October 21, 2008

Companies Must Review Their Performance-Based Compensation Arrangements for Compliance With New IRS Rules

Holland & Knight Alert
Robert J. Friedman



Section 162(m) of the Internal Revenue Code of 1986, as amended (the “Code”), imposes a $1 million deduction limit on compensation paid to a publicly-held company’s chief executive officer and next four highest compensated officers (“covered employees”). However, amounts that qualify as “performance-based compensation” as defined in Code Section 162(m) are excepted from this $1 million deduction limitation. To qualify as performance-based compensation, Code Section 162(m) requires that the compensation be payable “solely on account of the attainment of one or more performance goals.”

Regulations issued under Code Section 162(m) provide that performance-based compensation is not payable solely on account of the attainment of one or more performance goals if the covered employee could receive all or part of the compensation without attaining the performance goals. The regulations, however, provide an exception: compensation does not fail to be qualified performance-based compensation if the plan or award permits the compensation to be paid upon the covered employee’s death or disability, or upon a change of ownership or control of the company (although the compensation actually paid on account of those events prior to the attainment of the performance goal would not be qualified performance-based compensation). Based on certain private letter rulings published by the Internal Revenue Service (IRS), publicly-held companies also routinely included provisions in their agreements and arrangements which provided that performance-based compensation would be paid to a covered employee upon a termination of the employee’s employment (i) by the company without cause; (ii) by the employee for good reason; or (iii) due to retirement.

New Rulings

Earlier this year, the IRS released Private Letter Ruling 200804004, which was followed by Revenue Ruling 2008-13 (together, the “rulings”) which reversed the IRS’ earlier position regarding the payment of performance-based compensation upon a covered employee’s termination of employment by the company without cause, termination of employment for good reason or retirement. In the rulings, the IRS stated that if a plan or agreement provides that compensation will be paid (regardless of whether the performance goal is attained) in the event of the employee’s termination of employment by the company without cause, termination of employment for good reason or retirement, such compensation will be deemed not payable solely on account of attainment of the performance goals, and therefore, will not be performance-based compensation under Code Section 162(m). Therefore, according to the rulings, the performance awards in question would be subject to the $1 million deduction limit under Code Section 162(m), even if employment was never actually terminated and the award was paid upon attainment of the pre-stated performance goal while the covered employee remained in the employ of the company (i.e., the inclusion of these provisions in the plan or agreement are sufficient to disqualify the awards even if such provisions are never utilized).

Effective Dates

The rulings apply to any new, renewed or extended employment agreement that became or becomes effective after February 1, 2008. In addition, the rulings will apply prospectively to any amounts that are paid under a plan, agreement or contract if the performance period for such compensation begins after January 1, 2009.

Action Items

Based on the rulings, if the performance period begins on or before January 1, 2009, the old rule will continue to apply throughout the performance period. Additionally, the old rule will continue to apply to employment agreements in effect prior to or on February 1, 2008 (without respect to future renewals or extensions).
However, if the performance period begins after January 1, 2009, the new rule will apply and companies will need to review their plans, agreements and arrangements that are intended to qualify as performance-based compensation under Section 162(m) to determine if the plans or arrangements are compliant with the new rules. In addition, any new, renewed or extended employment agreements should be immediately reviewed for compliance as the new rule already applies to these agreements.

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