• IRS Issues Ruling Impacting the $1 Million Compensation Deductibility Cap for Public Company Executives
  • March 14, 2008
  • Law Firm: Bingham McCutchen LLP - Boston Office
  • Late last month, the Internal Revenue Service released a private letter ruling that would make the performance-based compensation exception to the $1 million deductibility cap of Section 162(m) of the Internal Revenue Code unavailable where the relevant performance goals are deemed met without regard to performance upon the executive's involuntary or "good reason" employment termination. The ruling represents a major shift in the IRS position on this issue and has caused considerable consternation in the public company executive compensation world. 

    Generally, Section 162(m) of the Code provides that compensation in excess of $1 million paid by a public company in a taxable year to certain executives is not deductible unless it qualifies as "performance-based compensation." Performance-based compensation is compensation that is payable solely on account of the attainment of pre-established and objective performance goals which have been approved by shareholders. Under a regulatory exception, an arrangement may provide for the deemed satisfaction of performance goals upon the executive's death or disability or upon a change in control of the company, and the compensation will still qualify as performance-based compensation (though any payments actually made in these circumstances would not be deductible because the compensation would not have been paid solely on attainment of performance goals). Prior IRS private letter rulings had extended this exception to arrangements where performance goals are deemed met on terminations of employment without cause or for good reason. 

    The recent ruling, PLR 200804004, involved an employment agreement between a public company and an executive that provided for equity awards under a performance-based incentive compensation plan. Under the employment agreement, the performance goals would be deemed satisfied and the award paid if the executive's employment was terminated by the company without cause or by the executive for good reason. In a reversal of its prior position, the IRS concluded that payments under the arrangement could never be considered performance-based compensation under Section 162(m), even if the executive did not terminate employment and in fact satisfied the performance goals, as payment could be made under certain circumstances regardless of whether the performance goal was attained.

    Although private letter rulings have no value as precedent, they do provide insight into the IRS's interpretation of a statute. Because executive employment agreements frequently contain provisions deeming performance goals met in the event of certain terminations of employment, including termination without cause, good reason resignation or retirement at or after early or normal retirement age, public companies are concerned not only that many of the arrangements they have designed to meet the performance-based compensation now no longer qualify but also that they may need to revisit tax returns and financial statements for past fiscal years. We understand that the IRS is in the process of drafting guidance which will provide relief of some sort (possibly making IRS's ruling position prospective only) and which it anticipates issuing by the end of February. The IRS has also informally cautioned taxpayers not to make any drastic changes to executive compensation arrangements before seeing the guidance. However, public companies should now be reviewing employment agreements and executive incentive plan documents to assess the possible impact of the ruling.