Daily Tax Update - February 11, 2008

IRS TAKES ADVERSE POSITION ON WHAT CONSTITUTES PERFORMANCE BASED COMPENSATION FOR PURPOSES OF SECTION 162(m) DUE TO TERMS OF EMPLOYMENT AGREEMENT; THIS POSITION COULD HAVE IMPLICATIONS BEYOND SECTION 162(m):  Last week, the Internal Revenue Service made public a private letter ruling (PLR 200804004) stating that compensation payable to an executive under an incentive arrangement will not be treated as “performance-based” and therefore exempt from Section 162(m) of the Internal Revenue Code if that compensation is also payable without regard to performance when the executive is terminated from employment or terminates for “good reason.” (Section 162(m) limits the deduction for amounts paid to executives of public companies to $1 million, but “performance-based compensation” as defined in the regulations is excluded from this limit.)

  • Under the facts of the ruling, the executive’s employment agreement stated that upon termination of employment by the company without cause or by the executive for “good reason,” the performance goals under any performance share or unit awards would be deemed to be met. The IRS indicated that the existence of this provision would make the agreement non-performance based even if, in fact, the executive was not terminated and the pay was based on company performance. The rationale is that because the target compensation could be payable regardless of actual performance, this would violate the requirement that performance-based compensation be paid “solely on account of the attainment of one or more preestablished, objective performance goals.”
  • Although a private letter ruling technically only applies to the taxpayer who receives it, the position taken in this ruling seems to suggest a change in the IRS’ views on what constitutes performance-based compensation. The position taken differs from at least two other private letter rulings (PLR 200613012 and PLR 199949014), where the IRS took the position that compensation was performance based if paid upon the attainment of  performance goals, notwithstanding the fact that the compensation could have been paid upon involuntary termination. It is not known whether the IRS will revoke the earlier two PLRs in light of this ruling.
  • Some taxpayers have expressed their opinions that PLR 200804004 is not correctly decided based on an analysis of the requirements of performance-based compensation under the regulations. Nonetheless, employers that are public companies should review how their incentive plans and employment and severance agreements deal with the payment of incentive compensation upon severance or retirement and whether modification may be appropriate in light of this ruling. Note that Section 162(m) can affect both tax and SEC reporting obligations for public companies. In addition, under Section 409A of the Code, this ruling may have implications for all companies, private as well as public, that take advantage of the special election rules for performance-based plans under Section 409A.
  • The PLR can be accessed via: http://www.steptoe.com/attachment.html/3297.pdf

INTERNAL REVENUE SERVICE - CIRCULAR 230 DISCLOSURE:
As provided for in Treasury regulations, advice (if any) relating to federal taxes that is contained in this communication (including attachments) is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any plan or arrangement addressed herein.

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