IRS Affirms Controversial Section 162(m) Position But Provides Helpful Transition Period

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.

Prospective Application

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 performance period for the compensation begins on or before January 1, 2009, or
• The compensation is paid pursuant to the terms of an employment contract as in effect on February 21, 2008. The contract will cease to qualify for grandfathering if it is renewed or extended, including any automatic renewal according to its provisions.

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.

• The payment will be deductible if the payment is made contingent on achieving the performance goal even after a termination or retirement. This would require delaying the payment until the performance period ends and measuring actual performance. This type of delay may be more acceptable for disability and retirement than for death, particularly for a multi-year performance period.
• The provisions for retirement or involuntary termination payments might be eliminated entirely. As part of that change, an employment or other agreement could be amended to provide a payment that occurs on retirement or involuntary termination but is measured differently from the performance-based compensation. For example, a separate payment could be equal to the prior year’s performance payment or to an average of bonuses made over the last few years. This approach may be less attractive for a voluntary retirement than for death or disability because an employee could time the retirement and affect the amount of payment. In addition, care should be taken to structure the retirement or involuntary termination payments so that they are separate from and unrelated to the performance-based compensation that is payable under other circumstances so as to avoid “tainting” the compensation that is intended to be performance-based.
• Companies can get some extra time to address this issue by having a performance period starting no later than January 1, 2009. For annual bonus plans of calendar year companies, resolving the issue could be delayed until 2010. However, some companies may decide that it is appropriate to begin to comply with the new ruling with performance periods that begin before January 1, 2009. This may be the case where a company decides to alter its compensation philosophy on early payment of incentive compensation.
• To the extent that the problem is created by an employment contract, the grandfathering provision for employment contracts is fairly generous. Other than extending the term of the contract, any amendments to the contract appear to be permissible. For example, amending an employment contract to comply with Section 409A would not appear to eliminate the grandfathering provided in the ruling.

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.