In Revenue Ruling 2008-13 (Feb. 21, 2008), the Internal Revenue Service (IRS) added an additional layer of complexity to drafting compensation arrangements for senior executives - an area of the law that already has been subjected to unprecedented changes as the result of Internal Revenue Code (IRC) Section 409A. The ruling adopts a new interpretation of IRC Section 162(m), which Congress enacted in 1993 to limit the amount publicly-traded companies and their affiliates can deduct for compensation paid to their highest-ranking executives. Rev. Rul. 2008-13 expands the scope of Section 162(m) so that an executive's performance-based compensation under a performance plan that satisfies all the criteria of Section 162(m) will be non-deductible solely because the executive also is covered by a severance provision that takes his or her targeted performance bonus into account in calculating severance pay.
Section 162(m) denies a deduction to any publicly held corporation for compensation in excess of $1 million per year paid to a "covered employee." A "covered employee" is the chief executive officer of the corporation and any other employee whose compensation must be disclosed because he or she is one of the four highest compensated employees of the registrant (not counting the CEO).
Some types of compensation do not count against the $1 million limit, including compensation payable "solely on account of the attainment of one or more performance goals," provided that the adoption and implementation of the performance bonus plan satisfy certain requirements related to corporate governance and shareholder consent. Treasury Regulation § 1.162-27 elaborates on this requirement:
"Compensation does not satisfy [this requirement] if the facts and circumstances indicate that the employee would receive all or part of the compensation regardless of whether the performance goal is attained [including circumstances where] the payment of compensation under a grant or award is only nominally or partially contingent on attaining a performance goal...Compensation does 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, although compensation actually paid on account of those events prior to the attainment of the performance goal would not satisfy the requirements of this paragraph (e)(2)."
Treas. Reg. § 1.162-27(e)(2)(v). On January 25, 2008, the IRS issued a Private Letter Ruling that relied in part on this regulation to hold that a corporation could not deduct a performance bonus paid to an executive after the attainment of the pre-established performance criteria because the executive's employment agreement provided that if he were terminated without cause or even for good reason, pending performance bonus targets would be deemed satisfied and the executive would be paid the target bonus. Priv. Ltr. Rul. 200804004 (Jan. 25, 2008).
Rev. Rul. 2008-13
The Private Letter Ruling came as a surprise to many, and there were almost immediate calls for its withdrawal and clarification. Rev. Rul. 2008-13 was in part a response to these requests. However, the Revenue Ruling neither withdrew nor clarified the reasoning of the Private Letter Ruling. Instead, it adopted the holding of the Private Letter Ruling, and further expanded the circumstances under which compensation will not be considered performance-based compensation to which the $1 million limit under Section 162(m) does not apply. Under Rev. Rul. 2008-13, compensation payable to a covered employee following the attainment of properly established performance criteria will count against the $1 million deduction limit if compensation would otherwise be paid upon the executive's involuntary termination without cause, voluntary termination for good reason, or retirement, whether or not the goal had been attained.
Thus, Rev. Rul. 2008-13 establishes unequivocally that compensation counts against the $1 million deduction limit, even if it is paid because of the attainment of a properly-established performance goal to an executive who has not terminated employment, if the compensation is otherwise payable either in the event of attaining performance criteria or under any alternative scenario when the performance criteria is not met other than the alternatives specifically mentioned in Treas. Reg. § 1.162-27(e)(2)(v), i.e., death, disability, or a change in control.
It is important to note that Treas. Reg. § 1.162-27(e)(2)(v) provides for a facts-and-circumstances determination of whether compensation is payable for a reason other than attainment of a performance goal. The regulation instructs that this facts-and-circumstances determination "is made taking into account all plans, arrangements, and agreements that provide for compensation to the employee." It seems to follow that (as in Priv. Ltr. Rul. 200804004), if an executive employment agreement or senior executive severance plan provides for payment of a performance-based bonus target upon a voluntary or involuntary termination of employment, the holdings in Rev. Rul. 2008-13 would be applicable to any compensation paid under the performance plan, even if the performance plan itself complied in all respects with Section 162(m).
Thus the practical implications of Rev. Rul. 2008-13 are even more far-reaching than its holdings suggest. Rev. Rul. 2008-13 should be taken into account in drafting any executive employment agreement or executive severance arrangement for a public company or for any company that might become a public company at any time during the term of the employment agreement or severance plan. Similarly, in the context of an acquisition by a publicly-traded company, the prospective new owner may need to consider whether any of the target's surviving employment agreements or other executive arrangements unexpectedly might trigger the disallowance of deductions for performance-based pay to senior executives of the combined enterprise.
Temporary Transition Relief Under Rev. Rul. 2008-13
Perhaps in recognition that many existing performance bonus plans and executive deferred compensation arrangements unexpectedly would trigger disallowance of deductions under Section 162(m) if Rev. Rul. 2008-13 were applicable immediately, the ruling provides some limited transition relief, including a "grandfathering" exception. The holdings in Rev. Rul. 2008-13 will not be applied to disallow an otherwise allowable deduction for compensation payable under a plan with a performance period that begins on or before January 1, 2009. In addition, the holdings in Rev. Rul. 2008-13 will not be applied to compensation payable under the terms of an employment contract as in effect on February 21, 2008, without regard to any future renewals or extensions (including renewals or extensions that occur automatically under the terms of the contract without action on the part of the employer or employee).