Performance-Based Compensation Exemption in Severance Protection Cases

By Herbes, Stephen F. | The CPA Journal, July 2008 | Go to article overview

Performance-Based Compensation Exemption in Severance Protection Cases


Herbes, Stephen F., The CPA Journal


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.

Private Letter Ruling Background

The company in PLR 200804004 had adopted a variety of incentive awards, including performance-share and performance-unit awards. These awards were intended to be qualified performance-based compensation under IRC section 162. The company entered into an employment contract with its executive which provided that if the executive's employment was terminated by the company other than for cause or by the executive for good reason, any performance goal under any outstanding performance-share or performance-unit awards would be deemed to have been achieved, and the awards would vest at termination to the extent the awards would have become vested in accordance with the executive's regular vesting schedule. …

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