$1Million Executive Compensation Limitation under Code Section 162(m)

Under Internal Revenue Code (“Code”) Section 162(m), a publicly-traded company is not permitted to deduct compensation paid to a “covered employee” to the extent such compensation exceeds more than $1 million. For this purpose, a covered employee generally includes the CEO (or an individual acting in such capacity) and the next four highest paid officers whose compensation is required to be reported to shareholders under the Securities Exchange Act of 1934 (i.e., the executive officers listed in the company’s proxy statement). An exception to this deduction limitation exists for pre-established, objective performance-based compensation paid to the executive. Most public companies have adopted bonus or incentive compensation plans intended to qualify for the exception.

Performance-Based Compensation Elections Under Nonqualified Deferred Compensation Arrangements Under Code Section 409A

Under Code Section 409A, all executives participating in a nonqualified deferred compensation program (regardless of whether the company is publicly-traded or privately-held) must make elections to defer compensation into the deferred compensation program before the beginning of the year of its deferral (or performance period). An exception for the timing of the election exists when the compensation being deferred is for pre-established, objective performance-based compensation. Elections related to qualified performance-based compensation can be made up to six months preceding the end of the performance period. Many public and private companies allow their executives to take advantage of this delayed election period for incentive compensation plans intended to qualify for the exception.

IRS’ Recent Private Letter Ruling

The IRS recently ruled, in what arguably is a reversal of prior guidance, that provisions in an employment agreement may prevent the performance-based compensation from qualifying for the exception to the $1 million limitation under Code Section 162(m) and the delayed election period permitted under Code Section 409A.

Based on a recent private letter ruling (PLR 200804004), the application of these exceptions must now be reviewed in light of an executive’s employment agreement. The IRS’ private letter ruling held that compensation payable to an executive under an incentive plan was not “performance-based compensation” under the exception to the $1 million deduction limit because the incentive compensation was payable if the executive’s employment terminated “without cause” or “for good reason” under the executive’s employment agreement—even if the performance objectives were not achieved. Significantly, the IRS concluded that the incentive compensation did not qualify as “performance-based compensation” even in the years during which the executive’s employment was not terminated and the performance goals were attained.

The IRS reasoned that since the incentive compensation was payable regardless of actual performance in the year of termination, the incentive compensation plan did not meet the exception. The IRS reached this conclusion after noting that the exception requires compensation to be paid solely on account of attaining one or more pre-established, objective performance goals.

Lessons for Employers

While private letter rulings technically apply only to the specific taxpayers to whom they were issued, such rulings frequently reflect the IRS’s general position. Based on this ruling, employers should recognize that the IRS may begin challenging deductions taken by public companies for performance-based compensation and also begin challenging deferred compensation elections made by executives (regardless of whether the company is publicly-traded or privately-held) to nonqualified deferred compensation programs.

Employers should review the provisions of their incentive programs in light of executive employment agreements or other severance arrangements. Both the exception to IRC Section 162(m) and delayed deferral election period under Code Section 409A require that performance targets be established within the first 90 days of the performance period (i.e., the end of March for calendar year performance programs). Thus, such review should be undertaken promptly.