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Carefully Craft Executive Compensation Arrangements
The IRS has issued a new ruling that could have a major impact on compensation arrangements for certain corporate executives. It has to do with a surprising change in the definition of "performance-based compensation" under Internal Revenue Code Section 162(m).
Background: Traditionally, a company has been allowed to deduct the full amount of compensation paid to
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Section 162(m) Basics
Under Internal Revenue Code Section 162, a company is allowed to deduct all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services rendered.
IRC Code Section 162(m) provides that in the case of a publicly held corporation, no deduction is generally allowed for annual compensation that exceeds $1 million for "covered employees." However, there is an exception for "qualified performance-based" compensation, which must meet several requirements.
What is a "covered employee?" The tax code defines the term as any employee of the taxpayer if:
- At the close of the taxable year, the employee is the CEO or is acting in such a capacity, or
- The total compensation of the employee for the taxable year is required to be reported to shareholders under the Securities Exchange Act of 1934 because the individual is among the four highest compensated officers for the taxable year (other than the CEO).
| employees, regardless of the amount. However, in response to public reaction about inflated compensation packages for high-profile executives, Congress imposed a deduction limit back in 1993. For the chief executive officer (CEO) and the four other highest-compensated employees of a publicly held corporation, the annual compensation deduction is restricted to $1 million.
There is, however, a key exception to the $1 million limit. This tax law provision does not apply to performance-based compensation paid solely on account of attaining one or more pre-established performance goals.
If the inducement is only nominally based on performance goals, none of the compensation is considered to be performance-based. However, under the prevailing regulations, compensation that is payable on account of death, disability or a change in ownership or control may still qualify.
The shake-up started with a private letter ruling issued in late January of 2008. In it, the IRS concluded that an employment compensation arrangement, which allowed payment when an executive was terminated without cause or quit for good, did not qualify for the performance-based exception. Reason: It allowed compensation to be paid in a situation other than death, disability or a change in ownership or control. (IRS Private Letter Ruling 200804004)
An IRS private letter ruling only applies to the taxpayer it is issued to, but tax professionals use these rulings to gauge how the tax agency will proceed in other similar cases.
To clarify its position on the matter, the IRS followed up with new Revenue Ruling 2008-13, which provides two hypothetical situations:
A compensation plan provides that an award will be paid to an executive if a performance goal is reached. Even if the performance goal is not attained, the award will be paid if the executive dies, becomes disabled, or the company experiences a change of ownership or control. The award will also be paid, even if the performance goal is not attained, if the executive is terminated without cause or if the executive terminates employment for good reason.
Result: The award is not performance-based compensation. The executive's termination without cause or for good reason may arise from poor performance and a failure to meet the performance goal.
The facts are the same as Situation 1 with one key difference. In this case, the award will be paid, even if the performance goal is not attained, if the executive voluntarily retires during the calendar year or if termination otherwise occurs. In other words, payment under the plan is broadened to include voluntary retirement.
Result: The award is not performance-based compensation either. Retirement is a voluntary action. Consequently, the compensation is not payable solely on account of the attainment of one or more performance goals.
This Revenue Ruling does not signal the end of performance-based compensation. In fact, as a concession to the tax community, it won't be used to disallow deductions if the performance period begins on or before January 1, 2009. Also, employment contracts that were in effect as of February 22, 2008 are generally grandfathered. Nevertheless, going forward, there is a clear need to carefully craft future executive arrangements, as well as review and modify contract renewals. Consult with your tax adviser on how to proceed.
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