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No Performance-Based Exception to 162(m) $1 Million Deduction Limit for Compensation Payable upon Termination for Cause or Good Reason -- IRS Reverses Course

    Client Alerts
  • February 01, 2008

Publicly-traded companies with incentive plans or arrangements for top executives may need to take a close look at plan provisions and related agreements in light of a new IRS private letter ruling (“PLR”) that may have implications for arrangements intended to qualify for the performance-based compensation exception to the $1 million compensation deduction limit under Section 162(m) of the Internal Revenue Code.  In the PLR, an executive had been granted performance share and performance unit awards under an incentive plan, all of which were intended to be qualified performance-based compensation not subject to the deduction limit.  Separately, the employer and the executive entered into an employment agreement that provided that if the employer terminated the executive’s employment other than for “cause,” or if the executive terminated employment for “good reason,” performance goals under any outstanding performance share or performance unit awards would be deemed achieved at target. (Time-based vesting of the awards also would accelerate by two years).


Citing its own regulations, the IRS noted that “qualified performance-based compensation must be paid solely on account of the attainment of one or more pre-established, objective performance goals” and that “if the payment of compensation under a grant or award is only nominally or partially contingent on attaining a performance goal, none of the compensation payable under the grant or award will be considered performance-based.”  It also noted that the regulations 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 in such case would not qualify as performance-based compensation).  Taking these last provisions at face value, the IRS ruled that allowing compensation to be payable on termination without cause or for good reason did not meet the exception for compensation payable on death, disability or change in control since the compensation was not payable solely upon attainment of a performance goal. Even if paid upon attaining a performance goal, the payment would not be considered performance-based compensation.


Interestingly, the IRS had ruled in a 1999 PLR (and somewhat similarly in a 2006 PLR) that terminations without cause or for good reason were “both involuntary terminations similar to terminations as a result of death, disability or change in control” such that restricted share awards under the plan at issue in that PLR were considered performance-based, even though the compensation could have been paid upon termination of the executive by the employer without cause or by the executive for good reason.


Although PLRs apply only to the taxpayer that requested the ruling and cannot be used or cited as precedent, they often are viewed as guidance regarding the IRS position on various tax matters.   This recent PLR indicates that the IRS has apparently shifted its view on this performance-based compensation issue.  Publicly-traded companies should review their incentive plans and other agreements to assure that payments intended to be performance-based and covered by the 162(m) exception will not otherwise be made in the event of an executive’s termination without cause or for good reason.