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.
In general, a covered employee is the publicly-held corporation’s Chief Executive Officer and the four other highest compensated officers of the corporation. Often this foursome includes the CFO. Under Section 162(m)(4)(C),
applicable employee remuneration does not include any compensation payable solely based on the attainment of one or more performance goals. Furthermore, the tax code — specifically Reg. Sec. 1.162-27(e)(1) — provides that “qualified performance based compensation” (deductible without regard to the $1 million cap generally applicable to a covered employee’s compensation) is compensation that meets the requirements of another section, namely, Reg. Sec. 1.162-27(e)(2) through (5).
In this regard, one subsection (Reg. Sec. 1.162-27(e)(2)(v)) provides that compensation does not satisfy the requirements of a previous subsection (Reg. Sec. 1.162-27(e)(2)) if “the facts indicate that the executive would receive all or part of the compensation regardless of whether the performance goal is attained.”
Moreover, the regulations also provide that if the payment of compensation is only “nominally or partially” contingent on attaining a performance goal, none of the compensation payable under a grant or award will be considered performance based.
On the other hand, the regulations provide that compensation does not fail to be qualified performance based compensation merely because the plan allows the compensation to be payable upon death, disability, or a change of ownership or control, a so-called “permissible payment event”*.
With these principles in mind, the ruling observes (as did the I.R.S. letter on which the ruling is based) that a covered employee’s termination “without cause” or “for good reason” is not listed as a permissible payment event under Reg. Sec. 1.162-27(e)(2)(v). More important, termination without cause may occur, or a good reason may arise, as a result of Mr. E’s poor performance and his failure to meet the performance goal.
Accordingly, the ruling concludes that the compensation is not remuneration payable solely on account of attainment of performance goals, and therefore, the compensation payable under the bonus plan is applicable employee remuneration to which the provisions of Sec. 162(m) are fully and unremittingly applicable. (Note that compensation may become payable as a result of events and circumstances that do not entail the attainment of performance goals, and which are not considered permissible payment events.)
A similar conclusion was reached with respect to the second scenario described in the ruling. An executive’s “voluntary retirement” is not listed as a permissible payment event. Moreover, because retirement is a voluntary action within the control of the covered employee, the compensation payable as a result of the action is not remuneration payable solely on account of the attainment of one or more performance goals. As a result, in each case, the cash award did not constitute qualified performance based compensation and, therefore, X Corp. was denied a tax deduction in the manner provided for in Sec. 162(m)(1).
It appears that many (if not most) corporations have adopted incentive plans for their covered employees that parallel the plan addressed in Rev. Rul. 2008-13. As a result, to ease the sting of the ruling’s conclusions, the I.R.S. provides for a generous transition rule. Thus, the holdings of Rev. Rul. 2008-13 will not be applied to disallow a corporate deduction for cases that are similar to the two scenarios if: (1) the “performance period” for such compensation begins on or before January 1, 2009; or (2) the compensation is paid pursuant to the terms of an employment contract “as in effect” on February 21, 2008.
This issue may well become the subject of litigation. Judging by the nature of the protests lodged by the legal community, it would appear that attorneys firmly believes that the case to be made against the I.R.S.’s conception of the parameters of performance based compensation is a compelling one. Indeed, it seems safe to say that the debate will not end merely because the I.R.S. has chosen to “formalize” its views with respect to this matter through the issuance of a revenue ruling.
Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a regular tax column for CFO.com.
*Compensation actually paid on account of these permissible payment events prior to the attainment of the performance goals does not satisfy the requirements of Reg. Sec. 1.162-27(e)(2) and, therefore, constitutes applicable employee remuneration.