In a surprise move, the IRS has changed its ruling position on an important
issue under Section 162(m) of the Internal Revenue Code. The position involves
performance-based compensation that is payable upon a covered employee’s
termination of employment without cause or for good reason without regard to
actual performance. In a
private letter ruling released January 25, 2008, the IRS has ruled that this
type of plan does not qualify for the performance-based exemption to the one
million dollar deduction limitation under Section 162(m).
To illustrate the effect of the ruling, take a long-term incentive award that
provides for a payment at the end of three years if the company’s earnings meet
a minimum threshold, with larger payments at target performance and a maximum
payout. The plan and award otherwise qualify under Section 162(m) as
performance-based compensation. The award also provides that, if the executive
is terminated without cause or the executive terminates for good reason during
the three-year performance period, the executive is paid a pro rata amount upon
termination based on target performance.
In prior rulings as recently as 2006, the IRS had said that payments under
this type of award would be performance-based compensation if the executive
remained employed and received a payout based on actual performance. A payment
made due to a termination would not be performance-based compensation.
The new position is that the award in the example would not be
performance-based compensation in any circumstance. The key factor in the
example is that the payment on termination does not relate to actual
performance. The possibility of payment on termination disqualifies the award
from being performance-based compensation even if the executive does not
Note the new IRS position does not impact payments that may be accelerated
and paid due to an executive’s termination for death or disability (or payments
that are accelerated on account of a change in ownership or control of the
employer). However, payments on any other type of termination -- including
retirement -- are affected.
A private letter ruling can only be relied upon by the taxpayer who requests
it and cannot be used or cited as precedent by any other taxpayer. Nevertheless,
private letter rulings are widely viewed as reflecting the IRS’s current
positions on issues.
The ruling has potential implications for any publicly traded company that
has claimed a deduction for performance-based compensation to a covered employee
in excess of the one million dollar limitation for any open tax year.
Public companies should review their existing incentive plans and
arrangements to determine whether compensation may be accelerated and paid upon
an executive’s earlier termination regardless of actual performance. In many
cases, the relevant provisions may be contained in separate employment,
severance, change-in-control or other plans or agreements that potentially
accelerate incentive payments upon a covered employee’s termination of
Public companies potentially affected by this new IRS position have a number
of factors to consider. These factors include the weight to be given to a
private letter ruling, the potential differences between awards already paid and
future awards, possible restructuring of awards to meet the requirements with a
minimum effect on the executive, and the likely need to address the solution
through multiple agreements. The Employee Benefits Group at McGuireWoods is
available to help in this process.