The IRS Throws Down the Gauntlet on Executive Comp

Attorneys are up in arms about an IRS ruling that nixes corporate deductions for executive compensation.

A recently-issued private letter ruling (LTR 200804004) signaled a radical change in the Internal Revenue Service’s position regarding the nature of certain compensation paid to executives. The ruling concluded that such compensation was not “qualified performance based compensation.” As a result, compensation paid to “covered employees” (in amounts exceeding $1 million), would not produce a tax deduction for the paying entity. (See The Willens Report, “Tax Talk From Washington, D.C.”, Volume 2 Issue 41, February 22, 2008, subscription required.)

The ruling was met with a firestorm of criticism, even outrage, by the pillars of our nation’s legal community — in excess of 90 law firms lodged protests with the I.R.S. in which they concluded that the agency’s position was unwise and, as a matter of law, incorrect. These protests fell on deaf ears: The I.R.S. has now “upped the ante.” It has “upgraded” the position it adopted in the letter to “published ruling” status. Thus, with the issuance of Revenue Rule 2008-13, the I.R.S. has unequivocally signaled its intentions with respect to this issue.

Rev. Rul. 2008-13 addresses the case of X Corp., which is, within the meaning of Section 162(m)(2) of the tax code, a “publicly-held” corporation. Here are the facts outlined in the ruling’s example: X Corp. maintains a “bonus plan” that pays a cash award to covered employees if the company’s earnings per share do not decrease during the calendar year, which is determined on December 31, 2009. Mr. E is a covered employee. Further, the company’s compensation committee established the EPS performance goal in writing, within 90 days after the performance goal period started. Also, in 2009, X Corp.’s EPS wound up increasing by some seven percent.

In the two scenarios presented by the I.R.S. for Rev. Rul. 2008-13, the bonus plan provides that the cash award will be paid if the performance goal is attained. Additionally, the plan states that even if the EPS goal is not attained, the cash award will be paid if Mr. E dies, becomes disabled, or if X Corp. experiences a change of ownership or control.

However, in the first scenario, the plan states that if the performance goal is not met, Mr. E. still receives his bonus pay if the executive is fired without cause or voluntarily terminates his employment “for good reason.” The second scenario differs slightly. It says that the award will be paid even if the performance goal is not attained if Mr. E “voluntarily retires” during the calendar year.

Both scenarios present a problem for companies that hope to claim a tax deduction related to executive compensation, here’s why.

Performance Based Compensation

Section 162(a)(1) of the tax code allows a deduction for “reasonable” compensation paid or incurred during the taxable year for personal services actually rendered. However, Sec. 162(m)(1) provides that in the case of a publicly-held corporation, no deduction is allowed for “applicable employee remuneration,” with respect to any “covered employee,” to the extent that the amount for the taxable year exceeds $1 million.

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