Public companies subject to the $1 million deduction limit of Internal Revenue Code Section 162(m) should continue to monitor the fallout from IRS Revenue Ruling 2008-13 for further developments, and should give themselves plenty of lead time to implement changes to employment agreements and plan documents.

On February 21, 2008, the Internal Revenue Service (IRS) issued Revenue Ruling 2008-13 (the Revenue Ruling) to provide additional guidance on the application of Internal Revenue Code Section 162(m). The Revenue Ruling is availablehere. The IRS issued the Revenue Ruling in response to the uproar caused when the IRS issued Private Letter Ruling 200804004 (the PLR), which created substantial uncertainty regarding what constitutes “performance-based compensation” under Section 162(m). A previous McDermott On the Subject analyzing the PLR is available here. This On the Subject briefly summarizes what the Revenue Ruling does and does not change, and discusses possible next steps.

What the Revenue Ruling Does Not Change

The Revenue Ruling does not change the new approach to 162(m) taken by the IRS in the PLR. In short, amounts otherwise qualifying as performance-based compensation will fail to so qualify where the amounts may be paid upon an executive’s involuntary termination without cause, voluntary termination for “good reason,” or retirement, even if the performance goal is not attained. This negative result applies in every year in which the arrangement is in place—not just in the year in which the executive terminates employment—and applies even if the compensation is paid because the performance goals are achieved.

On one hand, the Revenue Ruling’s holding is not surprising, because the author of the PLR stated informally that, contrary to usual practice, the PLR was briefed to the executive level of the IRS—meaning that the new IRS position taken in the PLR was a conscious agency decision rather than simply the result of a different reviewer. On the other hand, the IRS unfortunately appears to have flatly rejected calls by more than 90 leading law firms (including McDermott Will & Emery) and two former chairs of the ABA Tax Section’s Employee Benefits Committee for a formal review of its position in the PLR with the opportunity for public comment. Many executive compensation experts find it difficult to believe that contract provisions merely making it possible that an employee might receive some compensation (a) if a performance goal is not attained, and (b) if a covered termination actually occurs, meet the test in the regulation that “the facts and circumstances indicate that the employee would receive all or a part of the compensation regardless of whether the performance goal is attained” in every year.

What the Revenue Ruling Does Change

Although there continue to be concerns over whether the technical analysis underlying the PLR is correct, much of the uproar over the PLR is related to the potential financial statement impact. Specifically, several large accounting firms took the position that the new PLR made it difficult for publicly held companies to assert—in FIN 48 parlance—that a tax deduction was “more likely than not” if the company’s plan did not comply with the new PLR. Because companies could not have anticipated the IRS’s sudden change in position, many plans did not comply with the new PLR, and accountants began questioning whether their clients needed to retroactively reverse the tax deductions for open years, which could trigger a current accounting charge and affect book income, earnings per share, etc.

The author of the PLR has acknowledged that the IRS did not consider the financial and tax accounting ramifications of the PLR, and the Revenue Ruling attempts to eliminate those financial and tax accounting concerns for prior years by applying the new IRS position prospectively. Specifically, the Revenue Ruling provides that it will not be applied to disallow a deduction for any compensation that otherwise qualifies as “performance-based compensation” that is paid under a plan, agreement or contract that has payment terms similar to the terms described in the Revenue Ruling if either of the following is true:

1.) The performance period (i.e., the period of service to which the performance goal applicable to such compensation relates) for such compensation begins on or before January 1, 2009.

2.) The compensation is paid pursuant to the terms of an employment contract in effect on February 21, 2008, and that is not extended or renewed, including through an “evergreen” provision.

What to Do Now

The transition relief means that there is no need for immediate action to amend plans or employment contracts. Instead, public companies may want to continue to monitor this issue for further developments. One issue that the IRS has indicated it is considering (but did not address in the Revenue Ruling) is whether there is still an issue if a plan pays awards to terminating employees based on actual rather than target performance, but does not prorate the award for an employee who terminates during the middle of the year.

While waiting for future IRS guidance, public companies may wish to catalog which of their arrangements might be adversely affected by the Revenue Ruling (i.e., arrangements that are intended to qualify for the performance-based compensation exception to Code Section 162(m) but where amounts will be paid at target levels rather than actual performance levels upon an involuntary termination, voluntary termination for good reason or retirement). Next, public companies will need to determine what types of changes (e.g., (1) paying at the lesser of target or actual performance following the end of the performance period, (2) paying a predetermined amount that is not deemed to be a substitute for performance-based compensation, (3) not guaranteeing any payment) will be acceptable to affected constituencies (e.g., executives, shareholders). Finally, to the extent a proposed modification to an arrangement requires shareholder approval, companies will want to give themselves plenty of lead time to implement the changes.