Daily Tax Update - February 25, 2008

IRS TAKES ADVERSE POSITION ON WHAT CONSTITUTES PERFORMANCE BASED COMPENSATION IN REVENUE RULING; PROVIDES TRANSITION RELIEF:  Last week, in Revenue Ruling 2008-13, the Internal Revenue Service confirmed its conclusion that was made public in 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,” or if the executive terminates voluntarily. (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.) Unlike the private letter ruling issued earlier, this revenue ruling would apply to all taxpayers.

  • Under Situation (1) set forth in the revenue ruling, the executive’s employment agreement stated that a performance award would be paid upon termination of employment by the company without cause or by the executive for “good reason,” regardless of whether the performance goals were met. Situation (2) describes a performance award where the award would be paid even if the performance goal is not attained if the employee terminates voluntarily. The IRS indicated that the awards would not be performance-based in either situation (even if there was no termination and the award was in fact based on performance) because “termination of employment,” “termination for cause,” or “voluntary termination” was not described as a permissible payment event under the performance-based requirements in Treas. Reg. § 1.162-27(e)(2)(v). 
  • The IRS did provide some transition relief. The holdings in the ruling will not be applied to disallow a deduction for any compensation that otherwise satisfies the requirements for performance-based compensation under Section 162(m) if either (i) the performance period for such compensation begins on or before January 1, 2009, or (ii) the compensation is paid pursuant to the terms of an employment agreement in effect (without respect to future renewals or extensions, including renewals or extensions that occur automatically absent further action of one of more of the parities to the contract) on February 21, 2008.
  • As most publicly traded companies provide performance-based compensation to their executives, this revenue ruling could have far reaching effects on the deductibility of compensation by those companies. We recommend that publicly traded clients review not only their bonus and incentive plans, but also any employment agreements that guarantee a certain level of bonus or incentive payments in the event of termination or that provide payments on termination “in lieu of” bonus or incentive payments. There are several different approaches that may be used to avoid the loss of deductions, but companies should begin reviewing these approaches well before the end of the transition period provided by the IRS.   
  • If you have any questions, contact Ellen Kohn at ekohn@steptoe.com; Anne Moran at amoran@steptoe.com; Don Wellington at dwellington@steptoe.com; Catherine Wilkinson at cwilkinson@steptoe.com, or the Steptoe lawyer with whom you work.

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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