On January 25, 2008, the Internal Revenue Service (“IRS”) released Private Letter Ruling (“PLR”) 200804004. This new PLR has apparently reversed an important position that served as guidance to public companies and practitioners regarding the tax deductibility of certain performance-based pay under Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”). For background, Code Section 162(m) generally limits the ability of public companies from deducting compensation in excess of $1 million paid to certain executive officers. 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) 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 ruled that compensation does not fail to qualify as performance-based merely because compensation is payable upon termination of employment by an employer without cause, or by the executive for good reason. The IRS’ stated view then was that such involuntary terminations were similar to terminations due to death, disability or a change in ownership or control. In PLR 200804004, the IRS appears to have reversed its position set forth in the 1999 and 2006 PLRs and ruled that compensation does not qualify as performance-based if it is possible for the compensation to be paid upon a termination without cause or for good reason, without regard to the achievement of the performance objectives.

Other than specifically referencing the regulation that only mentions death, disability or a change in ownership or control, the IRS provided no explanation in its ruling as to the change in its position, nor does the ruling reference or distinguish the 1999 and 2006 PLRs. However, at a February 14, 2008 nationwide webcast, the IRS official who signed the new PLR indicated that the IRS’ view now was that terminations without cause or for good reason were problematic because compensation could be paid out even when performance was “poor”, which is contrary to the central intent and purpose of the Section 162(m) performance-based exception. This view presumably reflects a belief that a termination without cause or for good reason is more likely to occur under circumstances when the executive and/or the employer is underperforming.

While PLRs are only binding on the requesting taxpayer, this new PLR provides a surprising result that impacts not only the design of future arrangements intended to qualify for the performance-based exemption, but perhaps also for existing arrangements that were drafted based on the IRS’ position in its 1999 and 2006 rulings. Calendar-year, public companies that are currently in the process of designing their Code Section 162(m) performance goals should consider this new PLR with respect to any compensation that would be paid under a termination without cause or good reason event. The IRS official indicated that further guidance is intended to be provided by the IRS in February 2008 and that companies should therefore not yet take any drastic actions with respect to their performance-based compensation plans, previously filed tax returns and/or financial accounting. We note that the IRS official said that the IRS is actively working on this issue and is trying to respond to concerns that have been expressed by practitioners and companies. However, we also note that the IRS official said that the new PLR reflects a conscious decision by the IRS and that such decision was briefed to higher ranking officials within the IRS which could mean that the future guidance will not overrule the new PLR. In any event, we are available to discuss any specific situations you or your company may have with respect to this issue.

For further information, please contact Gregory Schick at (415) 774-2988 or Michael Chan at (213) 617-5537.