- IRS Issues Surprise 162(m) Ruling
- March 14, 2008 | Authors: Randy L. Gegelman; Lisa R. Pugh
- Law Firm: Faegre & Benson LLP - Minneapolis Office
“Performance-based compensation” is exempt from the $1 million deduction limit of Section 162(m) of the Internal Revenue Code—simple enough. But what if the performance contingency associated with an incentive plan is watered down? Could that taint a bonus paid under the plan, even when the contingency is met?
The Internal Revenue Service thinks so.
Let’s take a simple example. Public Co. maintains two bonus plans: one a performance-based incentive plan that pays $1 million only if stated performance goals are met, the other a plan that pays $1 million even if the performance goals are not met. The second bonus plan “taints” the first, with the result being that the performance-based plan does not qualify under Section 162(m). This is the exact example given in the regulations.
For purposes of determining whether compensation is “performance-based,” the regulations require that you consider all the facts and circumstances as to whether the employee would receive all or part of the compensation regardless of whether the performance goal is attained. All plans, arrangements and agreements that provide for compensation to the employee are taken into account. This is why, for Public Co., the bonus under the second plan effectively negates the performance-based conditions of the first plan.
There are a couple of exceptions. Compensation can be paid on death, disability or change in control without tainting the entire arrangement. While a payment made on death, disability or change in control would not be performance-based, a payment made on satisfaction of the performance conditions would still be exempt from the deduction limit. In past private letter rulings (PLR 200613012), the IRS has allowed additional payment contingencies—involuntary termination without cause, good reason voluntary termination, or retirement—to be included (with payment measured by reference to target or a vested percentage of target) without tainting the entire arrangement. (Of course, even in these cases, only if the payment is actually made upon satisfaction of the performance conditions is it exempt under Section 162(m).)
Or so it was.
The IRS has started out the year with two rulings that reflect a significant shift in its prior ruling position. The first is a Private Letter Ruling issued in January (PLR 200804004). The second is Revenue Ruling 2008-13, released on February 21, 2008. PLR 200804004 surprised many practitioners. Revenue Ruling 2008-13 confirms the conclusions in PLR 200804004 but gives employers more time to make the needed changes. Unfortunately, neither ruling gives any guidance on how to spot and correct flawed arrangements.
In PLR 200804004, the IRS ruled that an employment agreement provision that calls for an incentive bonus to be paid at target in the event of an involuntary termination without cause, or a good-reason voluntary termination, taints the entire performance-based arrangement for the employee. Even if the termination event never occurred and the employee was actually paid upon satisfaction of the performance conditions, that payment is not performance-based compensation within the meaning of Section 162(m). Viewing the incentive arrangement and the employment agreement compensation together, the facts and circumstances apparently call the performance-based nature of the incentive arrangement into question. Presumably, neither would the arrangement be treated as performance-based for purposes of Section 409A.
Revenue Ruling 2008-13 presents two situations. In both, the IRS assumes a standard Section 162(m) performance-based plan where the employee will receive a bonus, even if the performance goal isn’t met, in the event of death, disability or change of control. The first employee also will receive the bonus, even if the performance goal isn’t met, in the event of termination for cause or good reason. The second employee will also receive the bonus, even if the performance goal isn’t met, in the event of a voluntary retirement.
The IRS determined that both plans fail to be performance-based under 162(m) because an employee would receive a performance-based bonus for a reason other than actually meeting the goal, or one of the permitted exceptions of death, disability or change in control.
Revenue Ruling 2008-13 doesn’t change the conclusions reached in PLR 200804004. The ruling isn’t effective for compensation attributable to a performance period beginning on or before January 1, 2009, or for compensation paid under an “employment contract” in effect on February 21, 2008, until its renewal or extension (including any automatic extension). While the delay gives employers more time to take a hard look at their agreements (and, remember, all agreements need to be looked at together) the ruling itself doesn’t provide much information about what arrangements may work or not.
Now let’s stroll down hypothetical lane.
Consider Public Co., which provides a performance-based incentive plan that purports to comply with 162(m), and then provides separation pay benefits to a covered employee under a separate employment agreement.
What if the employment agreement provided a separation pay benefit in the event of an involuntary termination without cause, or a good-reason voluntary termination, and defined the benefit as 1x the target incentive bonus for the performance period in which termination occurs? Even if this is under a separate agreement from the incentive plan itself, it seems like the same economics as under Revenue Ruling 2008-13, and presumably we’d get the same result—not performance-based.
What if the employment agreement provided a separation pay benefit in the event of an involuntary termination without cause, or a good-reason voluntary termination, and defined the benefit as 1x the sum of base pay plus the target incentive bonus for the performance period in which termination occurs? What if the severance is 2x or 3x that amount? Is paying out a multiple of base salary plus target bonus enough of a “break” with the incentive plan to keep the separation pay benefit from tainting the incentive plan?
What if the employment agreement provided a separation pay benefit in the event of involuntary termination without cause or a good-reason voluntary termination, and defined the benefit as 2x base pay plus last year’s actual incentive bonus? Using a historical measure of bonus to define the separation pay benefit creates an additional disconnect that would suggest that the separation pay is not a substitute for the incentive pay. Is that enough or, at least, is that enough in normal circumstances?
The rulings provide very little analytical basis for defining when all or a portion of a payment due under a second compensation (e.g., an employment agreement or separation pay arrangement) is a substitute for lost incentive pay, thus negating the performance-based nature of an incentive arrangement under Section 162(m). It is a facts and circumstances test, at least in those situations where some compensation measured by reference to incentive pay is payable for a reason other than death, disability or change in control.
Pending clarification from the IRS, an employer will necessarily need to make a risk assessment where a severance payment is tied in some way to amounts paid or payable under a performance-based arrangement. A conservative approach may be to define any severance strictly by reference to base pay.