
relationship with Corporation X. Unless terminated, the arrangement is 
treated as renewed on February 15, 1996, and the deduction limit of 
paragraph (b) of this section applies to payments under the arrangement 
after that date.
    Example 2. Corporation Y executed a 5-year employment agreement with 
B on January 1, 1992, providing for a salary of $900,000 per year. 
Assume that this agreement constitutes a written binding contract under 
applicable state law. In 1992 and 1993, B receives the salary of 
$900,000 per year. In 1994, Corporation Y increases B's salary with a 
payment of $20,000. The $20,000 supplemental payment does not constitute 
a material modification of the written binding contract because the 
$20,000 payment is less than or equal to a reasonable cost-of-living 
increase from 1993. However, the $20,000 supplemental payment is subject 
to the limitation in paragraph (b) of this section. On January 1, 1995, 
Corporation Y increases B's salary to $1,200,000. The $280,000 
supplemental payment is a material modification of the written binding 
contract because the additional compensation is paid on the basis of 
substantially the same elements or conditions as the compensation that 
is otherwise paid under the written binding contract and it is greater 
than a reasonable, annual cost-of-living increase. Because the written 
binding contract is materially modified as of January 1, 1995, all 
compensation paid to B in 1995 and thereafter is subject to the 
deduction limitation of section 162(m).
    Example 3. Assume the same facts as in Example 2, except that 
instead of an increase in salary, B receives a restricted stock grant 
subject to B's continued employment for the balance of the contract. The 
restricted stock grant is not a material modification of the binding 
written contract because any additional compensation paid to B under the 
grant is not paid on the basis of substantially the same elements and 
conditions as B's salary because it is based both on the stock price and 
B's continued service. However, compensation attributable to the 
restricted stock grant is subject to the deduction limitation of section 
162(m).

    (2) Special transition rule for outside directors. A director who is 
a disinterested director is treated as satisfying the requirements of an 
outside director under paragraph (e)(3) of this section until the first 
meeting of shareholders at which directors are to be elected that occurs 
on or after January 1, 1996. For purposes of this paragraph (h)(2) and 
paragraph (h)(3) of this section, a director is a disinterested director 
if the director is disinterested within the meaning of Rule 16b-
3(c)(2)(i), 17 CFR 240.16b-3(c)(2)(i), under the Exchange Act (including 
the provisions of

[[Page 816]]

Rule 16b-3(d)(3), as in effect on April 30, 1991).
    (3) Special transition rule for previously-approved plans--(i) In 
general. Any compensation paid under a plan or agreement approved by 
shareholders before December 20, 1993, is treated as satisfying the 
requirements of paragraphs (e)(3) and (e)(4) of this section, provided 
that the directors administering the plan or agreement are disinterested 
directors and the plan was approved by shareholders in a manner 
consistent with Rule 16b-3(b), 17 CFR 240.16b-3(b), under the Exchange 
Act or Rule 16b-3(a), 17 CFR 240.16b-3(a) (as contained in 17 CFR part 
240 revised April 1, 1990). In addition, for purposes of satisfying the 
requirements of paragraph (e)(2)(vi) of this section, a plan or 
agreement is treated as stating a maximum number of shares with respect 
to which an option or right may be granted to any employee if the plan 
or agreement that was approved by the shareholders provided for an 
aggregate limit, consistent with Rule 16b-3(b), 17 CFR 250.16b-3(b), on 
the shares of employer stock with respect to which awards may be made 
under the plan or agreement.
    (ii) Reliance period. The transition rule provided in this paragraph 
(h)(3) shall continue and may be relied upon until the earliest of--
    (A) The expiration or material modification of the plan or 
agreement;
    (B) The issuance of all employer stock and other compensation that 
has been allocated under the plan; or
    (C) The first meeting of shareholders at which directors are to be 
elected that occurs after December 31, 1996.
    (iii) Stock-based compensation. This paragraph (h)(3) will apply to 
any compensation received pursuant to the exercise of a stock option or 
stock appreciation right, or the substantial vesting of restricted 
property, granted under a plan or agreement described in paragraph 
(h)(3)(i) of this section if the grant occurs on or before the earliest 
of the events specified in paragraph (h)(3)(ii) of this section.
    (iv) Example. The following example illustrates the application of 
this paragraph (h)(3):

    Example. Corporation Z adopted a stock option plan in 1991. Pursuant 
to Rule 16b-3 under the Exchange Act, the stock option plan has been 
administered by disinterested directors and was approved by Corporation 
Z shareholders. Under the terms of the plan, shareholder approval is not 
required again until 2001. In addition, the terms of the stock option 
plan include an aggregate limit on the number of shares available under 
the plan. Option grants under the Corporation Z plan are made with an 
exercise price equal to or greater than the fair market value of 
Corporation Z stock. Compensation attributable to the exercise of 
options that are granted under the plan before the earliest of the dates 
specified in paragraph (h)(3)(ii) of this section will be treated as 
satisfying the requirements of paragraph (e) of this section for 
qualified performance-based compensation, regardless of when the options 
are exercised.

    (i) [Reserved]
    (j) Effective date--(1) In general. Section 162(m) and this section 
apply to compensation that is otherwise deductible by the corporation in 
a taxable year beginning on or after January 1, 1994.
    (2) Delayed effective date for certain provisions--(i) Date on which 
remuneration is considered paid. Notwithstanding paragraph (j)(1) of 
this section, the rules in the second sentence of each of paragraphs 
(e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of this section for 
determining the date or dates on which remuneration is considered paid 
to a director are effective for taxable years beginning on or after 
January 1, 1995. Prior to those taxable years, taxpayers must follow the 
rules in paragraphs (e)(3)(ii)(A), (e)(3)(ii)(B), and (e)(3)(ii)(C) of 
this section or another reasonable, good faith interpretation of section 
162(m) with respect to the date or dates on which remuneration is 
considered paid to a director.
    (ii) Separate treatment of publicly held subsidiaries. 
Notwithstanding paragraph (j)(1) of this section, the rule in paragraph 
(c)(1)(ii) of this section that treats publicly held subsidiaries as 
separately subject to section 162(m) is effective as of the first 
regularly scheduled meeting of the shareholders of the publicly held 
subsidiary that occurs more than 12 months after December 2, 1994. The 
rule for stock-based compensation set forth in paragraph (f)(3) of this 
section will apply for this purpose, except that the grant must occur

[[Page 817]]

before the shareholder meeting specified in this paragraph (j)(2)(ii). 
Taxpayers may choose to rely on the rule referred to in the first 
sentence of this paragraph (j)(2)(ii) for the period prior to the 
effective date of the rule.
    (iii) Subsidiaries that become separate publicly held corporations. 
Notwithstanding paragraph (j)(1) of this section, if a subsidiary of a 
publicly held corporation becomes a separate publicly held corporation 
as described in paragraph (f)(4)(i) of this section, then, for the 
duration of the reliance period described in paragraph (f)(2) of this 
section, the rules of paragraph (f)(1) of this section are treated as 
applying (and the rules of paragraph (f)(4) of this section do not 
apply) to remuneration paid to covered employees of that new publicly 
held corporation pursuant to a plan or agreement that existed prior to 
December 2, 1994, provided that the treatment of that remuneration as 
performance-based is in accordance with a reasonable, good faith 
interpretation of section 162(m). However, if remuneration is paid to 
covered employees of that new publicly held corporation pursuant to a 
plan or agreement that existed prior to December 2, 1994, but that 
remuneration is not performance-based under a reasonable, good faith 
interpretation of section 162(m), the rules of paragraph (f)(1) of this 
section will be treated as applying only until the first regularly 
scheduled meeting of shareholders that occurs more than 12 months after 
December 2, 1994. The rules of paragraph (f)(4) of this section will 
apply as of that first regularly scheduled meeting. The rule for stock-
based compensation set forth in paragraph (f)(3) of this section will 
apply for purposes of this paragraph (j)(2)(iii), except that the grant 
must occur before the shareholder meeting specified in the preceding 
sentence if the remuneration is not performance-based under a 
reasonable, good faith interpretation of section 162(m). Taxpayers may 
choose to rely on the rules of paragraph (f)(4) of this section for the 
period prior to the applicable effective date referred to in the first 
or second sentence of this paragraph (j)(2)(iii).
    (iv) Bonus pools. Notwithstanding paragraph (j)(1) of this section, 
the rules in paragraph (e)(2)(iii)(A) that limit the sum of individual 
percentages of a bonus pool to 100 percent will not apply to 
remuneration paid before January 1, 2001, based on performance in any 
performance period that began prior to December 20, 1995.
    (v) Compensation based on a percentage of salary or base pay. 
Notwithstanding paragraph (j)(1) of this section, the requirement in 
paragraph (e)(4)(i) of this section that, in the case of certain 
formulas based on a percentage of salary or base pay, a corporation 
disclose to shareholders the maximum dollar amount of compensation that 
could be paid to the employee, will apply only to plans approved by 
shareholders after April 30, 1995.

[T.D. 8650, 60 FR 65537, Dec. 20, 1995, as amended by T.D. 8650, 61 FR 
4350, Feb. 6, 1996]