In the world of executive compensation, Internal Revenue Code Section 162(m) limits the deduction that a publicly held corporation can claim in any tax year for compensation paid a top executive to $1 million, with several exceptions. Two recent Internal Revenue Service rulings explored these exceptions.In Rev. Rul. 2008-13, the IRS reversed its position regarding the availability of the performance-based exception from the million-dollar cap if payment may be made in the event of involuntary termination, even if the performance standards discussed below are met. Rev. Rul. 2008-32 deals with whether a director can be an outside director for Sec. 162(m) purposes after briefly serving as an interim chief executive.


The $1 million cap does not apply with respect to "qualified performance-based compensation." In order to be treated as such, the compensation must be paid solely on account of the attainment of one or more pre-established performance goals, which must be established by a compensation committee comprised solely of two or more outside directors.

Performance-based compensation must be fully and genuinely contingent upon satisfaction of the performance requirements. Thus, if the facts and circumstances suggest that the compensation is payable regardless of whether the performance requirements are satisfied or if the performance requirements are so insubstantial as to be only nominal hurdles, the compensation does not qualify even if the requirements are, in fact, satisfied.

In assessing compliance with this particular provision, compensation that may be payable under any other agreement is considered, including the payment of severance under a non-performance-related employment or other agreement.

However, most significantly for purposes of considering Rev. Rul. 2008-13, the $1 million cap regulations permit a waiver of the performance requirements in the event of the employee's death, disability or a change in control.

Company deductions attributable to the exercise of stock options and stock appreciation rights, or SARs, qualify as performance-based compensation, and thus are not subject to the cap, if certain requirements under the regulations regarding the maximum number of shares that may be granted and compensation are met.

If the requirements are met, options and SARs satisfy the definition of performance-based compensation even if they are not contingent upon the satisfaction of other pre-established performance goals.

Note that grants of restricted stock or restricted stock units (which are rights to receive stock at some designated point in the future) do not qualify for the special exception and would not qualify as performance-based compensation unless either the number of shares awarded or the vesting of those awards is based upon the satisfaction of objective, pre-established goals.

In addition to granting any performance-based compensation, including options and SARs, the compensation committee must also determine the payment amount pursuant to satisfaction of performance-based standards consistent with the terms of the plan. To be an outside director, the director must not be a current or former employee, or former officer of the public corporation, or receive remuneration in any capacity other than as a director.

For these purposes, an officer is "an administrative executive who is or was in regular and continuous service," and "the determination of whether an individual is or was an officer is based on all of the facts and circumstances in the particular case, including without limitation the source of the individual's authority, the term for which the individual is elected or appointed, and the nature and extent of the individual's duties." The regulations indicate that the term "officer" implies continuity and does not include a person employed for a special or single purpose.

The $1 million cap regulations provide that an award may permit payment regardless of whether the performance requirements are satisfied, if payment is possible on account of death, disability or change of control. The key point is that the mere possibility of payment under these limited circumstances does not disqualify from the exception to the cap any bonus amount actually payable because the performance requirements are, in fact, met.

Presumably, the IRS permits this deviation from the strict performance-based prerequisite because the circumstances permitting such deviation are limited, clear and outside the control of an employee. In private letter rulings, the IRS informally expanded the death, disability and change-of-control list to include payment in the event of an involuntary termination of employment without regard to whether the performance requirements are met. This had made sense because, like death, disability or change of control, involuntary termination is typically limited, clear and beyond the control of the employee.

Practitioners were justifiably surprised when, in early 2008, the IRS issued a private ruling reversing its position with regard to involuntary termination: If payment is merely possible in the event of involuntary termination without regard to satisfaction of the performance requirements, any bonus payable because the performance standards are met is subject to the million-dollar cap (assuming all other provisions regarding the cap apply), even if no involuntary termination occurs.

In Rev. Rul. 2008-13, the IRS formally confirmed its position in the 2008 private ruling by concluding that a company's cash bonus award is subject to the cap. The ruling addresses an award payable to a covered employee if the company's earnings per share as of Dec. 31, 2009, do not decrease. The ruling assumes this performance goal is set by the compensation committee within the first 90 days of the performance period and that the performance goal is, in fact, met, because actual EPS increases by 7 percent.

The ruling considers payment in two situations in addition to satisfaction of the performance requirements. In the first, the plan provides that even if the performance requirement is not met, the award will be payable in the event of death, disability, change of control and involuntary termination without cause and voluntary termination for "good reason."

In the second case, the award is payable, even if the performance goal is not attained, if the covered employee voluntarily retires (in addition to death, disability or change of control).

In both cases, the IRS concluded that the compensation does not qualify as performance-based compensation and is therefore subject, along with salary (and perhaps other pay), to the $1 million cap.

As suggested by the IRS in Rev. Rul. 2008-13, the IRS's previous liberal interpretation regarding involuntary termination was ironic and illogical in the sense that involuntary termination, often sparked by a failure of performance, could actually be the basis under that prior position for payment pursuant to an exception based solely on performance.


The impact of Rev. Rul. 2008-13 is likely to be tricky in practice. First, it should be noted that it provides transition guidance limiting its application to performance periods beginning on or after Jan. 1, 2009, and excluding from its application compensation paid pursuant to an employment contract in effect as of Feb. 21, 2008 (not including future renewals or extensions, even if automatic). Note that the transition relief also applies to voluntary termination in connection with retirement.

Aside from the transition relief, Section 162(m)-compliant performance plans may no longer permit payment in the case of involuntary termination if the performance requirements are not met. However, while plans often prohibit any payment whatsoever to employees who voluntarily quit prior to the end of a performance period, it is possible that the plan could provide for at least pro rata payment of an award based on the involuntary termination date, assuming that the performance standards are, in fact, met. Other objective partial-payment possibilities can also be considered.

Unfortunately, in practice there are often several agreements providing post-termination payments. For example, severance, change-of-control or employment agreements often have blanket payment of partial or full bonuses in the event of certain events, most especially in the event of involuntary termination. These agreements may or may not pre-date a participation in a performance plan, but often do not take into account (and indeed, prior to Rev. Rul. 2008-13, did not have to take into account) the effect of the provisions on a Section 162(m)-compliant plan. Also, provisions drafted in connection with a change in control often do not consider the impact on such plans.

Given the surprise developments of Rev. Rul. 2008-13 and the Jan. 1, 2009, transition effective date, as practitioners work to address compliance with Section 409A by the Jan. 1, 2009, expiration of the Section 409A transition relief, those who represent public companies need also to consider the ramifications of all executive compensation arrangements that are intended as performance-based compensation excepted from the million-dollar cap.

Meanwhile, Rev. Rul. 2008-32 addresses the fairly common circumstance in which, following the unexpected departure of a chief executive, a member of the board steps in as interim CEO. The question is not whether the interim CEO is a covered employee (in the assumed facts, the interim CEO resigns as a CEO on Dec. 8, 2008 - presumably prior to the end of the tax year) but rather, whether the interim CEO may continue as an outside director for purposes of approving options and determining performance-based compensation criteria.

As noted, an outside director may not be a former officer of the public company. An officer is determined not based on title, but on the basis of actual authority. Although individuals hired for special or single projects can be excluded from the definition of an officer, the IRS noted that the interim CEO was not hired for special purposes or for a limited purpose. Instead, the CEO was hired indefinitely with all the powers applicable to a CEO.

Thus, even though the interim CEO performed as such for less than a year until a replacement was named, such person was an officer and is thus not qualified thereafter to be an outsider director for Sec. 162(m) purposes.

P. Garth Gartrell, CPA, Esq., is a shareholder in the Silicon Valley office of Greenberg Traurig LLP.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access