Performance-Based Compensation Exemption in Severance Protection Cases

CPA Journal, The,
 Jul 2008
 by Herbes, Stephen F

IRS Reverses Its Position

In
an abrupt about-face from its position in earlier private letter
rulings, the IRS ruled, in Private Letter Ruling (PLR) 200804004
(January 25, 2008) and Revenue Ruling 2008-13 (February 21, 2008), that
performance-based compensation that is required under a compensation
plan to be paid to an executive when employment is terminated without
cause or terminated by the executive for good reason is not eligible
for the performance-based compensation exemption under IRC section
162(m).

IRC Section 162(m) and Executive Compensation

Generally, IRC section 162(a)(1) allows a company to deduct ordinary
and necessary expenses incurred in carrying on its trade or business.
In the case of publicly held corporations, however, IRC section 162(m)
limits the deduction of certain employee compensation expenses to $1
million annually per "covered" employee. The limit in IRC section
162(m)(1) generally applies to the company's CEO and four highest-paid
executive officers. Performance-based compensation is not subject to
the $1 million limit if it meets certain requirements, however.

In 1995, the IRS issued regulations providing, in part, that
performance-based compensation, in order to qualify for the exemption
from the $1 million limit, must be paid solely on account of the
attainment of one or more pre-established, objective performance goals
[Treasury Regulations section 1.162-27(e)(2)(i)]. If the
performance-based compensation is only nominally or partially
contingent on attaining a performance goal, then none of the
compensation is considered performance-based [Treasury Regulations
section 1.162-27(e)(2)(v)]. The regulations provide a notable
exception: Compensation does not cease to be performance-based merely
because the plan allows it to be paid upon death, disability, or change
of ownership or control [Treasury Regulations section 1.62-27(e)(2)].

Prior to PLR 200804004 and Revenue Ruling 2008-13, the IRS had taken
the position that termination by a company without cause and
termination by an executive for good reason were both involuntary
terminations, similar to terminations as a result of death, disability,
or change in control [see PLR 199949014 (Dec. 13, 1999) and PLR
200613012 (March 31, 2006)]. Therefore, the IRS had ruled that
performance-based compensation received by an executive when he was
terminated by the company without cause or terminated his employment
for good reason-provided the compensation met the other requirements of
IRC section 162-was fully deductible. In January 2008, the IRS, without
explanation, reversed its ear lier position by issuing PLR 200804004.

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