December 31, 2009 Deadline for Amending Plans and Agreements to Comply with Million Dollar Cap on Compensation
Public companies may want to consider certain issues relating to executive employment arrangements and Section 162(m) of the Internal Revenue Code of 1986, as amended (Section 162(m)) by December 31, 2009.
Section 162(m) generally provides a limit of $1 million on the deduction of compensation paid during any tax year to the named executive officers of a publicly held company (i.e., the CEO and the three highest compensated officers other than the CFO). Performancebased compensation, payable solely on account of the attainment of one or more performance goals, is not subject to this limitation. If the compensation payment is only nominally or partially contingent on attaining a performance goal, none of the compensation so payable will be considered performance-based. Treasury regulations contain an exception to this rule providing that if a plan or compensation arrangement allows the compensation to be paid upon death, disability, or a change of control, even if the performance goals are not met, the payment does not fail to qualify as performancebased compensation. In private letter rulings from 2006 and 1999, the IRS extended this exception to payments upon an involuntary termination of employment (both without cause and for good reason) or retirement.
However, in January 2008, the IRS reversed the prior rulings and held that the inclusion of a provision in an employment agreement or plan permitting the payout of a performance bonus at the target performance level in the case of involuntary termination or retirement, regardless of whether the performance goals were attained, caused the entire bonus to fail to qualify for the performance-based compensation exception of Section 162(m). As a result, even if the employee is not involuntarily terminated or does not retire and the bonus is only paid upon the attainment of the performance goals, the bonus does not qualify for the exception from the Section 162(m) deduction limit.
The IRS provided a transition period and grandfathered plans, agreements and arrangements so long as (i) the performance period for such compensation began on or before January 1, 2009 or (ii) the compensation is paid pursuant to the terms of an employment agreement in effect on February 21,2009 (but without respect to future renewals or extensions, including those that occur automatically absent notice by one or more of the parties to the contract). Therefore, beginning January 1, 2010, companies need to have their executives employment agreements in compliance. Employment agreements that were in effect on February 21, 2009 but that provided for employment “at-will” are not grandfathered.
If a company has employment agreements that provide for payment of bonus amounts for the year in which an executive terminates employment for good reason, without cause or due to retirement, three possible solutions companies can consider are: (i) leave the language as is and understand that the bonus is not 162(m) eligible in any years; (ii) amend the language to provide that the executive may receive the pro rata bonus only if the performance targets are met; or (iii) eliminate the provision for payment of a pro-rata bonus and provide additional severance payments.