Sec. 162(m) governs the deductibility of certain excessive employee compensation. In recent months the IRS has issued Rev. Rul. 2008-13 and Rev. Rul. 2008-32, providing for additional clarification related to certain components of the performance-based compensation rules contained within Sec. 162(m)(4)(C) and Regs. Sec. 1.162-27(e). Corporations not paying careful attention to the application of these recent rulings can be subject to unexpected negative results.
What Is Sec. 162(m)?Sec. 162(m) disallows a tax deduction to corporations for compensation paid to any “covered employee” in excess of $1 million for the tax year. This section applies only to publicly held corporations registered under Section 12 of the Securities Exchange Act of 1934. As interpreted by Notice 2007-49, issued in June 2007, a covered employee under Sec. 162(m)(3) refers to a publicly held corporation’s chief executive officer, or an individual acting in that capacity, and the three other highest-paid officers whose compensation must be reported to shareholders under SEC regulations, but not including the chief financial officer (unless the CFO was also acting as the CEO or the CFO held another position that was among the top three highest-paid officers other than the CEO).
Commissions based on income generated from individual performance and other performance-based compensation are excepted from the $1 million limitation. Specifically, performance-based compensation is excluded for purposes of Sec. 162(m) if:
- The compensation is payable upon the realization of one or more performance goals (Sec. 162(m)(4)(C));
- The performance goals are determined by a compensation committee of the corporation’s board of directors, which is composed solely of two or more outside directors (Sec. 162(m)(4)(C)(i));
- The material terms under which the compensation is paid, including performance goals, are disclosed to shareholders and approved by a majority in a separate shareholder vote before the compensation is actually paid (Sec. 162(m)(4)(C)(ii)); and
- Before payment of the compensation, the compensation committee confirms or certifies that the performance goals and any other material terms were in fact satisfied (Sec. 162(m)(4)(C)(iii)).
Rev. Rul. 2008-13Rev. Rul. 2008-13, issued on February 21, 2008, affirms the IRS’s position in Letter Ruling 200804004 that compensation will not qualify as performance based under Sec. 162(m) if all or part of the compensation can be paid to a covered employee upon his or her involuntary termination by the corporation without cause, voluntary termination for good reason, or voluntary retirement, even if the performance-based goals and other terms of the plan are satisfied and the covered employee continues employment with the corporation.
This ruling runs contrary to Letter Rulings 199949014 and 200613012. Letter Ruling 199949014 concluded that compensation paid under a performance-based stock award plan qualifies as performance based compensation under Sec. 162(m) even though the plan provided for accelerated vesting upon the covered employee’s termination without cause or for good reason. Similarly, Letter Ruling 200613012 provided that compensation paid under a performance-based plan qualified under Sec. 162(m) even though the plan provided for accelerated payment upon a covered employee’s retirement.
Letter Rulings 199949014 and 200613012 expanded on the exceptions included in Regs. Sec. 1.162-27(e)(2)(v), which provides that compensation does not fail to qualify as performance-based compensation simply because the plan or agreement allows for compensation to be paid upon death, disability, or a change in ownership or control of the company. It also provides that compensation would not qualify as performance based if the plan or agreement indicated that the covered employee would receive full or partial payment regardless of whether the performance goal was met.
In contrast to these prior letter rulings, Rev. Rul. 2008-13 applies a more literal reading of Sec. 162(m) and Regs. Sec. 1.162-27. As such, plans or agreements providing for payment of compensation for conditions (i.e., termination without cause, voluntary termination for good reason, and voluntary retirement) other than death, disability, or a change in control of the company will disqualify all compensation paid under that particular plan or agreement as performance based under Sec. 162(m)(4)(C). Thus, such compensation will be subject to the $1 million deduction limitation, even though the event that would accelerate the payment may not actually occur and the performance goals established under the plan are otherwise met.
Realizing that many corporations drafted compensation arrangements, plans, and employment contracts using prior IRS guidance, Rev. Rul. 2008-13 is applied prospectively. For compensation that otherwise qualifies as performance based under Sec. 162(m)(4)(C) and Regs. Sec. 1.162-27(e), payments under the plan will be excluded as performance-based compensation if either: (1) the performance period begins on or before January 1, 2009, or (2) the compensation is paid pursuant to the terms of a plan or agreement as in effect, not including renewals or extensions, on February 21, 2008.
Rev. Rul. 2008-32Rev. Rul. 2008-32, issued on July 7, 2008, provides additional guidance in determining whether an individual qualifies as an outside director for purposes of Sec. 162(m)(4)(C)(i). The ruling concludes that an individual does not qualify as an outside director of a corporation if the individual has served as the corporation’s interim CEO in regular and continued service with the full authority vested in that office.
Sec. 162(m)(4)(C)(i) provides one of the qualifications that must be satisfied in order for compensation to be qualified as performance based. It states that performance goals must be determined by a compensation committee of the corporation’s board of directors that is composed solely of two or more outside directors. Regs. Sec. 1.162-27(e)(3)(i) provides that an outside director of a publicly held corporation:
1. Must not be a current employee;
2. Must not be a former employee who receives compensation for prior services during the tax year;
3. Has not been an officer; and
4. Does not receive compensation, directly or indirectly, in any capacity other than as a director.
Regs. Sec. 1.162-27(e)(3)(vii) further states that an officer is an administrative executive who is or was in regular and continued service; it does not include an individual employed for a single and special transaction or an individual with the title of officer but not the authority of an officer.
The circumstances of each case must be assessed individually, but generally a director who has served as interim CEO will not qualify as an outside director for purposes of Sec. 162(m)(4)(C)(i). As such, any plan or agreement approved by the board of directors, while a former interim CEO sits on the board, cannot qualify as a performance-based compensation plan, and any payments under the plan will be subject to the $1 million deduction limitation under Sec. 162(m).
ConclusionRecent IRS positions have further complicated the rules under Sec. 162(m). Publicly held corporations need to be aware of these developments to avoid unexpected negative results. Current compensation arrangements, plans, and employment contracts, including renewal and extension provisions, should be reviewed to ensure the included language provides for the most advantageous tax treatment. Corporations also should make sure that directors on the compensation committee are in fact considered outside directors for purposes of Sec. 162(m).
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.