IRS Change of Position On Performance-Based Compensation Causes Concern

A recent Internal Revenue Service (IRS) private letter ruling under Section 162(m) of the Internal Revenue Code has cast in doubt a compensation arrangement that is commonly used by public companies.  This ruling conflicts with several earlier IRS rulings.

Section 162(m) of the Internal Revenue Code generally disallows a tax deduction related to compensation in excess of $1 million per year provided by a public company to certain of its executive officers.  The IRS regulations under Section 162(m), however, provide details related to an exception to the $1 million limitation for qualified performance-based compensation.  This exception for qualified performance-based compensation requires that compensation be payable only if applicable performance goals are achieved. The IRS regulations expressly provide that this requirement is not violated merely because payments may be made without regard to actual performance in the event the participant dies or becomes disabled, or if the public company undergoes a change of ownership or control. 

Previous IRS guidance released in private letter rulings in 1999 and 2006 expanded the events (i.e., in addition to death, disability or a change of control) that could entitle a plan participant to payment without regard to whether applicable performance goals were achieved.  In the 1999 and 2006 private letter rulings, the IRS reasoned that arrangements providing for the payment of compensation upon an executive officer’s termination of employment without cause or upon an executive officer’s resignation for good reason (in each case, an “Involuntary Termination”) were similar to arrangements permitting payment upon death, disability or a change in control, and that deductions would not be disallowed under Section 162(m) if compensation were paid as a result of such Involuntary Terminations.

In a private letter ruling released on January 25, 2008, the IRS changed its position from the guidance released in the earlier private letter rulings.  In this recent letter, the IRS informed the taxpayer that an award intended to satisfy the qualified performance-based compensation exception would not qualify as such because the compensation could be paid upon the officer’s Involuntary Termination, without regard to whether the performance goals were attained.  As a result, the IRS ruled that any compensation paid under the arrangement, even if the compensation was paid upon the actual achievement of the performance goals, would not qualify under the qualified performance-based compensation exception.   

While a private letter ruling may be relied upon only by the taxpayer to whom it was issued, many public companies have relied upon the IRS guidance set forth in the 1999 and 2006 private letter rulings in designing their compensation arrangements and negotiating employment agreements with  executive officers.  Accordingly, the recent private letter ruling may affect the compensation arrangements currently in place at many public companies.  It is not known whether the IRS will challenge deductions taken in reliance on the 1999 and 2006 private letter rulings, although informal statements made by IRS personnel suggest that the IRS may withdraw the prior letter rulings.  

Public companies operating compensation arrangements designed to qualify as performance-based compensation, and which are impacted by severance arrangements triggered upon an Involuntary Termination, should review these arrangements in light of this recent private letter ruling.

The ruling does not address, and should have no implications for, qualification of typical public company stock options as performance-based compensation under Section 162(m).

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