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In a recent private letter ruling (PLR 200804004) and a companion published ruling (Rev. Rul. 2008-13), the Internal Revenue Service has reversed its prior position with respect to the structuring of executive compensation arrangements. In this recent ruling, the IRS concluded that performance-based compensation arrangements maintained by public companies that also allow for the payment of compensation in the event of the company’s involuntary termination of an executive’s employment without cause or the termination of employment by an executive for good reason or upon retirement, will cause the entire compensation arrangement to fail to qualify as “performance-based compensation” exempt from the $1 million cap on the deductibility of executive compensation contained in Code Section 162(m). In an effort to avoid significant hardship to both employers and executives who would be adversely impacted by the retroactive application of this new position, the IRS has granted transitional relief.

The recently published rulings involve an incentive compensation plan that provides a performance bonus to a participating executive in the event specified performance goals are achieved. At issue in the rulings is a provision in the plan that further provides that the performance bonus will also be paid, without regard to whether the performance goals are attained, if the executive’s employment is involuntarily terminated either by the employer without cause (as defined in the employment agreement) or by the executive for good reason (also defined in the employment agreement) or upon normal retirement.

In the two recent rulings, and contrary to the position it had taken in earlier private rulings, the IRS concluded that the inclusion of these plan provisions relating to the termination of employment will cause all payments under a plan, including payments under a plan that are made to an executive who remains employed and the performance goals are attained, to fail to qualify as “performance-based compensation” under Code Section 162(m)(4)(C).

Section 162(a)(1) of the code allows a deduction for all of the ordinary and necessary expenses paid or incurred during the taxable year by a taxpayer in carrying on any trade or business, including reasonable salaries or other compensation paid for personal services actually rendered. Section 162(m)(1) provides that in a case of any publicly held corporation, no deduction is allowed for compensation payable with respect to certain specified high-level executives (generally, the chief executive officer and the next three highest paid executives, excluding the chief financial officer) to the extent that the amount of compensation paid to such an executive for the taxable year exceeds $1 million.

Section 162(m)(4)(C) provides an exception to the $1 million cap on deductible compensation for “performance based compensation.” For this purpose, performance-based compensation is defined as compensation payable solely on account of the attainment of one or more performance goals, but only if: (i) the performance goals are determined by a compensation committee of the board of directors of the employer which is comprised solely of two or more outside directors, (ii) the material terms under which the compensation is to be paid, including the performance goals, are disclosed to shareholders and approved by a majority of the shareholders in a separate shareholder vote before payment of the compensation; and (iii) before any payment of such compensation, the compensation committee certifies that the performance goals and other material terms were satisfied.

The regulations promulgated under Section 162(m) provide that compensation will not be deemed performance-based compensation if the facts and circumstances indicate that the compensation would be paid regardless of whether the performance goals are attained. However, the regulations further provide that compensation does not fail to be performance-based compensation merely because the plan allows the compensation to be payable upon death, disability or change of ownership or control, although compensation actually paid on account of these events prior to attainment of the performance goals would not constitute performance-based compensation.

In two earlier private rulings (PLR 199949014 and PLR 200613012), the IRS concluded that compensation paid under a plan that would otherwise constitute performance-based compensation under Section 162(m)(4)(C) would not fail to constitute performance-based compensation merely because the plan provided that compensation could also be paid upon the termination of the executive’s employment by the employer without cause, by the executive for good reason or upon the executive’s retirement. The apparent rationale of these rulings was that termination without cause, termination for good reason or termination on account of retirement were “involuntary” events, like death, disability or change of control, and payment on account of such an event should not cause the plan to be viewed as providing for the payment of benefits without the attainment of the performance goals.

It is important to note that these two earlier rulings did not conclude that compensation payable upon death, disability, involuntary termination by the employer without cause, by the executive for good reason or upon retirement, would be considered “performance-based compensation” and therefore fully deductible pursuant to the exception contained in Section 162(m)(4)(C). Rather, these earlier rulings merely concluded that the inclusion of these provisions would not taint the deductibility of compensation actually paid in the ordinary course upon the attainment of the performance goals.

Based upon the IRS position expressed in PLR 199949014 and PLR 200613012, many public companies have implemented performance-based compensation plans, which contain provisions similar to the provisions sanctioned by the rulings (i.e., allowing for payments upon involuntary termination, for good reason or upon retirement). Accordingly, by reversing its position with respect to these early payment provisions, the IRS has, in effect, retroactively jeopardized the intended tax effect of these existing plans. As a consequence, the potential loss of the deductibility of the compensation payable pursuant to such plans could, in addition to requiring the payment of significantly more taxes, require a restatement of an impacted company’s financial statements.

Shortly after the issuance of PLR 200804004 (released Jan. 25, 2008), a letter signed by 90 prominent law firms was delivered to the acting commissioner of the IRS requesting reconsideration of the IRS position and guidance with respect to the potentially retroactive impact of the new IRS position. A number of industry groups also made similar appeals. In Revenue Ruling 2008-13, the IRS reaffirmed its change of position but also issued transitional relief. Under this ruling, the new IRS position with respect to performance-based compensation will not be applied to any plan, agreement or contract that has payment terms similar to the terms described in the new revenue rulings if either (i) the performance period for such compensation begins on or before Jan. 1, 2009, or (ii) the compensation is paid pursuant to the terms of an employment contract as in effect (without respect to future renewals or extensions) on Feb. 21, 2008.

As a result of the new position taken by the IRS with respect to performance-based compensation, new compensation plans will need to be structured to remove the possibility of payment in the event of involuntary termination, termination for good reason or retirement without attainment of stated performance goals. Moreover, existing compensation plans maintained by public companies will need to be examined to determine their eligibility for transitional relief.

Mark L. Silow is the administrative partner and chief operating officer of Fox Rothschild. Silow formerly was chairman of the firm’s tax and estates department. Silow’s work involves a broad range of commercial and tax matters including business and tax planning, corporate acquisitions and dispositions, real estate transactions, estate planning and employee benefits.

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