Introduction1

Section 162(a) of the Internal Revenue Code of 1986, as amended (the “Code”), permits a business to deduct all the “ordinary and necessary” expenses associated with operating the business during the taxable year, including reasonable compensation for its employees (e.g., salaries, bonuses, and health benefits). Nonetheless, Code Section 162(m)(1) prohibits publicly held corporations from taking a deduction for amounts paid to “covered employees” in excess of $1,000,000. Covered employees are determined as of the last day of the taxable year and include the chief executive officer of the corporation and the three highest paid officers whose compensation must be reported to shareholders under the Securities Exchange Act of 1934.2

Code Section 162(m)(4)(c), however, exempts “performance-based” compensation from the $1,000,000 deduction limitation. In order to qualify as performance-based under Code Section 162(m)(4)(c), compensation must be payable only upon the achievement of one or more preestablished objective performance goals established by a compensation committee consisting solely of two or more outside directors. Code Section 162(m)(4)(c) also requires that the material terms of the performance goals be disclosed to and approved by a majority of the corporation’s shareholders. In addition, the compensation committee must certify the achievement of such goals before payment can be made.

Compensation that may be paid regardless of whether the performance goals are achieved is not performance-based and will not qualify for the exemption even if the goals are

achieved from year-to-year. For example, if a bonus plan sets forth certain performance criteria for determining bonuses but the compensation committee retains discretion to pay such bonuses even if the criteria are not met, the plan and any bonuses paid under it will not meet the requirements of Code Section 162(m).

One notable exception to the general rule...(see article for more).