Thursday, August 09, 2012

Company Directors Have No Independent Fiduciary Duty to Minimize Taxes Rules Delaware Chancery, Structuring Executive Bonus under IRS Revenue Ruling Not Waste

Company directors have no general independent fiduciary duty to minimize taxes, ruled the Delaware Chancery Court, and a failure to minimize taxes is not per se a waste of corporate assets. There are a variety of reasons why a company may choose or not choose to take advantage of certain tax savings, reasoned Vice Chancellor Glasscock, and a company’s tax policy typifies an area of corporate decision-making best left to management’s business judgment, so long as it is exercised in an appropriate fashion. (Seinfeld v. Slager, Civil Action No. 6462-VCG, June 29, 2012)

While not foreclosing the theoretical possibility that under certain circumstances overpayment of taxes might be the result of a breach of a fiduciary duty, the Vice Chancellor noted that a decision to pursue or forgo tax savings is generally a business decision for the board of directors. Citing Vice Chancellor Noble’s decision earlier this year in Freedman v. Adams, Vice Chancellor Glasscock observed that a company’s tax policy may be implicated in nearly every decision it makes, macro or micro, including about its capital structure, when to purchase capital goods, where to locate its operations and whether to rent or buy real property.

More specifically, the court rejected the shareholder’s claim that the awarding of a bonus to the company’s retiring CEO constituted waste because it rendered the bonus, and potentially the company’s entire executive incentive plan, invalid under the federal tax code, thereby making it taxable. The court ruled that the decision of an independent board of directors to rely, in setting executive compensation, on an IRS revenue ruling, is within the business judgment of the board, and that a waste claim arising from this decision must be dismissed.

Section 162(m) of the Internal Revenue Code provides that annual compensation in excess of $1 million is not tax-deductible unless the compensation is granted pursuant to a performance-based, stockholder-approved plan containing  pre-established, objective criteria. Regulations adopted under Section 162(m) provide that compensation is not tax deductible when the employee would receive all or part of the compensation regardless of whether the performance goal is attained.

The company had an agreement with the CEO to pay him on retirement the full target amount of his performance bonuses, including the amount he would have received if he had worked for the entire bonus period and achieved his performance goal, with no pro-rata reduction. This contract provided, therefore, that the CEO would receive the full target amount of his performance bonuses regardless of whether he actually met the performance goal or worked for the entire applicable period. The company and the CEO later entered into new employment contracts on February 21 and May 4, 2009; however, limiting his right to receive upon retirement the full target amount of his performance bonuses to those bonus periods which began on or before January 1, 2009.  For bonus periods beginning after January 1, 2009, he could receive only a pro-rata share of any performance bonus.

On February 21, 2008, the IRS issued Rev. Rul. 2008-13 holding that compensation is not performance-based, and therefore is not tax-deductible, if executives receive any of their performance compensation regardless of whether they actually achieve their performance goals. In other words, said the court, under the IRS ruling, a plan like that applicable to the CEO, providing full bonuses upon retirement as if performance goals had actually been met is not tax-deductible. But the IRS, apparently recognizing
that some plans already in existence would run afoul of this rule, limited the impact of Rev. Rul. 2008-13 by stating that it would not be applied to disallow a deduction paid pursuant to an employment contract in effect on February 21, 2008 and would not be applied to disallow a deduction if the performance period for such compensation began on or before January 1, 2009.  The IRS, therefore, limited the impact of Rev. Rul. 2008-13 both retroactively and prospectively.

The CEO’s employment agreement was meant to comply with Rev. Rul. 2008-13 because it stated that he would be paid the full target amount for periods beginning on or before January 1, 2009, and that he would be paid a pro-rata amount for periods beginning after January 1, 2009.

The shareholder alleged that the IRS’s decision to apply Rev. Rul. 2008-13 prospectively was beyond the scope of the agency’s power and that the January 1, 2009 provision is ineffective, thereby rendering the CEO’s performance award non-tax-deductible at some undetermined time. The shareholder alleged that the revenue ruling will eventually be superseded and that the CEO’s compensation and potentially all compensation under the executive incentive plan will become taxable, that the board should have known this and, thus, its decision to structure the compensation in accordance with the revenue ruling constituted waste and a breach of a fiduciary duty to minimize taxes. Essentially, said the court, the shareholder’s waste claim is that, hypothetically, the compensation scheme will lead to an unnecessary payment to the federal government in the future in the form of a greater tax bill.

The court noted that the company’s board of directors apparently structured the CEO’s compensation in a way that avoided tax liability under Rev. Rul. 2008-13. The court ruled that the decision of an independent board to rely, in setting compensation, on a revenue ruling of the IRS, is within the business judgment of the board.

With regard to the issue of the bonus tainting the entire executive incentive plan, the shareholder alleged that, while the stockholders approved the original plan as required under the federal tax code, the company materially changed it when the company paid the CEO his full target amount upon retirement. Since the plan allowed the board to enter employment agreements of the type it provided to the CEO, reasoned the court, the shareholder failed to plead facts, which if true, would show that the plan has been amended or that the board has otherwise committed waste in connection with the executive’s compensation under the plan.