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The following section summarizes some of the key corporate income tax considerations related to stock-based compensation under US federal income tax laws and regulations. It is intended to provide helpful context for considering plan design from the employer perspective. However, it is not intended to be and should not be considered comprehensive authoritative guidance for any specific employer or employee tax consequences.

10.8.1 IRC Section 162(m) limitation

The tax deduction that an employer is eligible for under IRC Section 83(h) may be subject to certain limitations. One limitation is the million-dollar limitation, which was established by IRC Section 162(m). IRC Section 162(m) provides that for public companies, the annual compensation that may be deducted in a year with respect to covered employees is limited to $1 million per covered employee. Prior to the 2017 tax law changes, certain performance-based compensation was exempt from this limitation. That exception may still be applied to remuneration paid under a written binding agreement that was in effect on November 2, 2017 and has not been materially modified. There was previously an exemption under the IPO transition rules for newly public companies, which was eliminated in 2020.
All individuals who hold the position of either chief executive officer or chief financial officer at any time during the taxable year are covered employees. Covered employees also include the company's three other most highly compensated officers, pursuant to the SEC's rules for executive compensation disclosures in the annual proxy statement. Any individual who is deemed a covered employee will continue to be a covered employee for all subsequent taxable years, including years after the death of the individual. The anticipated effect of the Section 162(m) limitation should be considered, using one of three methods, when recognizing deferred tax assets for awards that may be subject to the limitation. The selection of a method should be treated as the election of an accounting policy and should be applied consistently. We believe any of the following approaches would be acceptable for determining whether a deferred tax asset should be recorded for stock-based compensation that is subject to the IRC Section 162(m) limitation:
  • The impact of future cash compensation takes priority over stock-based compensation awards. In other words, if the anticipated cash compensation is equal to or greater than the total tax deductible annual compensation amount ($1 million) for the covered employee, a company would not record a deferred tax asset associated with any stock-based compensation cost for that individual.
  • The impact of the stock-based compensation takes priority over future cash compensation. In other words, a deferred tax asset would be recorded for the stock-based compensation up to the tax deductible amount.
  • Prorate the anticipated benefit between cash compensation and stock-based compensation and reflect the deferred tax asset for the stock-based compensation award based on a blended tax rate that considers the anticipated future limitation in the year such temporary difference is expected to reverse.

10.8.2 Golden parachute rules

In addition to the IRC Section 162(m) limitation, the tax deduction for stock-based compensation may also be limited by the golden parachute rules under IRC Section 280G. IRC Section 280G(a) provides that an employer is not allowed to take a deduction for an excess parachute payment. An excess parachute payment is any payment that serves as compensation to (or that is for the benefit of) a disqualified individual and:
  • is contingent on (1) a change in ownership or effective control of the corporation, or (2) a change in ownership of a substantial portion of the corporation's assets; and
  • has an aggregate present value that equals or exceeds an amount that is three times the base amount.
Treasury Regulation Section 1.280G-1 specifies that certain compensation payments can be excluded from the definition of parachute payments. Some forms of stock-based compensation may qualify for this exception, such as reasonable compensation for services that are actually rendered after a change of control; payment from certain privately held companies; payment from qualified plans; and payments made by a small-business corporation.
To determine the IRC Section 280G value of stock options, taxpayers must use an option valuation model, such as Black-Scholes, to determine the parachute value of a stock option where vesting is accelerated upon a change of control. To accurately track the corporate tax deduction related to stock options with parachute value, companies may need to establish a separate tracking mechanism for the time these options remain outstanding following the change of control.
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