In our last issue, we alerted you to published reports that 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"). Section 162(m) generally provides for payment of bonuses which are otherwise contingent on the satisfaction of certain performance goals in the event of involuntary terminations and retirement. We noted that 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 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 pre-established, 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 held 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 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.
Under recently released PLR 200804004 (September 12, 2007), the IRS now holds 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. The new PLR has been widely reported by industry publications as potentially raising significant issues in the executive compensation arena. See, e.g., 35 BNA Pens. & Ben. Rep. 278 (Feb. 5, 2008) (extensively quoting White & Case personnel regarding the impact of the PLR).
The ramifications here are significant. 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 are made more complicated in that the IRS has not expressly provided 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. It is even possible that the IRS will eventually issue a Revenue Ruling with transition relief. In this regard, the author of ther recent ruling has informally indicated during a recent webcast that the IRS is keenly aware of these issues, and that additional guidance of some nature should be forthcoming shortly.