The Ruling is contrary to two earlier IRS private letter rulings (PLR 199949014, September 9, 1999; and PLR 200613012, December 5, 2005), each of which found that the inclusion of such a provision did not prevent an amount from qualifying as performance-based compensation.   In fact, PLR 200613012 even held that a provision guaranteeing the payment of a bonus due to a qualifying retirement did not prevent an award from qualifying as performance-based compensation. (We understand that the IRS is considering the revocation of these earlier rulings but has not yet done so.  It is likely that the IRS will consider an arrangement to be non-performance-based under Section 162(m) notwithstanding PLR 200613012 to the extent persons who are retirement eligible are guaranteed the bonus without regard to whether the performance goal is attained.)

The key existing regulation on this issue is the U.S. Department of Treasury regulation section 1.162-27(e)(2)(v), which provides that an amount will not qualify as performance-based “if the facts and circumstances indicate that the employee would receive all or a part of the compensation regardless of whether the performance goal is attained.  Thus, 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.” (Emphasis added.)  To illustrate this point, the regulation provides an example of an arrangement where a payment under a non-performance-based arrangement will be paid only upon the failure to attain the performance goals under an otherwise performance-based arrangement; not surprisingly, the regulation concludes that neither arrangement provides for performance-based compensation because the employee will receive the compensation regardless of whether the performance goals are attained. 

In contrast, the regulation provides that compensation does not fail to be qualified performance-based, however, “merely because the plan allows the compensation to be payable upon death, disability, or change of ownership or control, although compensation actually paid on account of these events prior to the attainment of performance goals will not satisfy the requirements . . .”   (Note that, under existing law, if a named executive officer terminates employment before the end of the year, the executive ceases to be subject to Code section 162(m).)

In PLR 199949014, the IRS concluded that involuntary and good reason terminations “are both involuntary terminations similar to terminations as a result of death, disability or change in control.”   Now, the Ruling finds the inclusion of these events as additional exceptions to the performance requirement causes the amounts not to be payable solely upon attainment of a performance goal.

Is the Ruling Correct?

We believe the Ruling is incorrect.   The mere presence of the involuntary and good reason termination provisions should not be treated as sufficient to indicate that the employee would absolutely receive the compensation in each year regardless of whether the performance goal is attained and regardless of whether a termination occurs.  Including these provisions means that the employee might receive the compensation if the performance goal is not attained—but only in those situations where a covered termination actually occurs.  The regulation requires that “the facts and circumstances indicate that the employee would receive all or a part of the compensation regardless of whether the performance goal is attained,” for the amount to fail to qualify as performance-based.  In fact, failure to attain the performance goal most often will result in no award being paid.  The possibility of an involuntary or good reason termination is relatively remote and the inclusion of a provision assuring payment under these circumstances should not make an award “only nominally or partially contingent on attaining a performance goal.”  (Cf. Reg. §§1.409A-1(d)(1) and 1.409A-1(n), which treat these payment events as substantial risks of forfeitures that prevent amounts subject to these contingencies from being vested, i.e., the involuntary or good reason termination is beyond the service provider’s control and something that is not certain to occur.) 

We believe that a better reading of Treasury regulation section 1.162-27(e)(2)(v) is to consider all of the relevant facts and circumstances, including the likelihood that an involuntary or good reason termination will occur, before concluding that a payment would be made “regardless of whether the performance goal is attained.”  In most cases, such an analysis should support the conclusion that payment of the award is dependent on the attainment of the performance goal.

Taxpayers must decide whether to deduct amounts that have already been paid, and amounts that the taxpayer is obligated to pay under arrangements currently in place, where such amounts otherwise qualify as performance-based compensation but are subject to a provision guaranteeing payment upon an involuntary or good reason termination.  We understand that some accounting and law firms have concluded that the Ruling prevents them from concluding that it is “more likely than not” that such an arrangement will meet the performance-based definition.  Based on the foregoing analysis, we believe the Ruling improperly applies the regulation, and the issuance of the Ruling to a single taxpayer (private letter rulings issued to other taxpayers have no precedential status,  Code § 6110(k)(3)), standing alone, should not prevent taxpayers from deducting amounts paid under such an arrangement.   In most situations, an analysis of the facts and circumstances should support the conclusion that it is not the case that the employee would receive the compensation if the performance goal is not attained.

What to Do Now

We recommend that companies give serious consideration to modifying their plans and/or agreements to comply with the Ruling on a going-forward basis.   Care must be taken in making these changes.  For example, the IRS may attempt to couple a severance arrangement, obligating a company to pay all or a pro rata portion of an otherwise performance-based bonus at target upon an involuntary or good reason termination, with an otherwise qualifying performance-based arrangement, thereby causing the performance-based arrangement to fail.  Because target bonuses payable on involuntary or good reason terminations are usually a multiple of the executive’s base pay (e.g., “executive’s target bonus shall be 150 percent/200 percent of his or her base salary as adjusted from time to time . . .”), one approach might be to provide that, upon a covered termination, the executive will not receive a bonus payment but rather an additional multiple of his or her salary.

On a related issue, the definition of “performance-based compensation” under Treasury regulation section 1.409A(e)(1) provides that compensation may be performance-based even though it could be paid without satisfying the performance criteria due to the service provider’s death, disability or change in control event.   We understand that many companies, in reliance on the Code section 162(m) ruling position previously taken by the IRS, have expanded the list of payment events to include involuntary or good reason terminations.  Although it is conceivable that the IRS will come to a different conclusion on this issue for purposes of Code Section 409A, we recommend that the exceptions for payment of performance-based compensation be limited to those specified in Treasury regulation section 1.409A-1(e)(1).

Each taxpayer’s situation and plan provisions are different; for example, the involuntary termination and good reason provisions may be in the plan document themselves and potentially affect all named executive officers or those provisions may be contained solely in one individual’s employment agreement.   Therefore, before taking any action, careful consideration to these rulings and IRS positions is warranted. 

© 2008 McDermott Will & Emery