Client Alert

Section 162(m): IRS' Reversal of Position on Performance-Based Compensation for Top Executives Raises Significant Issues For Public Companies

February 2008

The Internal Revenue Service has reversed its position on the treatment of certain performance-based compensation under Internal Revenue Code Section 162(m). The reversal calls into question the deductibility of performance-based compensation for top executives where the plan or employment contract provides that the performance goal is deemed to be met, in the event of a termination of employment without cause or for good reason. The IRS position is that the existence of such a plan or contract provision results in a disallowed deduction even if the top executive continues to work for the company.

Since it is not yet clear whether and to what extent the new IRS position will be applied retroactively, public companies may need to take the new IRS position into account immediately in preparing financial accounting statements and may need to revise disclosure documents.

The new IRS position may cause public companies to seek to redesign certain incentive pay plans and to revise employment, severance and change of control agreements with top executives.

The business and legal communities are understandably quite concerned about the effect the new IRS position will have on public companies and have begun to communicate their concerns to Treasury and the IRS. Our firm, together with a number of other law firms, has submitted a request to the IRS to reconsider its new position and to apply any change in position prospectively only.

In response to widespread concern from the business and legal community, we understand that the IRS intends to issue additional guidance to clarify its new position before the end of this month. While the IRS may not reverse its new position, we hope that the IRS will clarify that its position should be applied prospectively only, which may offer relief from some of the more immediate adverse tax, accounting and disclosure consequences of this new position.

Section 162(m) Limits Tax Deduction for Top Executive's Compensation

Section 162(m) limits to $1 million per year the amount a public company may deduct for compensation paid to each of its CEO and its three other most highly paid officers (excluding the CFO). Performance-based compensation that meets certain requirements is exempt from the $1 million limit.

Previous IRS Position on Severance Payments

Regulations under Section 162(m) provide that compensation can be treated as performance-based compensation exempt from Section 162(m) even if it is payable upon death, disability or change of ownership or control without regard to whether the performance goals are satisfied. Private letter rulings issued by the IRS in 1999 and 2006 extended this exemption to compensation that is payable upon the termination of employment without cause or for good reason without regard to whether performance goals are satisfied.

Although private letter rulings are binding only upon the taxpayers to whom the rulings are issued, they clarify the IRS position on certain issues. As a result, for years, companies have relied upon the two private letter rulings to support the deductibility of performance-based pay that is also payable upon termination without cause or for good reason.

New IRS Position on Severance Payments

In a surprising reversal of its earlier position on severance payments, the IRS recently issued a private letter ruling concluding that employment contracts and plans generally do not satisfy the Section 162(m) performance-based compensation requirements where the plan or contracts provide for a deemed satisfaction of performance goals in the event of termination without cause or for good reason.

While private letter rulings may reflect the IRS view of the law, they do not necessarily represent law. Nevertheless, public companies may wish to begin to consider their potential exposure in the event the IRS position is sustained.

Accounting and Disclosure Implications

If the new IRS position is correct and the IRS does not apply it on a prospective basis only, public companies that treated such payments as deductible for tax purposes may be required to reflect the new IRS position in preparing their financial accounting statements. We understand that some accounting firms are taking the position that tax reserves must be established and deferred tax assets must be revised to take into account the new IRS position because the prior position that such payments are tax deductible does not meet the "more likely than not" standard under FIN 48. This position is causing significant concern among public companies and their accounting firms. Companies may also be required to revise their SEC and other public disclosures related to Section 162(m) matters to reflect the new IRS position.

Next Steps

The IRS is expected to issue new guidance on this issue before the end of February. It is anticipated that the IRS will announce that any new rule would be applied prospectively only, although there is no guarantee this will happen. Under the circumstances, companies may wish to refrain from taking definitive action related to such matters until the new guidance addressing these issues is released.

Companies may wish, however, to begin to do the following:

• communicate the new IRS position and the potential issues associated with that position to the appropriate people at the company;
• consult with outside consultants, legal counsel and accountants on the implications of the new IRS position and with their regular outside accountants on their current views on the FIN 48 issues;
• review existing incentive pay plans and employment, severance and change of control agreements (the issue arises for performance-based cash bonuses, restricted stock and performance unit plans but not for stock options and stock appreciation rights); and
• develop an action plan and time schedule to amend existing incentive pay plans and executive agreements, if necessary, and obtain necessary approvals for the amendments (generally under the new IRS position, payment can be made upon termination of employment without cause or for good reason only if performance goals are met; alternatively, companies may consider providing enhanced severance in lieu of payments tied to performance goals).