February 22, 2008
On February 21, 2008, the IRS issued a revenue ruling that confirms a private letter ruling limiting the scope of performance-based compensation under Section 162(m). Revenue Ruling 2008-13 prevents payments from qualifying as performance-based compensation exempt from the 162(m) deduction limit if the amount could be payable either due to termination without cause or for good reason (which we refer to in this article as “involuntary terminations”), or due to retirement. Under the new interpretation, the mere presence of these payment events in an arrangement will disqualify any payments that are made under the arrangement from the exception, even if those events never occur. Despite being based on a strict interpretation of existing regulations, the IRS has given the revenue ruling a prospective effect only, as explained below. Unlike the previously issued private letter ruling, the new revenue ruling generally applies to all taxpayers.
IMPORTANCE OF RULING: Based on this ruling, public companies will need to ensure that compensation intended to be deductible under Section 162(m) is not affected by provisions that would pay on these types of termination or retirement even if performance conditions are not met. The only permissible conditions for payment without performance are death, disability or change of control.
In the ruling, the IRS gives two examples. In both situations, the compensation payable is otherwise eligible as performance-based compensation that would be deductible under Section 162(m) if earned. Also, the compensation would be payable if the employee dies or is disabled or if the employer has a change of control.
In the first example, the compensation is also payable if the employee is terminated without cause or the employee voluntarily terminates for good reason. Payment is made regardless of the performance. The ruling has fairly standard definitions of “cause” and “good reason”, however, the terms of the definitions of cause and good reason are not important to the IRS position.
In the second example, the compensation is payable if the employee voluntarily retires, without regard to the performance achieved. The special payment provisions are not actually triggered in either example. As noted above, the IRS position is based on merely having the language in the performance plan or a separate agreement.
The ruling applies a strict reading of the regulations under Section 162(m). Under the regulations, none of the compensation is performance-based compensation if the payment is only nominally or partially contingent on a performance goal.
According to the IRS, the regulations allow payment only on account of death, disability or change of control without meeting the performance goal if the compensation is to be deductible. Since a retirement or a termination without cause or for good reason are not covered in the regulations, having either of those provisions potentially affect a payment disqualifies the payment from being performance-based compensation.
The IRS recognized the disruption that would be caused by making this interpretation effective for all years, so the ruling has prospective application only. The ruling will not be applied to disallow a deduction if either:
The prospective application resolves favorably questions over the validity of deductions claimed on tax returns for 2007 and other open tax years, and the possible accounting effects of disallowing those deductions.
What To Do
It is likely that most companies will want to eliminate these termination and retirement accelerations from their plans and agreements. Since the presence of these provisions will result in the loss of a deduction even when the provisions are not triggered, the ongoing cost to the company will usually outweigh the potential benefit to the employee. The approach to eliminating these provisions will vary among companies but here are some initial considerations.
For more information on this ruling or assistance in planning how to comply with the ruling, please contact any of the individuals below or any other member of our Employee Benefits Group.