The Internal Revenue Service revenue ruling 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 will apparently be applied prospectively. Revenue ruling 2008-13 essentially backed up an earlier private letter made public by the IRS (LTR 200804004).
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).
A letter from 90 global corporate and securities law firms noted that, 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 urged the IRS to apply the new ruling prospectively. With regard to that, the revenue ruling states that it will not be applied to disallow a deduction for performance-based compensation paid under plan with payment terms similar to the those set forth in the ruling if either: 1) the performance period for the compensation begins on or before January 1, 2009; or 2) the compensation is paid under an employment contract in effect on February 21, 2008, the day of the ruling, but there can be no future renewals or extensions, including those that occur automatically.