NEW RULING CREATES IMPORTANT CHANGES TO PERFORMANCE-BASED COMPENSATION RULES
By: Leslie B. Wilkinson
May 9, 2008

Generally, companies are allowed to take tax deductions for reasonable compensation paid to employees. One exception, however, is found in Section 162(m) of the Internal Revenue Code.  Under that law, a public company may not deduct annual compensation in excess of $1 million paid to certain highly compensated executives.  Fortunately, deductions for "performance-based "compensation" are not subject to the $1 million limitation.  Performance based compensation includes any arrangement, however denominated, that requires payment only upon attaining one or more pre-established performance goals.  Performance shares and performance units are common examples of performance based compensation. 

It is very common for performance based compensation to be structured to permit payment where the executive's employment is terminated by the company "without cause" or by the executive for "good reason," even where the applicable performance goals are not attained at the time of termination.  It has been the long-standing position of the IRS that such arrangements constitute performance-based compensation and are not subject to the $1 million limitation on deductibility.  In a private letter ruling released in late 2007,however, the IRS reversed its position and held that such an arrangement would not constitute performance-based compensation.  That policy change was publicly echoed earlier this year in Revenue Ruling 2008-13. 

The IRS will apply its new position only to plans with performance periods beginning after January 1, 2009 or employment agreements effective after February 21, 2008.  Such plans or agreements that provide for payment of performance-based compensation upon an executive's termination without cause or by the executive for good reason even where the applicable performance goals are not attained at the time of termination will be subject to the $1 million limitation on deductibility.  Plans or agreements that provide for performance-based compensation upon the executive's death or disability or a change in control of the corporation will not be affected by the ruling.