Friday, February 22, 2008

IRS Revenue Ruling Impacts Executive Compensation Plans and Disclosure

In response to a letter from 90 global securities law firms, the Internal Revenue Service issued a revenue ruling essentially backing up an earlier private letter made public by the IRS (LTR 200804004) that cast doubt on the exclusion of some performance-based executive compensation from the $1 million pay cap mandated by IRC §162(m) if a company wants to deduct an executive’s pay from its income tax. The firms who signed the letter included Skadden Arps, Wachtell Lipton, Cleary Gottlieb, Baker Botts, and Clifford Chance.

Under IRC 162(m), compensation in excess of $1 million paid by a public company to its covered employees generally is not deductible. Notice 2007-49 states that the term "covered employee," for purposes of §162(m), will apply to the principal executive officer and the three highest compensated officers (other than the principal executive officer and principal financial officer).
Performance-based compensation is not subject to the deduction limitation and is not taken into account in determining whether other compensation exceeds $1 million. In general, performance-based compensation is compensation payable solely on account of the attainment of performance goals.

In the letter ruling, the IRS said that provisions in a company’s compensation scheme allowing for payment of performance-based compensation even if the performance goals are not met upon an executive's involuntary termination without cause or voluntarily termination with good reason do not meet the exception in section 1.162-27(e)(2)(v) of IRS regulations allowing compensation to be payable upon death, disability or change of ownership or control. Thus, the compensation cannot be excluded from the $1 million calculation.

In Revenue Ruling 2008-13, the IRS backed up the letter ruling by essentially saying that the performance goals must be met before the payment of performance-based awards can be excluded from calculating the $1 million cap. In the revenue ruling, the IRS set forth two separate scenarios that would not qualify as performance-based compensation under Code Section 162(m). In the first scenario, the executive did not meet the performance but received the performance-based compensation anyway after being terminated involuntarily without cause or voluntarily ending his/her employment for good reason. In such a situation, said the IRS, the compensation would not be considered payable solely on account of the attainment of a performance goal under the 162(m) exclusion. In the second scenario, the employee voluntary retired and the performance-based compensation was paid even though the performance goal was not attained. Similarly, this award is not qualified performance-based compensation under Code Section 162(m).

The law firms’ letter to the IRS comes against the backdrop of pressing deadlines for SEC-mandated financial and proxy disclosure. The letter cites the IRS regulation allowing performance-based compensation to be considered qualified for the exclusion if paid upon death, disability, or change of control even if the performance goal remains unsatisfied.

According to the law firms, consistent with prior IRS rulings, many public companies entered into compensation arrangements patterning the treatment of involuntary and good reason terminations after what the regulation authorized for death and disability. In the firms’ view, these prior rulings, now apparently reversed, represent a reasonable interpretation of the regulations and taxpayers who conformed their compensation plans to them acted in good faith.

The publication of this new position has significant repercussions for many public companies, said the firms, with an accounting impact that will affect financial reporting. In addition, the ruling presents considerable difficulty for companies that are currently making decisions regarding 2008 awards and proxy reporting regarding award deductibility. The situation is further complicated by the fact that many of the affected arrangements are bilateral contracts that will require negotiation with the affected employees.

Thus, the firms urge the IRS to apply the new ruling prospectively and also allow grandfathered tax treatment, consistent with the prior rulings, for compensation awards that are made prior to the publication of the new ruling, with special transition relief for binding, written agreements that obligate an employer to provide future grants that conform to these prior rulings; with such transition relief to continue, absent a material modification, for a period that provides an adequate opportunity to negotiate and implement revised agreements.

It should also be noted that, when it adopted the new executive disclosure regime, the SEC emphasized that any tax or accounting treatment, including a company’s section 162(m) policy, that is material to the company’s compensation policy or decisions with respect to a named executive officer is covered by Compensation Discussion and Analysis and should be discussed. Tax consequences to the named executive officers, as well as tax consequences to the company, may fall within this example.