Deadline Approaches to Bring Qualified Performance-Based Compensation into Compliance with Section 162(m)
Authors: Troutman Sanders Compensation & Employee Benefits Team
In 2008, the Internal Revenue Service (the “IRS”) issued Revenue Ruling 2008-13, which held that compensation arrangements that permit payment of performance-based compensation upon termination of the covered employee’s employment (regardless of whether the performance goals are achieved) will not constitute qualified performance-based compensation, which is exempt from the $1 million per year deduction limit under Section 162(m) of the Internal Revenue Code (the “Code”). Compensation arrangements covered by this Revenue Ruling generally should be amended by December 31, 2009 to avoid this adverse treatment.
Code Section 162(m) generally imposes a $1 million per year limit on the deduction a public company can take for aggregate compensation paid to each of its chief executive officer and three other highest compensated officers (other than the chief executive officer or the chief financial officer). However, compensation is exempt from the $1 million limit to the extent it constitutes “qualified performance-based compensation” under Code Section 162(m).
Qualified performance-based compensation must be paid solely on account of the attainment of one or more preestablished objective performance goals. Compensation does not satisfy this requirement if it can be paid regardless of whether the performance goals are achieved. Compensation does not fail to be qualified performance-based compensation, however, if the compensation can be paid upon the employee’s death or disability or a change of ownership or control (although compensation paid on those events prior to attainment of the performance goals will not constitute qualified performance-based compensation).
Prior to Revenue Ruling 2008-13, the IRS took the position that permitting payment of compensation upon termination of the employee’s employment (other than on death or disability), such as where the company terminates the employee without cause or the employee leaves for good reason, would be treated the same as payment upon death, disability or a change in ownership or control. In Revenue Ruling 2008-13, however, the IRS ruled that compensation payable to covered employees will not constitute qualified performance-based compensation under any circumstances where the arrangement permits the compensation to be paid when the employee retires, terminates employment for good reason or is terminated without cause (prior to attainment of the preestablished performance goals), even if the performance goals are achieved after payment is made or the employee remains employed and is paid in the ordinary course upon achievement of the performance goals. From its onset, any compensation payable under such an arrangement will not constitute “qualified performance-based compensation.”
To avoid this adverse result, affected compensation arrangements generally should be amended by December 31, 2009 for performance periods beginning in 2010. This includes amending the applicable bonus plan, employment agreement, severance plan or other arrangement that would permit the payment of the performance-based compensation upon termination of the covered employee’s employment (prior to attainment of the performance goals). Revenue Ruling 2008-13 does not apply to compensation payable with respect to performance periods beginning on or before January 1, 2009 or under an employment agreement in effect on February 21, 2008 (absent amendment or extension of the employment agreement, including for this purpose, built-in evergreen extensions).
The key to amending a compensation arrangement in light of the Revenue Ruling is to disconnect the payment to be made upon termination of the employee’s employment (other than on death or disability) from the amount payable upon achievement of the performance goals. For example, it would not be permissible to permit payment, upon termination of employment (other than on death or disability), of the employee’s target bonus (or some pro rated amount thereof) for the year of termination. To avoid running afoul of Revenue Ruling 2008-13, it will be very important to understand the facts and circumstances and to consider the historical results of the compensation arrangement at issue.
The following are three approaches public companies can take when amending arrangements in light of Revenue Ruling 2008-13:
- Payment could remain dependent on achievement of the preestablished performance goals after the employee terminates employment. The employee would only be entitled to payment after the performance period ended and if the performance objectives were achieved. In that case, payments can be prorated to take into account only the portion of the performance period during which the employee remained employed.
- The provision providing for payment upon termination could be deleted entirely and replaced with a provision that provides severance that is not tied to the performance-based compensation. For example, in lieu of payment of the employee’s target bonus for the year of termination, the employee might be able to receive an amount equal to the employee’s average annual bonus actually paid for the two years preceding termination (which could be prorated for the days during the year of termination in which the employee remained employed).
- The provision providing for payment upon termination could be deleted entirely and replaced with a provision that pays an additional multiple of base salary (provided the additional multiple is not the equivalent of the amount of the target bonus).
Public companies should be reviewing their employment and compensation agreements for Revenue Ruling 2008-13. The employee benefit attorneys at Troutman Sanders LLP would be delighted to assist with that process.
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