On February 21, 2008, the Internal Revenue Service (“IRS”) released Revenue Ruling 2008-13, which confirms and expands upon the position taken in Private Letter Ruling (“PLR”) 200804004 that compensation intended to qualify as “performance-based compensation” under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), will not be exempt from the $1 million deduction limit if such compensation may be paid upon a covered executive’s involuntary termination without cause by the employer, the executive’s termination for good reason or the executive’s retirement.
As background, Code Section 162(m) generally limits the ability of public companies to deduct compensation in excess of $1 million paid to certain executive officers (“covered executives”). However, compensation that meets the requirements of “performance-based compensation” is exempt from the $1 million limit under Code Section 162(m). Generally, compensation qualifies as performance-based only if it is payable when predetermined performance objectives are actually achieved in accordance with performance criteria that has been approved by shareholders. The regulations under Code Section 162(m) further provide that compensation does not fail to qualify as performance-based merely because compensation is payable upon death, disability or a change in ownership or control.
In PLRs released in 1999 and 2006, the IRS expanded on the regulations and ruled that compensation does not fail to qualify as performance-based merely because compensation is payable upon termination of the covered executive’s employment by an employer without cause or by the executive for good reason (or for retirement). The IRS’ stated view in its 1999 PLR was that involuntary terminations without cause or for good reason were similar to terminations due to death, disability or a change in ownership or control. Although a PLR may not be relied upon by taxpayers other than the taxpayer receiving the PLR, the earlier PLRs illustrated the IRS’ position on the issue and thus many corporations and practitioners structured employment/compensation arrangements based on these PLRs.
As we said in our February 14, 2008 blog post, PLR 200804004 essentially reversed the IRS’ position that had been espoused in the earlier two PLRs. However, in Revenue Ruling 2008-13, the IRS specifically points out that neither the IRS nor the Department of Treasury has previously issued any guidance on which taxpayers are entitled to rely that expressly addresses the situations that are addressed in the Revenue Ruling. Revenue Ruling 2008-13 resolves the inconsistency between the PLRs by making it clear that if performance-based compensation is also payable to a covered executive due to an involuntary termination without cause, a termination for good reason or due to retirement, then such compensation arrangements cannot qualify as performance-based compensation.
In recognition of the public outcry regarding PLR 200804004 and acknowledging the disruption that Revenue Ruling 2008-13 could have on preexisting compensation arrangements that were implemented in reliance on the IRS’ earlier position, the IRS provided transitional relief since Revenue Ruling 2008-13 shall only apply prospectively. In other words, Revenue Ruling 2008-13 will not be applied to disallow a deduction for any compensation that otherwise satisfies the requirements for qualified performance-based compensation under Code Section 162(m) and that is paid under a plan, agreement, or contract that has payment terms similar to the terms described in the Ruling if either:
- The performance period for the compensation begins on or before January 1, 2009, or
- The compensation is paid pursuant to the terms of an employment contract as in effect on February 21, 2008, not taking into account future renewals or extensions, including renewals or extensions that occur automatically absent further action of one or more of the parties to the contract.
Given this important change to Code Section 162(m) performance-based compensation arrangements, public companies should review their outstanding employment/compensation arrangements to determine whether they will need to be amended to comply with Revenue Ruling 2008-13. In particular, companies should focus on whether performance-based compensation is payable to a covered executive (or an employee who could become a covered executive), without regard to whether the performance goal is attained, in the event of an involuntary termination without cause, termination for good reason or retirement. Moreover, all future employment agreements (including any amendments to existing employment agreements) and future performance-based compensation arrangements should be prepared in light of Revenue Ruling 2008-13. In any event, we are available to discuss any specific situations you or your company may have with respect to this issue.