According to published reports, the Internal Revenue Service (the “IRS”) appears to have revised its thinking with respect to “performance-based compensation” plans under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), which provide for payment of bonuses which are otherwise contingent on the satisfaction of certain performance goals in the event of involuntary terminations and retirement. The new, more restrictive position could have ramifications not only for future planning, but also with respect to compliance for existing plans.
In general, Section 162(m) imposes on certain publicly held corporations a US$1 million limitation on the otherwise allowable tax deduction, with respect to the compensation of each of the chief executive officer and as many as four of its most highly paid other executives. However, Section 162(m) provides that compensation will not be subject to the US$1 million deduction limitation if it satisfies the requirements for “performance-based compensation.” For purposes of Section 162(m) and the related regulations (the “Regulations”), performance-based compensation is remuneration payable solely on account of the attainment of one or more performance goals but only if: (i) it is paid solely on account of the attainment of one or more preestablished, objective performance goals, (ii) the performance goals are determined by a compensation committee of the board of directors consisting solely of two or more outside directors, (iii) the material terms under which the compensation is paid are disclosed to, and approved by, the shareholders before payment is made and (iv) before a payment is made, the compensation committee certifies that the performance goals and any other material terms have been satisfied.
Under the Regulations, compensation will not fail to be qualified performance-based compensation merely because the plan allows the compensation to be payable upon death, disability or change of ownership or control. In two private letter rulings (“PLRs”), the IRS found that compensation which otherwise satisfies the requirements of Section 162(m) would not fail to be considered performance-based where the plan provided that the compensation could be payable (i) in the event of the executive’s termination by the company without cause or by the executive for “good reason,” PLR 199949014 (December 13, 1999), or upon the executive’s retirement on or after a stated age, PLR 200613012 (March 31, 2006). In PLR 199949014, the IRS specifically noted that termination by the company without cause or termination by an executive with good reason were both “involuntary terminations similar to terminations as a result of death, disability or change in control.”
While PLRs may generally not be used or cited as precedent by taxpayers other than to whom they are written, see Code Section 6110(k)(3), they are sometimes viewed by practitioners as an indication of the IRS’s current thinking regarding the issues addressed thereby. Thus, in light of these PLRs, a number of employers may as a practical matter have included in their plans provisions under which otherwise contingent compensation could become payable in the event of terminations other than those specified in the Regulations. Further, there could be provisions in executive employment and similar agreements which provide, for example, for a payment of a prorated portion of an executive’s target bonus in the event of involuntary termination.
Recent published reports indicate that the IRS is in the process of issuing or has issued a PLR providing that the possibility for payment in the event of involuntary termination, whether or not the applicable performance goals are met, will disqualify compensation from being performance-based for purposes of the exception to the US$1 million deduction limit under Section 162(m). Apparently, IRS personnel have indicated that the new PLR is the result of a reconsideration of the relevant issues.
If the IRS has indeed changed course here, the ramifications could be significant, and thus we are alerting you to this possibility in advance, before we have access to the ruling. Not only could this development cause employers to review whether they want to provide for the uncontingent payment of bonuses in the case of involuntary terminations or retirements, but it could also cause employers to review whether existing provisions raise issues regarding the deductibility of compensation under existing plans. We note that the practical issues may be made more complicated if the IRS does not expressly provide relief for those who may have proceeded in light of the earlier IRS position. Unlike in the case of a revocation of published authority (such as Revenue Rulings), where the IRS will sometimes provide that the effectiveness of a new ruling is deferred for a transition period, there may be no such relief regarding a change in an informal position taken in PLRs. While we hope that the IRS will be sympathetic to the practical implications of its revised position on companies that proceeded in good faith in light of the prior indications of the IRS’s position, it is not clear how the IRS will in fact proceed.