The Internal Revenue Service privately ruled recently that a delay in making awards under an incentive compensation plan until after the first 90 days of the performance period would not prevent compensation paid under the plan from qualifying for the performance-based compensation exception to the deduction limitations of Section 162(m) of the Internal Revenue Code (Private Letter Ruling 200949005 (Aug. 18, 2009)).
Section 162(m) limits to US$1 million the tax deduction a publicly held corporation can take for compensation paid to any covered employee (generally, a corporation’s “named executive officers,” as determined under the Securities and Exchange Commission’s executive compensation disclosure rules, other than its chief financial officer) in a taxable year. However, this limitation does not apply to performance-based compensation that satisfies the following general requirements:
- the compensation is paid solely on account of the attainment of one or more preestablished, objective performance goals that are determined by the corporation’s compensation committee;
- the corporation’s shareholders approve the material terms of the performance goals; and
- the compensation committee certifies in writing that the performance goals have been attained before the compensation is paid.
A performance goal is considered “pre-established” if it is established in writing by the compensation committee not later than 90 days after the commencement of the period of service to which the performance goal relates, as long as satisfaction of the performance goal is substantially uncertain at the time the compensation committee actually establishes the goal.
The pre-established performance goal must state, in terms of an objective formula or standard, the method for computing the amount of compensation payable to the employee if the goal is attained. A formula or standard is considered “objective” if a third party with knowledge of the relevant performance results could calculate the amount to be paid to the employee upon attainment or nonattainment of the performance goal. In addition, the formula or standard must specify the individual employees or class of employees to which it applies. The terms of the formula or standard must also preclude discretion to increase the amount of compensation payable upon attainment of the goal. A performance goal is not discretionary merely because the compensation committee reduces or eliminates the compensation or other economic benefit that was due upon attainment of the goal. However, the exercise of negative discretion with respect to one employee is not permitted to result in an increase in the amount payable to another employee.
The ruling concerns cash performance units (“CPUs”) granted under a corporation’s incentive compensation plan. The payment amount for each CPU is based on the degree to which the corporation achieves one or more performance goals over a specified performance period. Under the plan, the compensation committee establishes within the first 90 days of the performance period: (a) the period over which the performance goals will be measured; (b) the award payment date; (c) the performance goals applicable to each participant; (d) the method for evaluating performance; (e) the unit value for each CPU; (f) the method for determining the payment amount for each participant and (g) the maximum number of CPUs that may be granted to any one participant. However, the compensation committee may delay making grants of specific numbers of CPUs under the plan to participants until after the first 90 days of the performance period. The plan gives the compensation committee discretion to grant an individual participant the maximum number of CPUs that may be granted to any one participant or some reduced number of CPUs.
Without explaining its reasoning, the IRS ruled that the ability to designate the actual number of CPUs granted under the plan to a covered employee after the first 90 days of the performance period will not prevent compensation paid under the plan from qualifying for the performance-based compensation exception to the Section 162(m) deduction limitations.
It seems that the IRS could just as well have come to the contrary conclusion. To qualify for the Section 162(m) exception, a performance goal must include a formula or standard for computing the amount of compensation payable to the employee such that a third party could calculate the amount to be paid to the employee based on any given performance result. This performance goal must be established within the first 90 days of the performance period. Arguably, under the facts of the ruling, the performance goals are not established within this 90-day period because the amount of compensation payable to an employee based on a given result cannot be determined until the size of the employee’s award is determined after the first 90 days. Although not known, the IRS may have reasoned that, as the compensation committee established, within the first 90 days of the performance period, the formula or standard for computing the amount of compensation payable to an employee, including the maximum number of CPUs that may be granted any employee, the compensation committee’s grant of any lesser number of CPUs to any employee is negative discretion, which a compensation committee may retain, to reduce or eliminate the compensation otherwise due upon attainment of the goal.
Under this private ruling, a compensation committee that establishes the maximum grant that may be made to each participant in an incentive plan within the first 90 days of the performance period may wait until after this 90-day period to determine actual grant amounts for each participant without causing compensation paid under the plan to fail to qualify for the performance-based compensation exception to the Section 162(m) deduction limitations. Note, however, that although private letter rulings provide insight on the IRS’ current views of particular matters, they are applicable only to the particular taxpayers to whom they are issued and cannot be used or cited as precedent by others.