Under a new Revenue Ruling issued on February 21, 2008 (Rev. Rul. 2008-13), the Internal Revenue Service confirmed its reversal (as expressed in a January 2008 private letter ruling) of its prior position as to the effect of common severance provisions on the performance-based compensation exemption from Code Section 162(m) and, most significantly, provided a transition period for application of this new position.
Code Section 162(m) generally provides that a public company may not deduct compensation paid to its CEO or any of its next four highest-paid officers in excess of $1 million in any year. An exception is available for performance-based compensation that satisfies certain requirements. Waiver of the performance conditions is permitted in the event of death, disability or a change in ownership or control.
New IRS Position
Under Rev. Rul. 2008-13, the Section 162(m) performance-based compensation exemption will NOT be available for otherwise qualified performance-based awards if the performance conditions will be waived in whole or in part upon:
- the employee’s termination of employment without cause
- the employee’s resignation for “good reason” or
- the employee’s retirement.
The existence of any of these provisions will disqualify any payments under the plan or agreement even if the performance goals are achieved.
Performance waivers based on these events have become commonplace over the last few years, as taxpayers and practitioners relied on contrary positions expressed in private letter rulings issued in 1999 and 2006. In recognition of this widespread practice and the prior private letter ruling positions, Rev. Rul. 2008-13 provides a transition period for application of this more stringent interpretation of the Section 162(m) regulations.
Rev. Rul. 2008-13 will not be applied to disallow a deduction for any compensation that otherwise satisfies the requirements for qualified performance-based compensation if either
- the “performance period” (meaning the period of service to which the performance goal applicable to such compensation relates) begins on or before January 1, 2009; or
- the compensation is paid pursuant to the terms of an employment contract as in effect on February 21, 2008 (excluding any term that renews after February 21, 2008 either automatically or by agreement).
What Does This Mean for Public Companies?
As a practical matter, this means that every public company should review its incentive compensation arrangements and related documents during this transition period to make sure that the performancebased exemption will not be jeopardized unintentionally by this new Revenue Ruling.
Arrangements to concentrate on include the following:
- Equity incentive plans
- Performance-based award agreements
- Annual bonus plans
- Long-term cash incentive plans
- Employment, severance or change-in-control agreements or policies.
When examining these arrangements:
1. Look for provisions that accelerate the vesting of performance-based awards upon retirement or upon involuntary termination (i.e., termination without “cause” or resignation for “good reason”).
- Common features are provisions that deem such awards to be vested at the “target” level, or that truncate the performance period as of the date of termination of employment and payout based on actual performance through the shortened performance period.
- Note that accelerated vesting of stock options and SARs should not be affected by the new Revenue Ruling. In the case of these appreciation-type awards, the “performance goal requirement” of Section 162(m) is satisfied if the exercise price of the option or SAR is not less than the fair market value of the underlying stock as of the date of grant, since the amount of compensation the employee can receive is based solely on an increase in the value of the stock after the date of grant. Acceleration of exercisability is not a waiver of the performance condition.
2. In addition to accelerated vesting of equity awards or other long-term performance-based awards, in employment or severance agreements, look for provisions that guarantee payment of the employee’s final year annual bonus at the “target” or “maximum” level, or based on actual performance through the date of termination.
- Note that prorata payment of an annual bonus at the end of the year based on actual performance for the entire year should not be affected by the Revenue Ruling because there is no waiver of the performance condition.
- Note, too, that severance payments are often calculated by reference to a multiple of base salary and “target” annual bonus. This is not affected by the Revenue Ruling because severance pay is not “performance based” and does not qualify for the 162(m) exemption in any event.
3. Look now at the renewal terms of employment and severance agreements. The transition relief in Rev. Rul 2008-13 applies to agreements that are in effect as of February 21, 2008, but not to any such agreements that expire or renew after that date. Don’t count on having all of calendar year 2009 to make necessary adjustments. Bear in mind that these agreements are contractual arrangements that need consent of both parties to amend. In addition, the possible application of the deferred compensation rules under Code Section 409A should be considered with respect to any modifications.