February 27, 2008

Performance-Based Compensation Under IRS Scrutiny

Holland & Knight Alert
David Friedman

Do your executives have compensation packages worth more than $1 million? Are you relying on the performance-based pay exemption from the $1 million limit on deductions in order to get the full deduction for those amounts? If so, you may be surprised to know that these amounts may not be deductible after all, according to recent IRS guidance.

Under Internal Revenue Code section 162(m), a publicly-held company is generally limited to a $1 million deduction in any tax year for compensation paid to the chief executive officer and the next four highest paid officers (each, a “covered executive”). However, the Code exempts from this limitation certain performance-based compensation that is payable on account of the attainment of certain performance goals (the “Performance-Based Exemption”). Accordingly, many companies have structured the compensation packages for covered executives to comply with this Performance-Based Exemption.

Recently, the IRS issued guidance that suggests increased scrutiny of compensation structured to qualify for the Performance-Based Exemption. More importantly, the guidance reflects a new enforcement position regarding compensation that is automatically paid to an executive under a performance-based plan upon the employee’s termination without cause or for good reason.

Specifically, compensation that is automatically paid to an executive under a performance-based plan upon the covered executive’s termination without cause or for good reason, or upon the executive’s voluntary retirement, does not meet the Performance-Based Exemption. Accordingly, the $1 million deduction limitation will apply to those amounts.
Most companies affected by the new guidance will need to act quickly. The IRS provides limited relief for performance periods that begin on or before January 1, 2009, and for existing employment agreements.

For more information, or to arrange for a more detailed review of your compensation plans and arrangements, please contact your Holland & Knight attorney, or contact any one of the Holland & Knight attorneys listed.

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