The employer tax deduction may be subject to certain limitations. One limitation is the IRC Section 162(m) million-dollar limitation. For public companies, IRC Section 162(m) provides that 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 executive officers, determined pursuant to the SEC’s rules for executive compensation disclosures in the annual proxy statement. However, for IRC Section 162(m) purposes, the list of potential covered employees includes any executive officer during the year, not just those who are required to be disclosed on the 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: