IRS Reverses Position on Performance-Based Exemption to 162(m): Employer Deductions in Doubt

February 1, 2008

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 terminate.

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.

Important Note

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 employment.

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.