IRS Provides Transition Relief on Controversial Section 162(m) Issue

February 22, 2008

In reliance on the IRS’s view as expressed in private letter rulings in 1999 and 2006, many public companies have taken the position that amounts can qualify as “performance-based compensation” under section 162(m) of the Internal Revenue Code if the amounts are payable in connection with an executive’s termination of employment without “cause” or for “good reason” regardless of whether the performance goals have been satisfied.  However, in a controversial private letter ruling issued in late January, the IRS reversed its longstanding position that such provisions are permissible in performance-based arrangements, thereby calling into question deductions that many companies have taken in prior years and the attendant financial reporting, as well as the deductibility of amounts payable in the future under arrangements currently in place.

In response to a public outcry, the IRS issued Revenue Ruling 2008-13 on February 21.  The Revenue Ruling confirms that the IRS has changed its position on this issue, but provides important transition relief.  In general, the Revenue Ruling makes clear that the IRS will not challenge deductions taken in prior years under the approach approved in the earlier private letter rulings and will not apply the reasoning of the Revenue Ruling with respect to performance periods that begin on or before January 1, 2009 and in certain other limited circumstances.  Thus, the Revenue Ruling generally should protect against the risk that prior deductions will be disallowed (and the possibility that current accounting charges would have to be taken under FASB Interpretation 48 as a result of that risk). 


Code section 162(m) provides that compensation payable to a “covered employee” of a public company in excess of $1 million in any year, other than "performance-based" compensation, is nondeductible to the public company.  Covered employees generally include the public company’s chief executive officer and the three other most highly compensated executive officers other than the chief financial officer.  (See our June 8, 2007 client alert on these rules.)

Compensation must satisfy numerous requirements in order to qualify as performance-based.  Among other things, the compensation must be payable “solely” upon achievement of one or more shareholder-approved performance goals.  The IRS regulations under section 162(m) provide that compensation will not fail to be performance-based solely because it also is payable in connection with a change in control or the covered employee’s death or disability.

IRS private letter rulings in 1999 and 2006 provided that compensation also will not fail to be performance-based solely because it also is payable if the covered employee is terminated without cause, terminates for good reason or retires.  However, the IRS changed its position in PLR 200804004, holding that compensation will not be performance-based for purposes of Code section 162(m) if it is payable without regard to whether the performance goals were achieved in those events even if the employee does not terminate employment and the compensation ultimately is paid upon achievement of the performance goals.  In other words, because the amount could have been paid in connection with a without cause/good reason termination or voluntary retirement without regard to achievement of the performance goals, it was not payable “solely” upon achievement of the goals.

The ruling was very controversial.  In reliance on the rationale expressed in the earlier private letter rulings, many companies have provided for the payment of all or a portion of bonuses, vesting of performance-based restricted stock, etc., in the event of a without cause/good reason termination or voluntary retirement.  These promises can be in the plan itself, in the underlying award agreements, or in executive employment agreements.  For example, if an executive’s employment agreement provides for automatic payment of a pro rata target bonus upon a termination without cause, under the IRS’s new position, the bonus arrangement apparently is disqualified from qualifying as performance-based compensation in all circumstances.

IRS Provides Transition Relief

Following a barrage of complaints, the IRS issued Revenue Ruling 2008-13 on February 21.  The Ruling affirms the reasoning of the 2008 private letter ruling, holding that compensation cannot be performance-based if it is payable in the event of the covered employee’s without cause/good reason termination or voluntary retirement without regard to whether the performance goal is achieved.  However, the Revenue Ruling provides important transition relief.  In particular, the IRS will not enforce its new position in the following circumstances:

  • the period of service to which the performance goals relate begins on or before January 1, 2009; or

  • the compensation is paid pursuant to the terms of an employment agreement in effect on February 21, 2008 (without respect to future renewals or extensions, including renewals or extensions that occur automatically absent further action by the employee or the company).

Thus, the Revenue Ruling formally states the IRS’s new position in generally applicable guidance.  It would be high-risk to take a position contrary to the Revenue Ruling, especially because the IRS now focuses more audit resources on section 162(m) issues than in the past. 

However, the IRS has now provided reasonable transition relief.  As a general matter, it should be possible to design severance arrangements that do not run afoul of the IRS’s new position: 

  • Under the Revenue Ruling, performance-based characterization would continue to apply if, following a without cause/good reason termination or retirement, the bonuses or other awards intended to qualify as performance-based compensation (e.g., vesting of performance-based restricted stock) are paid only if the performance targets are actually achieved.  In other words, the payments are made only if and when the performance goals are actually achieved following termination of employment.
  • In addition, in certain circumstances, it may be permissible to pay out partial bonuses based on the achievement of performance targets through the date of the employee’s termination. 

  • Finally, with careful planning, it may be possible to design severance-type arrangements that closely replicate the desired economic terms but do not run afoul of the IRS’s new position.

Public companies should inventory all of their relevant incentive plans, arrangements and agreements that may be implicated by the Revenue Ruling.  For example, shareholder-approved bonus and equity incentive plans and the underlying award agreements should be reviewed and, if necessary, revised.  In addition, executive employment agreements should be analyzed to determine if any changes are necessary.  Because many employment agreements and other arrangements need to be revised by December 31, 2008 to comply with the rules applicable to deferred compensation under Section 409A of the Code (see our October 23, 2007 client alert), the 162(m) review can be performed in conjunction with the 409A review.  In that regard, one issue that will require careful analysis is whether an amendment to an employment agreement to bring it into compliance with Section 409A would disallow reliance on the section 162(m) transition rule summarized above.

In conclusion, the IRS’s new position with respect to the scope of "performance-based" compensation is troubling and arguably is inconsistent with the underlying Treasury Regulations.  However, the IRS has provided fairly generous transition relief, and public companies should act promptly to revise arrangements as necessary to preserve the deductibility of compensation payable to covered employees. 

Gibson, Dunn & Crutcher LLP

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn attorney with whom you work, or

Stephen W. Fackler (650-849-5385, [email protected]),
Charles F. Feldman (212-351-3908, [email protected]),
David West (213-229-7654, [email protected]),
David I. Schiller (214-698-3205, [email protected]),
Michael J. Collins (202-887-3551, [email protected]),
Sean Feller (213-229-7579, [email protected]),
Amber Busuttil Mullen (213-229-7023, [email protected]),
Jennifer Patel (202-887-3564, [email protected]), 
Chad Mead (214-698-3134, [email protected]), 
Jonathan Rosenblatt (650-849-5317, [email protected]), or
John C. Cook (202-887-3665, [email protected]). 

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