Internal Revenue Code Section 162(m) provides that a public company may not deduct annual compensation paid to a “covered employee” in excess of $1,000,000 per year, other than certain “qualified performance-based compensation.” For these purposes, “covered employees” generally include the company’s CEO and its three most highly compensated executive officers (other than the CEO and CFO) identified in the company’s “Summary Compensation Table.”

To qualify for the Section 162(m) qualified performance-based compensation exemption, compensation must be paid subject to pre-established and objective performance goals set by a compensation committee consisting solely of two or more outside directors, and the material terms of such goals must be approved by the company’s shareholders. Generally, any exercise of discretion with respect to the performance goals after they have been established would disqualify the compensation from being considered “qualified performance-based compensation.” However, an objective and non-discretionary adjustment made pursuant to the pre-established terms of a performance-based compensation plan or arrangement generally would not cause an award to fail to qualify for the Section 162(m) exemption.  Accordingly, Section 162(m) arrangements generally include provisions specifying whether and to what extent the performance goals will (or will not) be automatically and objectively adjusted in the event of certain unforeseen events, including a change in accounting standards impacting the underlying financial metrics on which the performance goals are based.

On January 9, 2015, the FASB issued an accounting standards update that, beginning with financial statements for 2016, eliminates the concept of “extraordinary items” as a technical accounting term. “Extraordinary items” has historically been defined to refer to items that were both “unusual in nature” and “infrequently occurring.” Commencing with 2016 financial statements, items that are “unusual in nature” or “infrequently occurring” or both are to be separately reported in companies’ income statements.

In light of the change in FASB standards, we recommend that companies review the adjustment provisions in their Section 162(m) incentive plans with a focus on both the new FASB accounting standards and the requirements under Section 162(m), with particular attention to any provisions providing for adjustments to financial goals due to “extraordinary items” within the meaning of applicable financial reports.