IRS Revenue Ruling 2008-13 (available here), issued on Feb. 21, 2008, could disqualify many payments that were intended to be performance-based compensation under 162(m). This ruling follows on the heels of a January ruling (PLR 200804004) that modified a long-standing IRS position on permissible performance award provisions. It affirms that the IRS is embracing a new position and provides transitional relief. The relief applies to employment agreements entered into before Feb. 21, 2008 and for awards with performance periods that begin before Jan. 1, 2009. As discussed below, many publicly traded companies will have a shorter transition period. Section 162(m) of the Internal Revenue Code limits deductibility for compensation paid to executive officers of publicly traded companies to $1 million annually. This limit does not apply to "performance-based compensation". Nearly all publicly traded companies rely on this exception to preserve deductibility of compensation items like cash bonuses and restricted stock. To qualify under 162(m), the payment or vesting of the award must be conditioned on achievement of performance goals. Achievement must be uncertain at the time the award is made. As an exception requirement, IRS regulations permit an award to pay on death, disability or change in control without regard to performance.
Many executive agreements provide for payment - without regard to performance - if an executive's employment is terminated without "cause," upon resignation for "good reason" or retirement. The IRS permitted these additional conditions in private letter rulings issued in 1999 and 2006. The new Revenue Ruling states that these termination exceptions are not permissible in a performance-based agreement. It doesn't matter that the payment would be made following termination of employment when the person is no longer an executive subject to 162(m). The inclusion of this exception disqualifies the award at the time it is made.
For now, it appears that death, disability and change in control should be the only exceptions to achieving the performance goals. The IRS distinguished these involuntary events to other involuntary terminations. Being fired without cause or resigning for good reason are involuntary but can happen when an executive is performing poorly; retirement is voluntary. The IRS reasoned that these conditions are antithetical to the performance-based pay standards required by 162(m).
What To Do Now
This ruling applies to performance bonus awards, stock incentives like restricted stock or RSUs that have performance-based vesting requirements, and similar awards. The ruling includes helpful transitional relief. Awards with a "performance period" that begins before 2009 will not be affected by this change. Employment agreements that were in place before Feb. 21, 2008 are "grandfathered" until they are renewed or extended.
These are the priorities for approaching this issue during the transition period:
- Modify the terms of all employment agreements that are under negotiation and provide an exception to the performance requirements due to termination for cause, good reason or retirement.
- Review all executive agreements for automatic renewals or other extensions. Many agreements have automatic evergreen renewals that will eliminate the grandfather treatment.
- Discuss this change with the compensation committee and executives in preparation for future negotiations. It will certainly be a change from the expectations of many executives of their termination rights.
- Review awards and agreements with securities counsel. Many changes to executive compensation arrangements require disclosure on Form 8-K or Form 10-Q. Changes in proxy disclosures may also be needed.
- Prepare to amend performance compensation plans and change the terms of future performance awards. Shareholder approval may be needed for such amendments.
Some companies have begun the review process already due to the January private ruling letter. It is already apparent that this review can be tedious for some. Language that could disqualify the award is not always obvious on the surface. For example, severance agreements that pay a multiple of "base salary and bonus" may violate the Revenue Ruling. There are usually acceptable modifications to "fix" the problem but it requires time for negotiations and deliberations. In other words, the transitional period may be much shorter than the IRS intended.
January Ruling Prompted Request For Relief
According to comments made by its author, the Revenue Ruling was issued in response to a loud outcry from executive compensation professionals. It was issued on an extraordinarily fast track. After the January private letter ruling, practitioners contacted the IRS and submitted written requests, including a letter from the two past chairs of the American Bar Association Tax Section and another from a group of 90 law firms (including Waller Lansden). The most alarming feature of the January ruling was the untenable accounting position in which companies found themselves due to the peculiar standards of FIN 48. Without the relief provided in the Revenue Ruling, some companies would have faced the prospect of an earnings charge due to their past reliance on the 1999 and 2006 rulings. Revenue Ruling 2008-13 presumably eliminates this concern under FIN 48.
Additional discussion regarding Revenue Ruling 2008-13 and 162(m) is available on our Executive Compensation blog at this link.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
