Disallowance of Deductions for Employee Remuneration in Excess of $1,000,000

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8650]

RIN 1545-AS23

Disallowance of Deductions for Employee Remuneration in Excess of

$1,000,000

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to the

disallowance of deductions for employee remuneration in excess of

$1,000,000. The regulations provide guidance to taxpayers that are

subject to section 162(m), which was added to the Code by the Omnibus

Budget Reconciliation Act of 1993.

DATES: These regulations are effective January 1, 1994.

For dates of applicability, see Sec. 1.162-27(j).

FOR FURTHER INFORMATION CONTACT: Robert Misner or Charles T. Deliee at

(202)622-6060 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collections of information contained in these final regulations

have been reviewed and approved by the Office of Management and Budget

in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under

control number 1545-1466. Responses to these collections of information

are required to obtain a tax deduction for performance-based

compensation in excess of $1 million.

An agency may not conduct or sponsor, and a person is not required

to respond to, a collection of information unless the collection of

information displays a valid control number.

The estimated average annual burden per respondent is 50 hours.

Comments concerning the accuracy of this burden estimate and

suggestions for reducing this burden should be sent to the Internal

Revenue Service, Attn: IRS Reports Clearance Officer, T:FP, Washington,

DC 20224, and to the Office of Management and Budget, Attn: Desk

Officer for the Department of the Treasury, Office of Information and

Regulatory Affairs, Washington, DC 20503.

Books or records relating to this collection of information must be

retained as long as their contents may become material in the

administration of any internal revenue law. Generally, tax returns and

tax return information are confidential, as required by 26 U.S.C. 6103.

Background

Under section 162(m) of the Internal Revenue Code, a publicly held

corporation is denied a deduction for compensation paid to its

``covered employees'' to the extent the compensation exceeds $1,000,000

if the compensation would otherwise be deductible in a taxable year

beginning on or after January 1, 1994.

On December 20, 1993, proposed regulations under section 162(m)

(the 1993 proposed regulations) were published in the Federal Register

(58

[[Page 65535]]

FR 66310). Amendments to the proposed regulations (the 1994 amendments)

were published in the Federal Register on December 2, 1994 (59 FR

61844). Public hearings were held on May 9, 1994, and August 11, 1995.

After consideration of the comments that were received in response to

the notices of proposed rulemaking and at the hearings, the IRS and

Treasury adopt the proposed regulations as amended and revised by this

Treasury decision.

Explanation of Provisions

A. Overview of Provisions

As noted above, section 162(m) provides that a publicly held

corporation is denied a deduction for compensation paid to a ``covered

employee'' to the extent the compensation exceeds $1,000,000. A

``covered employee'' includes the chief executive officer (CEO), as

well as any other individual whose compensation is required to be

reported to the Securities and Exchange Commission by reason of that

individual being among the four highest compensated officers for the

taxable year (other than the CEO), as of the end of the corporation's

taxable year.

``Performance-based compensation'' and certain other compensation

is not subject to the deduction limitation of section 162(m).

Performance-based compensation is remuneration payable solely on

account of the attainment of one or more performance goals, but only

if: (1) the goals are determined by a compensation committee of the

board of directors consisting solely of two or more outside directors;

(2) the material terms under which the compensation is to be paid are

disclosed to the shareholders and approved by a majority in a separate

vote before payment is made; and (3) before any payment is made, the

compensation committee certifies that the performance goals and any

other material terms have been satisfied.

Compensation is also excluded from the deduction limitation of

section 162(m) if it is paid under a binding written contract that was

in existence on February 17, 1993. In addition, in accordance with the

legislative history, the proposed regulations exempt from the

limitation compensation that is paid under an arrangement that existed

before the corporation became publicly held, to the extent that the

arrangement is disclosed in the initial public offering.

B. Discussion of Comments

Comments that relate to the application of the proposed regulations

and the responses to the comments, including an explanation of the

revisions reflected in the final regulations, are summarized below.

Dividend Equivalents Paid on Stock Options

Under the proposed regulations, the performance-based exception to

the deduction limitation generally is applied on a grant-by-grant

basis. If the facts and circumstances indicate, however, that the

employee would receive all or part of the compensation regardless of

whether the performance goal is attained, the compensation is not

performance based. For example, where payment under a nonperformance

based bonus is contingent upon the failure to attain the performance

goals under an otherwise performance-based bonus, neither bonus

arrangement will be considered performance based. The proposed

regulations provide that whether dividends (which generally are not

performance based) on restricted stock are payable before attainment of

the performance goal, will not affect the determination of whether the

restricted stock is performance based. The proposed regulations also

provide, however, that if the amount of any compensation the employee

will receive under a stock option is not based solely on an increase in

the value of the stock after the date of grant (for example, an option

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 will be performance based.

Commentators raised the question of whether nonperformance-based

dividend equivalents that are paid with respect to a granted but

unexercised stock option irrespective of whether the option is

exercised will cause the compensation paid upon the exercise of the

option to be nonperformance based. Section 1.162-27(e)(2)(vi) of the

final regulations provides that such dividend equivalents will not

cause the compensation paid upon the exercise of the option to be

nonperformance based, provided that the payment of the dividend

equivalents is not conditioned upon the employee exercising the option.

If the payment of the dividend equivalent is conditioned upon the

employee exercising the option, the dividend effectively reduces the

exercise price of the option, thereby causing the option to be

nonperformance based upon its exercise.

Bonus Pools

Section 1.162-27(e)(2)(ii) of the proposed regulations provides

that 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.

Section 1.162-27(e)(2)(iii) prohibits discretion to increase the

amount of compensation to be paid under the preestablished performance

goal, but permits the compensation committee to reduce or eliminate the

compensation that is due upon attainment of the goal.

Examples 7 and 8 under Sec. 1.162-27(e)(2)(vii) of the proposed

regulations illustrated the application of these rules to bonus pools.

In Example 7, the amount of the bonus pool was determined under an

objective formula. However, because the compensation committee retained

the discretion to determine the fraction of the bonus pool that each

covered employee would receive, the compensation that any individual

could receive was not determined under an objective formula and,

therefore, the bonus plan did not satisfy the requirements of paragraph

(e)(2). In Example 8, the compensation for any individual was

determined under an objective formula because each employee's share of

the bonus pool was specified and because, notwithstanding the

compensation committee's ability to reduce the compensation payable to

each individual employee, a reduction in one employee's bonus would not

result in an increase in the amount of any other employee's bonus.

Several commentators have indicated that, in some cases where

compensation committees have stated the amount payable to each

individual under a bonus pool plan as a percentage of the bonus pool,

the total of these percentages has exceeded 100 percent of the pool.

The use of such overlapping percentages is inconsistent with

Sec. 1.162-27(e)(2), as illustrated by both Example 7 and Example 8. As

noted, Example 8 states that negative discretion will not cause the

bonus plan to fail to satisfy the requirements of paragraph (e)(2),

``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.'' Where the total of the percentages payable under a bonus pool

plan exceeds 100 percent, it is impossible to award each individual the

[[Page 65536]]

stated percentage, and this necessary exercise of negative discretion

with respect to one or more employees means that it is impossible for a

third party, with knowledge of the relevant performance results, to

calculate the amount to be paid to each employee. Further, a reduction

in at least some employees' bonuses will result in an increase in the

amount available to pay other employees' bonuses.

Accordingly, Sec. 1.162-27(e)(2)(iii) is amended to state more

clearly that, when the compensation to be paid to each employee is

stated in terms of a percentage of a bonus pool, the sum of the

individual percentages for all participants in the pool cannot exceed

100 percent. In addition, the principle stated in Example 8, that the

exercise of negative discretion with respect to one employee cannot

increase the amount payable to another employee, is incorporated in

paragraph (e)(2)(iii). Example 8 is also revised to more clearly

illustrate this rule.

Although the IRS and Treasury believe that the changes made merely

clarify the proposed regulations, it is recognized that others have

interpreted the language of the proposed regulations differently.

Therefore, under Sec. 1.162-27(j)(2)(iv), this clarified rule will not

be applied to any compensation paid before January 1, 2001, under a

bonus pool based on performance in any period that began before

December 20, 1995.

Outside Directors

Section 1.162-27(e)(3)(vi) provides that a director is not

precluded from being an outside director solely because he or she is a

former officer of a corporation that previously was an affiliated

corporation of the publicly held corporation. The regulation is revised

to clarify that a former officer of either a spun off or liquidated

corporation, that formerly was a member of the affiliated group, is not

precluded from serving on the compensation committee of the publicly

held member of the affiliated group.

Companies that Become Publicly Held Without an Initial Public Offering

Under Sec. 1.162-27(f), the $1 million deduction limit does not

apply to any compensation plan or agreement that existed before the

corporation became publicly held to the extent that the plan or

agreement was disclosed in the prospectus accompanying the initial

public offering (IPO). This exception may be relied on until the

earliest of: (1) the expiration of the plan or agreement, (2) the

material modification of the plan or agreement, (3) the issuance of all

stock and other compensation that has been allocated under the plan, or

(4) the first shareholder meeting at which directors will be elected

that occurs after the close of the third calendar year following the

calendar year in which the IPO occurs.

Commentators have asked whether this rule applies to corporations

that become publicly held without an IPO.

As indicated in the legislative history accompanying Code section

162(m), the prospectus that accompanies the IPO provides an opportunity

to disclose the terms of the plan or agreement to the potential

shareholders, and the subsequent purchase of the stock with that

knowledge may be viewed as tantamount to a favorable vote on the

compensation arrangement. When a corporation becomes publicly held

without an IPO, there is no comparable alternative means of satisfying

the requirements of section 162(m)(4)(C)(ii). On the other hand,

because there is no requirement for privately held corporations to

comply with section 162(m), the IRS and Treasury recognize the need for

a transition rule for plans and agreements that are in existence when a

privately held corporation becomes publicly held without an IPO.

Accordingly, Sec. 1.162-27(f)(1) is revised to provide relief for

privately held corporations that become publicly held without an IPO.

Under the transition rule for these corporations, the reliance period

in Sec. 1.162-27(f)(2) lapses upon the first meeting of shareholders at

which directors are to be elected that occurs after the close of the

first calendar year following the calendar year in which the

corporation becomes publicly held.

Written Binding Contracts

Section 1.162-27(h)(1) provides the transition rules for

compensation payable under a written binding contract that was in

effect on February 17, 1993. Under those rules, 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 cancelation, if

made, would be effective. The proposed regulations further provide

that, 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.

Commentators have suggested that these regulations clarify the

outcome where a corporation will remain bound by the terms of a

contract beyond a certain date at the sole discretion of the employee.

For example, if a contract that is in effect on February 17, 1993,

provides that the employee has the sole discretion to extend or renew

the terms beyond its stated expiration, without the consent of the

corporation, a question arises whether the contract will be considered

a pre-February 17, 1993 written binding contract after the employee

chooses to extend.

Generally, the question of whether the terms of a contract are

binding is determined under state law. The IRS and Treasury believe

that the rules for determining whether a contract is binding should be

applied based on whether the corporation is bound by the terms of the

contract. Thus, if a contract provides the employee with the right to

extend or renew its terms without the consent of the corporation, and

the corporation is legally obligated to pay the agreed-upon

compensation to the employee if the employee chooses to extend or renew

the contract, the contract will be considered binding on the

corporation. Accordingly, a new sentence has been added to Sec. 1.162-

27(h)(1)(i) to clarify that, 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.

Awards Based on a Percentage of Salary

The 1994 amendments modified Sec. 1.162-27(e)(2)(iii) to provide

that, if the terms of an objective formula or standard fail to preclude

discretion 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, the objective formula or standard

will not be considered discretionary (and thus Sec. 1.162-27(e)(2)(iii)

will not be violated) if the maximum dollar amount to be paid is fixed

at the time the performance goal is established. The final regulations

clarify that a maximum dollar amount need not be specified under this

provision if, at the time the performance goal is established, the

dollar amount of salary or base pay is fixed. In such a case, the use

of salary or base pay does not cause the formula to fail to preclude

discretion to increase compensation.

The 1994 amendments made a corresponding amendment with respect to

salary-based formulas to the shareholder disclosure rules in

Sec. 1.162-27(e)(4)(i). However, the shareholder disclosure amendment

was not

[[Page 65537]]

explicitly limited to formulas that would otherwise be discretionary.

The final regulations clarify that the shareholder disclosure rule

relating to salary-based formulas applies only to those formulas that

would otherwise be discretionary.

In addition, the final regulations provide transition relief with

respect to the 1994 amendment of the shareholder disclosure requirement

relating to salary-based formulas. New Sec. 1.162-27(j)(2)(v) provides

that this disclosure requirement applies only to plans approved by

shareholders after April 30, 1995.

In the case of a preestablished performance goal that was

established prior to the publication of the 1994 amendments, a

corporation could, of course, rely upon a reasonable good faith

interpretation of the statutory provisions to determine that the

performance goal was stated in terms of an objective formula, to the

extent the issue to which the interpretation relates was not covered by

the 1993 regulations. An award made pursuant to such a performance goal

would not fail to be performance based merely because the award was

made after the publication of the 1994 amendments.

Stock-Based Compensation

The 1993 proposed regulations provided transition relief for

previously approved plans and agreements that did not satisfy the

written binding contract requirement as of February 17, 1993, but that

were approved by shareholders before December 20, 1993. See Sec. 1.162-

27(h)(3)(iii). The transition relief applied to compensation paid prior

to the expiration of a reliance period. In response to comments on the

1993 proposed regulations, the 1994 amendments expanded this relief to

encompass compensation paid after the reliance period with respect to

the exercise of stock options and stock appreciation rights, and the

substantial vesting of restricted property, provided that the stock

option, stock appreciation right, or restricted property was granted

during the reliance period. Similar relief provisions were also

included in new transition rules added by the 1994 amendments. (See

Secs. 1.162-27(f)(3), (f)(4), (j)(2)(ii), and (j)(2)(iii) of the final

regulations.)

Commentators have asked that the relief provided in the 1994

amendments for stock options, stock appreciation rights, and restricted

property be extended even further to cover other stock-based

compensation and deferred compensation in general. After careful

consideration of the comments received, the IRS and Treasury have

concluded that there is not adequate justification for a further

expansion of the 1994 expansion of the prior regulatory transition

relief for previously approved plans and agreements, or the other

similar relief provisions added in 1994.

Subsidiaries That Become Separate Publicly Held Corporations

Section 1.162-27(f)(4) of the proposed regulations contains special

rules for subsidiaries that become separate publicly held corporations.

A transition rule set forth in Sec. 1.162-27(i)(2)(iii) of the proposed

regulations specified delayed effective dates for these special rules.

However, commentators indicated that the regulations were not explicit

as to which rules applied prior to the delayed effective dates.

The final regulations clarify that compensation paid prior to the

delayed effective dates by a subsidiary that becomes a separate

publicly held corporation will not be subject to the $1 million

deduction limit if the conditions of the transition rule are satisfied.

(This transition rule and all other effective date provisions have been

moved from paragraph (i) to paragraph (j) of the final regulations.

Paragraph (i) is reserved.)

Special Analysis

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on its

impact on small business.

Drafting Information

The principal authors of these regulations are Charles T. Deliee

and Robert Misner, Office of the Associate Chief Counsel (Employee

Benefits and Exempt Organizations), Internal Revenue Service. However,

other personnel from IRS and the Treasury Department participated in

their development.

List of Subjects

26 CFR Part 1

Income taxes, reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.162-27 is added to read as follows:

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

[[Page 65538]]

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 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)(1) 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

($1,500,000 x $2,000,000/$3,000,000). Corporation Y has a

nondeductible compensation expense of $600,000

($900,000 x $2,000,000/$3,000,000). Corporation Z has a

nondeductible compensation expense of $400,000

($600,000 x $2,000,000/$3,000,000).

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

[[Page 65539]]

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.

(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 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

[[Page 65540]]

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 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.

[[Page 65541]]

The bonus 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 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.

[[Page 65542]]

(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 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.

(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

[[Page 65543]]

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.

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 that fails to preclude discretion to increase the amount

of compensation (as described in paragraph (e)(2)(iii)(A) of this

section) merely because the amount of compensation to be paid 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, 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 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

[[Page 65544]]

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 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 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

[[Page 65545]]

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.

(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 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

[[Page 65546]]

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 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 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)

[[Page 65547]]

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

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.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as

follows:

Authority: 26 U.S.C. 7805.

Sec. 602.101 [Amended]

Par. 4. In Sec. 602.101, paragraph (c) is amended by adding the

entry ``1.162-27. . . . 1545-1466'' in numerical order to the table.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: December 12, 1995.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 95-30869 Filed 12-19-95; 8:45 am]

BILLING CODE 4830-01-U