Recent Rulings Could Affect Deductibility of Performance-based Compensation

Recent Rulings Could Affect Deductibility of Performance-based Compensation

By James D. Slivanya, CPA, and Kevin F. Powers, CPA

The Internal Revenue Service (IRS) recently issued two revenue rulings that clarify the rules relating to the deductibility of performance-based compensation under Internal Revenue Code (IRC) Section 162(m). Authors James Slivanya and Kevin Powers warn that financial institutions failing to pay careful attention to the application of recent rulings could see costly consequences.

Section 162(m) of the IRC limits a publicly held corporation’s tax deduction for compensation paid to covered employees to $1 million each per tax year. “Covered employees” generally refers to a corporation’s chief executive officer (CEO), or an individual acting in that capacity, and the three other highest-paid officers whose compensation must be reported to shareholders under Securities and Exchange Commission regulations. Covered employees do not include the chief financial officer (CFO), unless the CFO was also acting as the CEO or the CFO held another position that was among the top three highest-paid officers other than the CEO.

Performance-based compensation, however, is excluded from the $1 million limitation if:

The compensation is payable upon the realization of one or more performance goals;
The performance goals are determined by a compensation committee of the corporation’s board of directors, composed solely of two or more outside directors;
The material terms under which the compensation is paid, including performance goals, are disclosed to shareholders and approved by a majority in a separate shareholder vote before the compensation is actually paid; and
The compensation committee confirms or certifies that the performance goals and any other material terms were satisfied before payment of the compensation.

Revenue Ruling 2008-13
Revenue Ruling 2008-13, issued on Feb. 21, 2008, affirms the IRS’s position in Letter Ruling 200804004 that compensation will not qualify as performance-based under Section 162(m) if all or part of the compensation can be paid to a covered employee upon his or her involuntary termination by the corporation without cause, voluntary termination for good reason, or voluntary retirement. It does not qualify even if the performance-based goals and other terms of the plan are satisfied and the covered employee continues employment with the corporation.

This ruling runs contrary to previous letter rulings that expanded the exceptions included in IRS Regulations Section 1.162-27(e)(2)(v), which provides that compensation does not fail to qualify as performance-based simply because the plan or agreement allows for compensation to be paid upon death, disability, or a change in ownership or control of the company. It also provides that compensation would not qualify as performance-based if the plan or agreement indicates that the covered employee would receive full or partial payment regardless of whether performance-based goals were met.

Revenue Ruling 2008-13 applies a more literal reading of Section 162(m) and related regulations. Plans or agreements providing for payment of compensation for conditions other than death, disability, or a change in control of the company (that is, termination without cause, voluntary termination for good reason, and voluntary retirement) will disqualify all compensation paid under that particular plan or agreement as performance-based. The compensation will be subject to the $1 million deduction limitation, even though the event that accelerates the payment might not actually occur and the performance goals are otherwise met.

Realizing that many corporations drafted compensation arrangements, plans, and employment contracts using prior IRS guidance, the IRS will apply Revenue Ruling 2008-13 prospectively. For compensation that otherwise qualifies as performance-based, payments under the plan will be excluded as performance-based compensation if either: (1) the performance period begins on or before Jan. 1, 2009; or (2) the compensation is paid pursuant to the terms of a plan or agreement as in effect, not including renewals or extensions, on Feb. 21, 2008.

Revenue Ruling 2008-32
Revenue Ruling 2008-32, issued on July 7, 2008, provides guidance in determining whether an individual qualifies as an outside director for purposes of excluding performance-based compensation under Section 162(m). It concludes that an individual does not qualify as an outside director of a corporation if he or she has served as the corporation’s interim CEO in regular and continued service with the full authority vested in that office.

Section 162(m) requires that for compensation to qualify as performance-based, the performance goals must be determined by a compensation committee of the corporation’s board of directors composed solely of two or more outside directors. An outside director:

Must not be a current employee;
Must not be a former employee who receives compensation for prior services during the taxable year;
Must not have been an officer; and
Must not receive compensation, directly or indirectly, in any capacity other than as a director.

Furthermore, an officer is an administrative executive who is or was in regular and continued service. The classification does not include an individual employed for a single and special transaction or an individual with the title but not the authority of officer.

The circumstances of each case must be assessed individually, but generally a director who has served as interim CEO will not qualify as an outside director. Therefore any plan or agreement approved by the board of directors while a former interim CEO sits on the board cannot qualify as a performance-based compensation plan. Any payments under the plan will be subject to the $1 million deduction limitation under Section 162(m).

Going Forward
The latest IRS positions have complicated the rules under Section 162(m). To avoid unexpected negative results, publicly held corporations must be aware of these developments. They should review current compensation arrangements, plans, and employment contracts – including renewal and extension provisions – to ensure the language therein provides for the most advantageous tax treatment. Corporations should also make certain that directors on the compensation committee are in fact outside directors for purposes of Section 162(m).

Jim Slivanya is a senior manager with Crowe Horwath LLP in the Columbus, Ohio, office. He can be reached at 614.280.5256 or jim.slivanya@crowehorwath.com.

Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or kevin.powers@crowehorwath.com.

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