Advisory

Section 162(m) of the Internal Revenue Code limits a public company’s income tax deduction for compensation paid to the Chief Executive Officer and the three most highly compensated executive officers other than the Chief Executive Officer and the Chief Financial Officer. The annual tax deduction is generally capped at $1 million per officer, but “performance-based compensation” is exempt from the $1 million limit. Many public companies structure their incentive bonus plans and arrangements to take advantage of this exemption.

In Revenue Ruling 2008-13, the Internal Revenue Service ruled that an incentive pay arrangement providing payments upon termination of employment without cause or for good reason, or upon voluntary retirement, can lose the “performance-based compensation” exemption if such payments can be made without regard to whether performance goals are actually achieved. For example, if payments to be made on termination of employment are based on the officer’s “target” bonus rather than on what he or she would have earned based on actual performance, then the officer’s bonus arrangement is not exempt from the $1 million deduction limit—even if the officer remains employed and is actually paid a bonus based on actual performance results. For a full explanation of these rules, see our March 4, 2008 Client Alert, IRS 162(m) Ruling Requires Review of Incentive Pay Arrangements.

As noted in our prior Client Alert, the IRS delayed application of the Revenue Ruling to allow companies relying on its earlier guidance to make appropriate changes to their compensation arrangements. Specifically, no deduction will be disallowed solely because of the payment provisions noted above if (i) the applicable performance period began on or before January 1, 2009 or (ii) the amount is paid under an agreement in effect on February 21, 2008 (excluding renewals or extensions, whether affirmative or automatic).

Many public companies, however, will have to comply with the Revenue Ruling for incentive plans and arrangements having a 2010 performance period. Public companies should review their executive employment agreements and compensation plans and arrangements to determine whether any modifications are needed to ensure the deductibility of incentive pay. For calendar year plans, action by the board of directors or the appropriate committee may be necessary before January 1, 2010.