On February 21, 2008, the IRS released Revenue Ruling 2008-13 regarding the treatment of certain performance-based compensation under Section 162(m) of the Internal Revenue Code of 1986, as amended (“Section 162(m)”). Revenue Ruling 2008-13 restates a private letter ruling on the same subject released January 25, 2008, and reverses prior IRS private letter rulings. Under Revenue Ruling 2008-13, the performance-based compensation exception under Section 162(m) is unavailable for arrangements that provide that compensation may be paid either upon an involuntary termination of employment (i.e., termination by the company without cause or by the employee for good reason) or upon retirement, without regard to whether the performance goal is attained (i.e., a minimum or deemed award). All payments under an arrangement that include such provisions will not be deductible. This loss of a deduction will occur even if no involuntary termination or retirement occurs. In other words, having such a provision in a plan, award, or employment agreement (which is very common), taints all performance-based awards for Section 162(m) purposes and could cost companies millions of dollars in lost tax deductions.
The new revenue ruling only applies prospectively. Additionally, any plan, agreement, or contract that would violate its holdings is grandfathered, as long as either (i) the performance period for such compensation begins on or before January 1, 2009 or (ii) the compensation is paid pursuant to the terms of an employment contract as in effect on February 21, 2008 (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). This means that plans that violate the revenue ruling do not need to be amended until 2009 (for fiscal year companies) or 2010 (for calendar year companies). Additionally, existing employment contracts do not need to be amended until their current term expires or is renewed.
Public company employers should commence the process of examining the terms of bonus plans, award agreements, employment, severance, and non-competition agreements, etc
Section 162(m) generally provides a deduction limit of $1 million for compensation paid during any tax year for the named executive officers (i.e., the CEO and the three highest compensated officers other than the CFO) of a publicly held corporation. Performance-based 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. The 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, this does not cause the payment to fail to be performance-based compensation absent the occurrence of such event. If the compensation is actually paid on account of those events before the attainment of and certification of the performance goal, the payment will not satisfy the performance goal requirement and will be subject to the Section 162(m) limitation.
In two private letter rulings from 2006 and 1999, the IRS extended the exception for payments upon death, disability, or a change of control, to plans or compensation arrangements that allow payments upon an involuntary termination of employment or retirement. PLR 200613012; PLR 199949014. On January 25, 2008, the IRS released a new private letter ruling that reversed the prior rulings regarding an involuntary termination of employment. PLR 200804004. The January 25 private letter ruling held that the inclusion of a provision in an employment agreement permitting a payout of a performance bonus at the target performance level in the case of an involuntary termination, regardless of whether the performance goals were attained, caused the entire bonus to fail to qualify for the performance-based compensation exception to Section 162(m). As a result, even if the employee is never involuntarily terminated and the bonus is only paid upon the attainment of the performance goals, the bonus does not qualify for the exemption from the Section 162(m) deduction limitation.
Although the January 25 private letter ruling may only be relied on by the taxpayer to whom it was issued, tax practitioners generally view such rulings as an indication of the current IRS view of the tax laws and act accordingly. Normally, when the IRS makes a major change in its position on a tax law, it issues a revenue ruling that applies to all taxpayers prospectively. Often, such ruling will also provide a number of transition rules so that previous arrangements that reasonably applied the prior position are grandfathered. The IRS’s revised position in the private letter ruling clearly raised issues regarding new performance-based compensation grants. By pronouncing this change of position in a private letter ruling, however, it was unclear how other taxpayers should proceed with respect to arrangements already in place, especially if the taxpayer has acted in good faith in applying the performance-based compensation exception to involuntary termination and retirement in line with prior rulings of the IRS.
Over 90 law firms, including Hogan & Hartson, requested, among other things, that the IRS provide a reasonable transition period to adjust to the new private letter ruling. The IRS responded by releasing Revenue Ruling 2008-13, which codifies the holding in the January 25, 2008 private letter ruling (PLR 200804004), extends it to cover retirement as well, and provides a transition period for public companies to get its plans, agreements, and contracts providing for performance-based awards into compliance.