IRS Issues More §162(m) Guidance
By Joseph Adams, Esq., Robert Feldgarden, Esq., Andrew Liazos,
Esq., and Stephen Pavlick,
Esq.
McDermott Will & Emery LLP, Washington, DC, Chicago, IL, Boston, MA
On February 21, 2008, the IRS issued Rev. Rul. 2008-13, 2008-10
I.R.B. 518 (3/10/2008) (the Revenue Ruling) to provide additional
guidance on the application of §162(m). The Revenue Ruling is
available at
http://www.irs.gov/pub/irs-drop/rr-08-13.pdf.
The IRS issued the Revenue Ruling in response to the uproar caused
when the IRS issued PLR 200804004 (the PLR), which created substantial
uncertainty regarding what constitutes “performance-based
compensation” under §162(m). A previous McDermott article
analyzing the PLR is available at
http://www.mwe.com/info/news/ots0208c.htm.
This commentary briefly summarizes what the Revenue Ruling does and
does not change, and discusses possible next
steps.
What the Revenue Ruling Does Not Change
The Revenue Ruling does not change the new approach to §162(m)
taken by the IRS in the PLR. In short, amounts otherwise qualifying as
performance-based compensation will fail to so qualify where the
amounts may be paid upon an executive's involuntary termination
without cause, voluntary termination for “good reason,” or
retirement, even if the performance goal is not attained. This
negative result applies in every year in which the arrangement is in
place--not just in the year in which the executive terminates
employment--and applies even if the compensation is paid because the
performance goals are achieved.
On the one hand, the Revenue Ruling's holding is not surprising,
because the author of the PLR stated informally that, contrary to
usual practice, the PLR was briefed to the executive level of the
IRS--meaning that the new IRS position taken in the PLR was a
conscious agency decision rather than simply the result of a different
reviewer. On the other hand, the IRS unfortunately appears to have
flatly rejected calls by more than 90 leading law firms (including
McDermott Will & Emery) and two former chairs of the ABA Tax
Section's Employee Benefits Committee for a formal review of its
position in the PLR with the opportunity for public comment. Many
executive compensation experts find it difficult to believe that
contract provisions merely making it possible that an employee
might receive some compensation (a) if a performance goal is
not attained, and (b) if a covered termination actually occurs, meet
the test in the regulation that “the facts and circumstances
indicate that the employee would receive all or a part of the
compensation regardless of whether the performance goal is
attained” in every year.
What the Revenue Ruling Does Change
Although there continue to be concerns over whether the technical
analysis underlying the PLR is correct, much of the uproar over the
PLR is related to the potential financial statement impact.
Specifically, several large accounting firms took the position that
the new PLR made it difficult for publicly held companies to
assert--in FIN 48 parlance--that a tax deduction was “more
likely than not” if the company's plan did not comply with the
new PLR. Because companies could not have anticipated the IRS's sudden
change in position, many plans did not comply with the new PLR, and
accountants began questioning whether their clients needed to
retroactively reverse the tax deductions for open years, which could
trigger a current accounting charge and affect book income, earnings
per share, etc.
The author of the PLR has acknowledged that the IRS did not
consider the financial and tax accounting ramifications of the PLR,
and the Revenue Ruling attempts to eliminate those financial and tax
accounting concerns for prior years by applying the new IRS position
prospectively. Specifically, the Revenue Ruling provides that it will
not be applied to disallow a deduction for any compensation that
otherwise qualifies as “performance-based compensation”
that is paid under a plan, agreement or contract that has payment
terms similar to the terms described in the Revenue Ruling if either
of the following is true:
1.
The performance period (i.e., the period of service to which the
performance goal applicable to such compensation relates) for such
compensation begins on or before January 1, 2009.
2.
The compensation is paid pursuant to the terms of an employment
contract in effect on February 21, 2008, and that is not extended or
renewed, including through an “evergreen”
provision.
What to Do Now
The transition relief means that there is no need for immediate
action to amend plans or employment contracts. Instead, public
companies may want to continue to monitor this issue for further
developments. One issue that the IRS has indicated it is considering
(but did not address in the Revenue Ruling) is whether there is still
an issue if a plan pays awards to terminating employees based on
actual rather than target performance, but does not prorate the award
for an employee who terminates during the middle of the year.
While waiting for future IRS guidance, public companies may wish to
catalog which of their arrangements might be adversely affected by the
Revenue Ruling (i.e., arrangements that are intended to qualify for
the performance-based compensation exception to §162(m) but where
amounts will be paid at target levels rather than actual performance
levels upon an involuntary termination, voluntary termination for good
reason or retirement). Next, public companies will need to determine
what types of changes (e.g., (1) paying at the lesser of target or
actual performance following the end of the performance period; (2)
paying a predetermined amount that is not deemed to be a substitute
for performance-based compensation; or (3) not guaranteeing any
payment) will be acceptable to affected constituencies (e.g.,
executives, shareholders). Finally, to the extent a proposed
modification to an arrangement requires shareholder approval,
companies will want to give themselves plenty of lead time to
implement the changes.
For more information, in the Tax Management Portfolios, see
Brisendine, Veal & Drigotas, 385 T.M., Deferred Compensation
Arrangements, and in Tax Practice Series, see ¶5710,
Nonqualified Deferred Compensation.
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