As a result of the position taken by the Internal Revenue Service (IRS) in Rev. Rul. 2008-13, (see March 2009 GT Alert, Section 162(m): Actions that Should be Taken Early this Year to Avoid the $1,000,000 Deduction Limitation) public companies may need to amend their employment agreements, as well as their equity and other incentive plans, by December 31, 2009, to preserve the deductibility of performance-based awards for 2010 under Section 162(m) of the Internal Revenue Code.

Section 162(m) generally provides that a publicly-held corporation may not deduct compensation with respect to its CEO or its three other most highly compensated officers other than its principal financial officer (each a "Covered Employee"), to the extent that the amount of the compensation payable to the covered employee for the taxable year exceeds $1,000,000. Compensation that qualifies as "performance-based compensation," however, is disregarded in applying the $1,000,000 limitation.

One of the requirements for compensation to qualify as "performance-based compensation" is that the compensation must be paid "solely" on account of the attainment of one or more pre-established, objective performance goals. In Rev. Rul. 2008-13, the IRS reasoned that compensation was not payable "solely" on account of satisfaction of the pre-established performance goals if an employment agreement between the employer and a Covered Employee also provided that the performance goals would be deemed to be satisfied if the Covered Employee's employment was terminated by the employer without "cause" or by the employee for "good reason." Accordingly, the IRS concluded that the compensation would not qualify as "performance-based compensation" — even if the goals in fact were achieved and regardless of whether the employee's employment terminated for one of those reasons. The IRS noted that Treasury Regulations permit the goals to be waived in the event of the employee's death, disability or change of ownership or control — but only under those circumstances.

Because of the prevalence of arrangements that would, under the rationale of Rev. Rul. 2008-13, fail to constitute qualified performance-based compensation, and because the new ruling effectively reversed the position taken by the IRS in a prior private letter ruling, the ruling was given prospective application only. Specifically, amounts that would otherwise be considered qualified performance-based compensation but for the fact that they may be payable upon an involuntary termination or retirement will nevertheless be treated as qualified performancebased compensation — and, therefore, exempt from the limitations of Section 162(m) — if either (1) the period of service for which the amounts are payable began on or before January 1, 2009, or (2) the compensation is paid pursuant to the terms of an employment contract as in effect (without respect to future renewals or extensions, whether negotiated or automatic) on February 21, 2008.

Compensation arrangements with Covered Employees that use a calendar year performance period should be reviewed to determine whether the performance goals under those arrangements will be treated as having been achieved if the employee's employment is involuntary terminated, is terminated by the employee for good reason, or the employee retires. If so, then those agreements generally will need to be modified no later than December 31, 2009, for the compensation for performance periods beginning on or after January 1, 2010, to be treated as performance-based compensation.

If, however, the provision for making payment upon a termination of employment other than as a result of death or disability or in the event of a change in control is contained in an employment agreement and the provision was in effect on February 21, 2008, the deadline for making modifications is extended to the time the agreement comes up for renewal.

Notwithstanding the issuance of Rev. Rul. 2008-13, employers should be able to provide some level of protection with respect to incentive compensation for Covered Employees who are involuntarily terminated or who retire. While the actual incentive awards themselves cannot be payable to the executives under those circumstances without jeopardizing the deductions for payments made upon satisfaction of the performance goals, an employment agreement should be able to provide that a similar amount (e.g., a payment equal to the average of the bonuses paid to the Covered Employee over a period preceding termination) will be paid upon an involuntary termination or retirement. Such a provision should not be viewed as causing the amount that is contingent upon the satisfaction of performance criteria for the year of the executive's termination to be paid without regard to those criteria; instead, a different amount, and one that relates to performance in previous years, would be paid to the terminating executive.

In addition, a payment of severance in an amount equal to the amount that would have been payable upon achievement of the performance goals should not put at risk deductions for amounts paid upon the satisfaction of performance goals, provided that the Covered Employee has no legally binding right to the severance payment before entering into a separation agreement and that the relevant facts and circumstances do not indicate that there was a preexisting intention to pay these amounts through a separation agreement (e.g., the employer does not have a pattern of making payments in this manner).

In each case, the amounts paid upon termination before the satisfaction of the performance goals will, as under the law before Rev. Rul. 2008-13, not be "qualified performance-based compensation." The payments should nevertheless be deductible because the person to whom they are paid will not be a “covered employee” for section 162(m) purposes if he is not employed on the last day of the year in which the payment is made.