The IRS recently issued an important ruling on whether dividends and dividend equivalents related to restricted stock and restricted stock units (“RSUs”) can be treated as performance-based compensation for purposes of Code Section 162(m). In Rev. Rul. 2012-19, 2012-28 IRB, the IRS held that such dividends and dividend equivalents would qualify as performance-based compensation, provided that each of them separately satisfy Code Section 162(m)’s performance-based compensation requirements. In contrast, if dividends and dividend equivalents were paid to employees at the same time as dividends on common stock were paid to shareholders, regardless of whether the underlying awards were vested, the dividends and dividend equivalents would not be performance-based compensation. This conclusion is consistent with what most practitioners already believed, but it was still welcomed news to see the IRS confirm this conclusion.

Code Section 162(m) Background. As background, Code Section 162(m) limits the deduction a publicly traded company may take with respect to remuneration paid to its “covered employees”– its CEO and three most highly paid officers (other than the CEO and CFO) — to the extent that such compensation exceeds $1 million. The deduction limit does not apply, however, to qualified performance-based compensation. Publicly traded companies often structure equity compensation grants, such as restricted stocks and RSUs, in a manner to qualify as performance-based compensation. Often times, these grants provide the recipient employees with dividends or dividend equivalent rights. Rev. Rul. 2012-19 analyzed the conditions in which these dividends and dividend equivalent rights would also qualify as performance-based compensation.

Revenue Ruling 2012-19 Background. Rev. Rul. 2012-19 analyzed these issues by describing two fact patterns that involved publicly held corporations: X and Y. Both companies granted restricted stock and RSUs under their equity compensation plans to their covered employees. The restricted stock and RSUs vested upon attainment of certain pre-established, objective performance goals. The Revenue Ruling stated that these awards satisfied the performance-based compensation requirements of Code Section 162(m). As such, compensation received upon the vesting of the restricted stock, and vesting and payment of the RSUs, qualified as performance-based compensation under Code Section 162(m). Accordingly, the compensation was exempt from the $1 million deduction limit.

Performance-Based Dividends and Dividend Equivalents. The two plans differed in how they awarded employees dividends and dividend equivalents. X Corp.’s plan provided that dividends and dividend equivalents otherwise payable to an employee during the period from grant through vesting of the awards were accumulated and became vested and payable only if the related performance goals with respect to the restricted stock and RSUs were satisfied. In other words, X employees received their dividends and dividend equivalents only if and when their underlying restricted stock and RSU awards vested. The IRS held that the dividends and dividend equivalents under X Corp.’s plan would be considered performance-based compensation under Code Section 162(m) because they were contingent upon achievement of the same performance goals that applied to the grants of restricted stock and RSUs. The IRS explained that in order for dividends and dividend equivalents to be considered performance-based compensation under Code Section 162(m), they—in addition to the underlying grants of the restricted stock and RSUs—must be subject to Code Section 162(m)’s performance-based criteria.

Non-Performance-Based Dividends and Dividend Equivalents. In contrast, Y Corp.’s plan provided for payment to an employee during the period from grant to vesting of dividends and dividend equivalents with respect to the awards at the same time dividends were paid on common stock of Corporation Y. Thus, Y employees received their dividend and dividend equivalents regardless of whether the performance goals established with respect to the restricted stock and RSUs were satisfied. The IRS held that the dividends and dividend equivalents under Y Corp’s plan were not qualified-performance based compensation and were therefore subject to the $1 million compensation deduction limitation. The IRS explained that these dividends and dividend equivalents did not vest and become payable solely on account of the attainment of pre-established performance goals. Consequently, they failed to satisfy the performance-based compensation requirements of Code Section 162(m).

What’s Next? This approach and the conclusions the IRS reached are consistent with what most practitioners had believed. Nevertheless, it is encouraging to see the IRS confirm these views in formal guidance. From a public company employer’s standpoint, the key lesson is to consider what it wants its equity compensation plan to accomplish. If the purpose of an award is to provide a mix of currently paid compensation and longer term performance-based compensation, the employer should pay dividends and dividend equivalents to employees at the same time dividends are paid on common stock. Under this approach, the employer may not be able to deduct the dividends and dividend equivalents. If the purpose is to make the entire award contingent on long-term performance, the dividends and dividend equivalents should be accumulated and paid if and when the underlying award vests. Under this approach, the employer would be able to deduct dividends and dividend equivalents.