Monday, March 03, 2008

IRS STRICTLY CONSTRUES EXCESS COMPENSATION LIMITS

Code Section 162(m)(1) denies an income tax deduction to publicly traded corporations to the extent compensation paid to certain key employees ("covered employees") exceeds $1 million. However, compensation that is contingent on performance goals being met will not be counted as compensation subject to this limitation. To use this exception, the goals have to be set by a committee of the board of directors which is comprised only of outside directors, and the payment arrangement must be approved by the shareholders.

To qualify, the payments can be made ONLY upon fulfillment of the goals. However, the plan may allow for payment without fulfillment of the goals upon the death, disability, or change of ownership or control of the company. Such a payment will be subject to the $1 million limit because the goals were not met - however, the presence of provisions in the plan allowing such payments will not act to disqualify payments made when the goals are otherwise met.

What happens if under the compensation plan an employee can be paid the performance compensation without reaching the goals, not just for death, disability or change in ownership, but also or instead upon termination by the company without cause or for good reason? The IRS has ruled that any payment under the plan will be subject to the $1 million limit (even if the employee is not terminated and actually satisfies the performance goals). Similarly, if the plan allows for payment due to a voluntary resignation from employment without regard to whether the performance goals are reached, all payments under the plan will also be subject to the $1 million limit regardless of whether the goals are reached.

This is a change from prior private letter rulings issued by the IRS. The IRS indicates that exceptions for termination without cause or voluntary resignation defeat the policy of the performance based pay exceptions to the $1 million limit by allowing payment without the requisite performance - indeed, in circumstances where there is a very good chance the goals will not be or have not been met. Therefore, to discourage such exceptions, it will disqualify all payments under such plans from the performance pay exception, even when the performance goals are met.

Rev.Rul. 2008-13

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