2008 was to be the year that companies and their tax advisors worked to get their nonqualified deferred-compensation plans in order to comply with the new requirements under Code Section 409A and the regulations thereunder. Recent positions from the Internal Revenue Service are, however, expanding the focus of compensation concerns for 2008 beyond deferred compensation to include deductions for current performance-based compensation.BACKGROUND
Code Sec. 162(m) limits the deductibility of compensation paid to certain executives of publicly traded corporations to $1 million per year. Compensation for this purpose is described as “applicable employee remuneration” and, under Code Sec. 162(m)(4)(c), does not include any remuneration payable solely on account of the attainment of one or more performance goals established using the criteria specified in the statute.
The regulations under Code Section 162 further specify that the qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals. The regulations further specify that compensation is not considered qualified performance-based compensation if the facts and circumstances indicate that the employee would receive all or part of the compensation regardless of whether the performance goal is attained. The regulations also provide that compensation will not fail to be qualified performance-based compensation merely because the plan allows the compensation to be payable upon death, disability, or change of ownership or control.
Many companies have established performance-based compensation for their top executives to avoid problems with deductions in excess of the $1 million limit. Many of these programs, however, permitted the executives to receive the performance-based compensation on termination or retirement, even if the performance goals had not been obtained.
Much of the reliance for these programs was placed on private letter rulings issued in 1999 and 2006, which stated that termination without cause or voluntary retirement were similar enough to death, disability or change of control to fall within the safe harbor. Although taxpayers other than the one to whom the ruling is issued are not entitled to rely on private letter rulings, those two private rulings were the only indication of the service’s position on the issue prior to 2008. In performing a FIN 48 analysis to determine if a position meets the “more likely than not standard,” tax practitioners are entitled to consider private letter rulings.
PLR 200804004
In January 2008, the IRS issued Private Letter Ruling 200804004. The IRS determined that the performance-based compensation was not deductible because the corporation’s plan provided that, if the executive’s employment would have been terminated by the company other than for cause or by the executive for good reason, any performance goal would be deemed to have been achieved.
The PLR caught many corporations and their tax advisors by surprise, and they immediately asked the IRS to clarify its position. The deductibility of this compensation would have an impact not only for tax purposes but also for accounting purposes under FIN 48 and for SEC purposes.
REV. RUL. 2008-13
In February 2008, the IRS clarified its position in Revenue Ruling 2008-13. Rather than back-tracking at all from the position taken in the PLR, the ruling affirmed the position taken in the PLR and expanded upon it. Under the revenue ruling, not only is a covered employee’s termination without “cause” or for “good reason” not a permissible payment event, but also voluntary retirement is not a permissible payment event.
Because of the impact on a large number of compensation plans and issues with respect to FIN 48 reporting, the IRS did provide for a deferred effective date. The holdings of the revenue ruling will not be applied to disallow a deduction for any compensation that otherwise satisfies the requirements for qualified performance-based compensation under Code Sec. 162(m)(4)(c) and Regulation Sec. 1.162-27(e) and that is paid under a plan, agreement or contract that has payment terms similar to the terms described in the revenue ruling if either the performance period for such compensation begins on or before Jan. 1, 2009, or the compensation is paid pursuant to the terms of an employment contract as in effect (without respect to future renewals or extension, including any that occur automatically absent further action of one or more of the parties) on Feb. 21, 2008.
Indications from the IRS are that it does not consider Rev. Rul. 2008-13 to be a policy shift, since the 1999 and 2006 private letter rulings were not official guidance, and the IRS has been considering its position on the issue ever since the 2006 ruling.
PLANNING
The result of Rev. Rul. 2008-13 is that 2008 will be a year not only for companies and their tax advisors to put their deferred-compensation plans into compliance with the new requirements under Code Sec. 409A, but also the year in which they will have to focus on putting their qualified performance-based compensation plans into compliance with the revenue ruling.
Although the IRS is stating that the safe harbor of death, disability or change of control does not now extend to termination without cause or voluntary retirement, indications are that the IRS is still leaving open the possibility that there may be circumstances other than death, disability or change of control that might be treated similarly.
Since changes to an employment contract might void the grandfather status provided by the revenue ruling, the question has arisen as to whether a change to comply with Code Sec. 409A would be a change for Rev. Rul. 2008-13 purposes. Indications from IRS personnel are that a Code Sec. 409A compliance change would not necessarily be a change that would bring a pre-existing employment contract under the ruling.
Although the IRS has emphasized that the revenue ruling is focused only on meeting performance goals and a company can still avoid disallowance of the deduction by deferring the payment of compensation until after the individual’s employment has ceased, proposed legislation before Congress would close that exception as well.
Companies and their tax advisors dealing with the deduction of executive compensation in excess of $1 million are increasingly being put into a tighter compliance box.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
