IRS Changes Its Position on Performance-Based Compensation for $1 Million Compensation Limit

Under Sec. 162(m), a public company may not deduct compensation paid to certain employees in excess of $1 million. However, compensation that qualifies as performance-based compensation is not subject to the $1 million limit. In Rev. Rul. 2008-13, the IRS ruled that an incentive plan is not performance-based compensation because it allows payments upon involuntary termination without cause by the employer, voluntary termination by the employee with good reason, or voluntary retirement regardless of whether the performance goals are met. Thus, all payments under the plan are subject to the $1 million limit, including payments made when the performance criteria have been met.

According to the IRS, the payment provisions run afoul of Regs. Sec. 1.162-27(e)(2)(v), which provides generally that compensation is not performance based if an employee would receive all or part of the compensation regardless of whether the performance goal is attained. The regulation makes specific exceptions to this general rule for payments made upon death, disability, or a change in control.

The revenue ruling and a recent similar letter ruling (200804004) are a surprise to many employers because they run contrary to two prior rulings (Letter Rulings 199949014 and 200613012). In those rulings, the IRS held that compensation was still performance based even though the payments could be made upon involuntary termination without cause or voluntary termination for good reason.

Because many employers have adopted compensation programs with provisions similar to those set forth in the prior letter rulings, the holdings in the revenue ruling will not apply to qualified performance-based compensation for performance periods beginning on or before January 1, 2009, or for compensation paid pursuant to an employment contract as in effect on February 21, 2008. (“Performance period” means the period of service to which the performance goal applicable to the compensation relates.)

Employers who relied on the prior rulings will now need to change their compensation programs on a prospective basis to eliminate payments upon involuntary termination without cause, voluntary termination for good reason, or voluntary retirement or, if no changes are made to the compensation program, reevaluate their tax position with respect to the deductibility of the compensation. These employers will also need to consider the impact of these tax positions on their financial statements.